Profitability Index (PI) Rule
What Is the Profitability Index (PI) Rule?
The profitability index rule is a dynamic exercise that assesses whether to continue with a project. The actual index is a calculation of the likely profit of the proposed project. The rule is that a profitability index or ratio greater than 1 demonstrates that the project ought to continue. A profitability index or ratio below 1 shows that the project ought to be abandoned.
Understanding the Profitability Index Rule
The profitability index is calculated by separating the current value of future cash flows that will be generated by the project by the initial cost of the project. A profitability index of 1 shows that the project will break even. On the off chance that it is under 1, the costs offset the benefits. On the off chance that it is over 1, the venture ought to be profitable.
For instance, in the event that a project costs $1,000 and will return $1,200, it's a "go."
PI versus NPV
The profitability index rule is a variation of the net present value (NPV) rule. As a rule, a positive NPV will relate with a profitability index that is greater than one. A negative NPV will compare with a profitability index that is below one.
For instance, a project that costs $1 million and has a current value of future cash flows of $1.2 million has a PI of 1.2.
PI varies from NPV in one important respect: Since it is a ratio, it gives no indication of the size of the genuine cash flow.
For instance, a project with an initial investment of $1 million and a current value of future cash flows of $1.2 million would have a profitability index of 1.2. In light of the profitability index rule, the project would continue, even however the initial capital expenditure required are not recognized.
PI versus IRR
Internal rate of return (IRR) is likewise used to decide whether another project or initiative ought to be attempted. Broken down further, the net present value discounts after-tax cash flows of a likely project by the weighted average cost of capital (WACC).
To ascertain NPV:
- First recognize all cash inflows and cash outflows.
- Next, decide a suitable discount rate (r).
- Utilize the discount rate to track down the current value of all cash inflows and outflows.
- Take the sum of every current value.
The NPV method uncovers precisely the way that profitable a project will be in comparison to alternatives. At the point when a project has a positive net present value, it ought to be accepted. In the event that negative, it ought to be dismissed. While gauging several positive NPV options, the ones with the higher discounted values ought to be accepted.
Interestingly, the IRR rule states that assuming that the internal rate of return on a project is greater than the base required rate of return or the cost of capital, then the project or investment ought to continue. In the event that the IRR is lower than the cost of capital, the project ought to be dispensed with.
Features
- The PI rule is a variation of the NPV rule.
- The PI rule is that an outcome over 1 shows a go, while an outcome under 1 is a loser.
- The formula for PI is the current value of future cash flows partitioned by the initial cost of the project.
