Home > Topics > International Finance > Profitability Index Method – Decision Making
← PreviousNext →

Profitability Index Method – Decision Making

What if you have ₹100 Cr (limited budget) and 5 good projects? You need to rank them. Profitability Index (PI) is the ranking tool.

1. Formula

PI = PV of Cash Inflows / Initial Cash Outflow

  • Rule:
    • If PI > 1 -> Accept. (Means you get back more than 1 Rupee for every 1 Rupee invested).
    • If PI < 1 -> Reject.
    • If PI = 1 -> Indifferent (NPV is 0).

2. Example

  • Investment: ₹ 100.
  • PV of Inflows: ₹ 120.
  • NPV: +20.
  • PI: 120 / 100 = 1.2.

3. Usage in Capital Rationing

When funds are limited, we choose projects with the Highest PI, not necessarily the Highest NPV.

  • Logic: PI measures "Efficiency" – bang for the buck.

4. Exam Notes: Writing the Answer

Question: "What is Profitability Index? When is it used?" (5 Marks)

Answering Strategy:

  1. Formula: PV Inflow / PV Outflow.
  2. Alt Name: "Benefit-Cost Ratio".
  3. Application: "Used in Capital Rationing (Scarcity of funds) to rank projects."

Summary

  • Relation: PI = 1 + (NPV / Investment).
  • Efficiency: It tells you the return per unit of investment.

Quiz Time! 🎯

Loading quiz…

← PreviousNext →