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# Pi

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### Pi

1. 1. Profitability Index An Investment Appraisal Technique
2. 2. Definition Profitability index is an investment appraisaltechnique calculated by dividing the presentvalue of future cash flows of a project by theinitial investment required for the project.
3. 3. Formula Present value of Future Cash FlowProfitability Index= Initial Investment Required Present Value = 1+ initial Investment Required
4. 4. ExplanationProfitability index is actually a modification ofthe net present value method. While presentvalue is an absolute measure (i.e. it gives asthe total dollar figure for a project), theprofitability index is a relative measure (i.e. itgives as the figure as a ratio).
5. 5. Decision RuleAccept a project if the profitability index isgreater than 1, stay indifferent if theprofitability index is one and dont accept aproject if the profitability index is below 1.
6. 6. ExampleCompany C is undertaking a project at a costof \$50 million which is expected to generatefuture net cash flows with a present value of\$65 million. Calculate the profitability index.
7. 7. SolutionProfitability Index = PV of Future Net Cash Flows /Initial Investment RequiredProfitability Index = \$65M / \$50M = 1.3Net Present Value = PV of Net Future Cash Flows −Initial Investment RequiredNet Present Value = \$65M-\$50M = \$15M.The information about NPV and initial investment canbe used to calculate profitability index as follows: Profitability Index = 1 + ( Net Present Value / InitialInvestment Required )Profitability Index = 1 + \$15M/\$65 = 1.3
8. 8. Advantages of PI It considers time value of money. It takes into account the cash inflows and outflows throughout the economic life of the project. Though PI method is almost similar to NPV method and has got the same advantages, the former is still a better measure because PI measures the relative profitability and NPV, being an absolute measure. PI ascertains the exact rate of return of the project.
9. 9. Disadvantages of PIIt is difficult to understand interest rate or discount rate.It is difficult to calculate profitability index if two projects having different useful life.
10. 10. Thank you