The profitability index is a capital budgeting technique that compares present value of future inflows with the initial outflow, in ratio terms. It is calculated by dividing the present value of cash flows by initial investment of a project. Accept projects with a profitability index greater than 1 and reject those with less than 1. Choose alternatives with higher profitability index because they generate a higher benefit per unit of investment.
Easy to Understand
The profitability index is easily understood by people with minimal background knowledge in finance, because it uses a simple formula of division. Calculating the profitability index only requires initial investment figure and present value of cash flows figures. The decision to undertake or reject a project relies on whether the profitability index is greater than or less than 1.
Calculating present value of cash flows involves discounting the cash flows by the opportunity costs. This takes into consideration time value of money. A dollar is more valuable now than in the future because it can be invested to earn interest. Money value also is affected by inflation with time, and therefore it is important to consider time value, in order to make profitable investments.
A major disadvantage of profitability index is that it may lead to incorrect decision when comparing mutually exclusive projects. These are a set of projects for which at most one will be accepted, the most profitable one. Decisions made out of profitability index do not show which of the mutually exclusive projects has a shorter return duration. This leads to choosing a project with longer return duration.
Estimates Cost of Capital
The profitability index requires an investor to estimate the cost of capital in order to calculate it. Estimates may be biased and thus be inaccurate. There is no systematic procedure for determining cost of capital of a project. Estimates are based on assumptions which may differ between investors. This may lead to inconsistent decision making when the assumptions do not hold in the future.