PROFITABILITY INDEX (PI)
Profitability index (PI) is the present value of an investment’s future cash flows divided by its initial cost. Also, it is benefit-cost ratio.
PI = PV/I
PV: sum of present value of cash flows subsequent to initial cash flow
I: initial cash flow
- if PI>1=> accept the project
- if PI<1=> reject the project
Advantages of Profitability Index (PI) :
- Closely related to NPV, generally leading to identical decisions.
- Easy to understand and communicate.
- May be useful when available investment funds are limited.
Disadvantages of Profitability Index (PI):
It may lead to incorrect decisions in comparisons of mutually exclusive investments.
Investment A has the following cash flows:
If discount rate is 10 percent, is it good investment?
Initial investment =10,000
PI=10,669/10,000=1.07 > 1. It means that $1 investment will return PV of $1.07, so this project should be taken.
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- Mcgraw-Hill – Fundamentals Of Corporate Finance