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Profitability Index (PI) Method

Prerequisites

Before studying this chapter, make sure you understand:

1. Definition

Profitability Index (PI), also known as Benefit-Cost Ratio (BCR), measures the present value of returns per rupee invested. It is a relative measure of profitability.

Decision Rule:

  • Accept: If PI > 1.0 (Benefits > Cost)
  • Reject: If PI < 1.0 (Benefits < Cost)
  • Indifferent: If PI = 1.0

2. Formula

Formula

Profitability Index = Present Value of Cash Inflows / Initial Investment

Alternatively: PI = 1 + (Net Present Value / Initial Investment)

3. Use in Capital Rationing

NPV gives absolute value (e.g., ₹5,000 profit), but PI gives efficiency (e.g., 1.2 times return). When funds are limited (Capital Rationing), PI is superior for ranking projects because it indicates which project gives more return per rupee invested.

Example:

  • Project A: Invest ₹100, NPV ₹50. (Efficiency: 50%)
  • Project B: Invest ₹1,000, NPV ₹100. (Efficiency: 10%)

NPV says Project B is better (₹100 > ₹50). PI says Project A is better (Higher return on investment). Under capital shortage, we prefer Project A.

4. Numerical Problem

Problem: Calculate Profitability Index for two projects. Discount Rate: 10%

Project X: Investment ₹20,000. Annual Cash Inflow ₹8,000 for 3 years. Project Y: Investment ₹15,000. Annual Cash Inflow ₹6,000 for 3 years.

Solution:

Step 1: Find PV Factor sum for 3 years @ 10% PV Annuity Factor = 0.909 + 0.826 + 0.751 = 2.486

Step 2: Analysis of Project X

  • PV of Inflows = ₹8,000 × 2.486 = ₹19,888
  • PI = PV of Inflows / Investment
  • PI = 19,888 / 20,000 = 0.99
  • Decision: Reject (PI < 1)

Step 3: Analysis of Project Y

  • PV of Inflows = ₹6,000 × 2.486 = ₹14,916
  • PI = 14,916 / 15,000 = 0.99
  • Decision: Reject (PI < 1)

(Both projects fail to cover cost at 10% rate).

Exam Pattern Questions and Answers

Question 1: "Calculate Profitability Index." (2 Marks) Given:

  • Total Present Value of Inflows: ₹1,20,000
  • Initial Investment: ₹1,00,000

Solution: PI = PV Inflows / Investment PI = 1,20,000 / 1,00,000 PI = 1.20

Question 2: "When is PI preferred over NPV?" (4 Marks) Answer: Profitability Index (PI) is preferred over Net Present Value (NPV) in situations of Capital Rationing, i.e., when the firm has limited funds. While NPV indicates total wealth creation in absolute terms, credit ranking based on NPV might lead to selecting large projects with lower efficiency. PI ranks projects based on "value created per unit of currency invested," ensuring maximum return for the limited available budget.

Quiz Time! 🎯

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