Capital Budgeting Evaluation Techniques^121
Initial investment : Rs. 1,00,000
Year 1 25,000
Year 2 40,000
Year 3 40,000
Year 4 50,000
The profitability index for this project is:
25,000 40,000 40,000 50,000
---------- + --------- + --------- + ---------
(1.12)1 (1.12)2 (1.12)3 (1.12)4
PI = ---------------------------------------------------------- = 1.145
1,00,000
With PI the acceptance rule is
PI > 1 Accept
= 1 Indifferent
< 1 Reject
If PI is greater than one we accept the project because we are getting a rate of return
which exceeds our desired rate of return. If it is equal to one we may or may not accept
the project as we are getting a return which is exactly equal to our desired rate of
return. If it is less than one we reject the project proposal because the rate of return we
are getting is less than our desired rate of return.
Putting it simply PI is an adaptation of the NPV rule because through it uses the same
figures it only helps in ranking of the project.
Evaluation
The proponents of profitability index argue that since this criterion measures net present
value per rupee of outlay it can discriminate better between large and small investments
and hence is preferable to the net present value criterion. How valid is this argument?
Theoretically, it can be very easily verified that:
(i) Under unconstrained conditions, the PI criteria will accept and reject the same
projects as the net present value criteria.
(ii) When the capital budget is limited in the current period, the benefit cost ratio
criteria may rank projects correctly in the order of decreasingly efficient use of
capital. However, its use is not recommended because it provides no means for
aggregating several smaller projects into a package that can be compared with a
large project.
(iii) When cash outflows occur beyond the current period, PI criteria is unsuitable as
a selection criteria.