Profitability Index (P.I.) = 1 + (Net Present Value/ Cash outflow)
- A good Profitability Index will be greater than 1, Accept and implement. The NPV will be positive and IRR will be comfortably more than the discount rate.
- Profitability Index is less than 1, Decline
- The project with highest Profitability Index is chosen if two projects are in the positive premise.
- Profitability Index can be one when the cash flows produced by the project are too low compared to the initial investment.
If Profitability index is more than 1, NPV must be positive, and the IRR must be greater than the discount rate.
Sunk cost makes the index negative, as they are unrecoverable and consume additional capital to turn around the cash flows. The index can be used in behalf of NPV to determine the profit per dollar of investment in the project in case of capital budgeting.
Since the formula includes Net Present Value of the project or an investment the time value of money is accounted. Capital outflow is the initial investment that a project demands, including the surcharges and setting up costs.
Even a vague look can bring out that the formula is same as rate of return. This becomes the perfect measure of proceeding with a project. Profitability Index can be The size bias which NPV and IRR encountered is eliminated, the profitability is the major concern.
Even though PI can be an acceptable parameter for undertaking a project, the value is a function of more uncertain variables, cash inflows and discount rate. The accuracy of PI depends on how well the cash flows are estimated for a project that may or may not be undertaken by the management.