Profitability Index (PI) or Benefit-Cost Ratio (BIC Ratio)
Yet another time-adjusted capital budgeting technique is profitability index PI or benefit-cost ratio (B/c). It is similar to the NPY approach. The profitability index approach measures the present value of returns per rupee invested, while the NPY is based on the difference between the present value of future cash inflows and the present value of cash outlays. A major shortcoming of the NPY method is that, being an absolute measure, it is not a reliable method to evaluate projects requiring different initial investments. The PI method provides a solution to this kind of problem. It is in other words, a relative measure. It may be defined as the ratio which is obtained dividing the present value of future cash inflows by the present value of cash outlays. Symbolically.
This method is also known as the B/C ratio because the numerator measures benefits and the denominator costs. A more appropriate description would be present value index.
Accept-Reject Rule Using the Die ratio or the PI, a project qualify for acceptance if its PI exceeds one. When PI equals 1, the’ firm is indifferent to the project. When PI is greater than, equal to or less than I, the net present value.is greater than, equal to or less than zero respectively In other words the PV will be positive when the Plis greater than will be negative when the PI is less than one. Thus. the NPY and PI approaches give the same results regarding the investment proposals The selection of projects with the PI .method can also be done on the basis of ranking. The highest rank will be given to.the project with the highest PI followed by others in the same order. In Example 10.6 (Table 10.IS) of machine A and B. the Pl would be 1.22 for machine A and 1.27 for machine B
Since the PI for both the machines is greater than I, both the machines are acceptable. Though it is common to define PI as the ratio of the PV of the cash inflows divided by the PY c:l cash outflows, the PI may’ also be. measured on the basis of the net benefits of a project against it.~current ash outlay rather than measure its gross ‘benefits against its total cost over the life of the project. This aspect becomes very important in situations of Capital rationing. H In such :I situation.the decision rulc would be to accept the project if the PI is positive and reject the project it it is negative
Evaluation Like the other discounted cash (low techniques, the PI satisfies almost all the requirements of sound investment criterion. It considers all the crescents of capital budgeting, such as the time value of money totality of I and so 01’1. Conceptually, it is a sound method of capital budgeting. Although ha~l’u on the “I it is 1 better evaluation technique than l’I’V in a situation of capital rationing, For instance. two projects may have the same NPV of Rs 10.000 but project requires an initial investment of Rs 10,000 whereas B only of R~25,000. Project B should be preferred a~ will he . The I’I’V method, however, will give identical rankings of both the protects. Thus, the 1’1 method is superior to the NI’V method as the former evaluates the worth of projects in terms of their relative rather than absolute magnitudes. However, in some problems of a mutually exclusive nature, the I’V method would he superior 10 the PI method. The comparison of PI and NPV is further explored in Chapter II. This method is, however, more difficult to understand. Also. it involves more computation than the traditional methods out less .than IRR.