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  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