Page 134 - DMGT409Basic Financial Management

Unit 7: Capital Budgeting

Profitability Index (PI)/Discounted Benefit Cost Ratio (DBCR) Notes
This is another discounted cash flow method of evaluating investment proposals. It is also known

as discounted benefit cost ratio method. It is similar to NPV method. It is the ratio of the present

value of cash inflows, at the required rate of return, to the initial cash outflow of the investment
proposal. PI method measures the present value of future cash per rupee, where as NPV is based

on the difference between present value of cash inflows and present value of cash outfl ows.
NPV method is not reliable to evaluate projects requiring unequal initial investments. PI method
provides solution to this problem. PI is the ratio, which is derived by dividing present value of
cash inflows by present value of cash outfl ows.

Pl is the ratio of present value of future cash benefits at the required rate of return at the initial

cash outflow of the investment.

PVof cashinflows
PI =
Initialcashoutlay
Like IRR and NPV methods, profitability index is a conceptually sound method of appraising

investment projects. It provides ready comparisons between investment proposals of different
magnitudes.

Accept-Reject Rule

Accept: PI > 1 Reject: PI < 1 Considered: PI = 1

Merits of PI

The PI Method satisfies almost all the requirements of a sound investment criterion. The

characteristic, as we recollect are:
1. It gives due consideration to time value of money.

2. It considers all cash flows to determine PI.
3. It help to rank projects according to their PI.

4. It recognizes the fact that bigger cash flows are better than smaller ones and early cash

flows are preferable to later ones.
5. It can also be used to choose mutually exclusive projects by calculating the incremental

benefit cost ratio.
6. It is consistent with the objectives maximization of shareholders’ wealth.
Illustration 9: The initial cash outlay of a project is ` 50000 and it generates cash infl ows of `
10000, ` 20000, ` 30000 and ` 10000. Assume 10% rate of discount. Find Pl.
Solution:

Computation of PI
Year Cash infl ow Present Value Present Value of
1 2 Factor @ 10% Cash infl ow
1 10000 0.909 9090
2 20000 0.826 16520
3 30000 0.751 22530
4 10000 0.683 6830
Total 54970

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