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What is Profitability index in discounted cash flow technique in capital budgeting?
Profitability index (PI) measures the ratio between the present value of future cash flow and the initial investment. This is used for ranking investment projects and value created per unit of investment. PI is also known as profit investment ratio (PIR) or the value investment ratio (VIR).
PI >1 (project generates value and the company may go with the project).
PI=1 (project breaks even and the company is indifferent between proceeding or not proceeding with the project).
PI<1 (project destroys value and the company should not proceed with the project).
Formula
Profitability index =$\frac{present\:value\:of\:future\:cash\:flows}{initial\:investment}$
$$=\frac{(Net\:present\:value\:+\:initial\:investment)}{initial\:investment}$$
Example
Initial investment = Rs. 15,00,000/-, discounted rate = 10%
| Year | Cash flow | Discounted Cash flow | |
|---|---|---|---|
| 1 | 1,50,000 | 1,50,000 / (1.10) | 1,36,363.64 |
| 2 | 3,00,000 | 3,00,000 / (1.10)^2 | 2,47,933.88 |
| 3 | 5,00,000 | 5,00,000 / (1.10)^3 | 3,75,657.40 |
| 4 | 2,00,000 | 2,00,000 / (1.10)^4 | 1,36,602.69 |
| 5 | 6,00,000 | 6,00,000 / (1.10)^5 | 3,72,552.79 |
| 6 | 5,00,000 | 5,00,000 / (1.10)^6 | 2,82,236.97 |
| 7 | 1,00,000 | 1,00,000 / (1.10)^7 | 51,315.81 |
| 16,02,663.18 |
PV of future cash flows$\Rightarrow\frac{1602663.18}{1500000} \Rightarrow$1.0684 (>1)
Therefore, project generates value and the company may go with the project.
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