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What is Profitability index in discounted cash flow technique in capital budgeting?

Finance ManagementAccountingAcademic Content

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%

YearCash flow
Discounted Cash flow
11,50,0001,50,000 / (1.10)1,36,363.64
23,00,0003,00,000 / (1.10)^22,47,933.88
35,00,0005,00,000 / (1.10)^33,75,657.40
42,00,0002,00,000 / (1.10)^41,36,602.69
56,00,0006,00,000 / (1.10)^53,72,552.79
65,00,0005,00,000 / (1.10)^62,82,236.97
71,00,0001,00,000 / (1.10)^751,315.81



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.

raja
Mandalika
Updated on 11-Aug-2020 11:33:51

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