The profitability index is the present value of the projects future cash flows divided by the projects initial cash outflow.
The formula for PI is given by-
PV of cash inflows
Initial cash outlay
The decision rule for profitability index is that it should be greater than one. If the index is greater than one then the project should be accepted else it should be rejected.
Profitability index is more or less the same as NPV. It's just a different way of presentation. While calculation NPV we subtract the initial cash outlay, while in this case we divide the initial cash outlay by the PV of all cash inflows. If the NPV is positive then the PI will be greater than 1 and if the NPV is negative then the PI will be less than 1. There can never be contradicting results between NPV and PI.
Calculate the PI for each of the following project and comment which one should be accepted, the discount rate to be used is 10%.
Year Project A Project B Project C
0 -3000 -3000 -3000
1 1500 300 1000
2 1200 900 1000
900 1200 1000
4 300 1800 1000
PI Project A = 3236.45/3000 = 1.078
PI Project B = 3147.53/3000 = 1.049
PI Project C = 3169.86/3000 = 1.056
According to Profitability Index criteria Project A must be chosen because it has got the highest PI.
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