What Is the Profitability Index (PI) Rule?
The profitability index rule is a decision-making exercise this is serving to evaluate whether or not or to not proceed with a problem. The index itself is a calculation of the imaginable advantage of the proposed problem. The rule of thumb of thumb is {{that a}} profitability index or ratio greater than 1 implies that the problem should proceed. A profitability index or ratio beneath 1 implies that the problem should be abandoned.
Key Takeaways
- The machine for PI is the existing worth of long run cash flows divided by means of the initial worth of the problem.
- The PI rule is {{that a}} result above 1 indicates a pass, while a result underneath 1 is a loser.
- The PI rule is a variation of the NPV rule.
Figuring out the Profitability Index Rule
The profitability index is calculated by means of dividing the existing worth of long run cash flows that will probably be generated by means of the problem by means of the initial worth of the problem. A profitability index of 1 implies that the problem will damage even. If it is not up to 1, the costs outweigh the benefits. If it is above 1, the enterprise should achieve success.
For example, if a problem costs $1,000 and will return $1,200, this can be a “pass.”
PI vs. NPV
The profitability index rule is a variation of the web supply worth (NPV) rule. Generally, a just right NPV will correspond with a profitability index that is multiple. A antagonistic NPV will correspond with a profitability index that is beneath one.
For example, a problem that costs $1 million and has a present worth of long run cash flows of $1.2 million has a PI of 1.2.
PI differs from NPV in one essential acknowledge: Since this is a ratio, it provides no indication of the size of the actual cash drift.
For example, a problem with an initial investment of $1 million and a present worth of long run cash flows of $1.2 million would have a profitability index of 1.2. In keeping with the profitability index rule, the problem would proceed, even supposing the initial capital expenditure required are not identified.
PI vs. IRR
Inside rate of return (IRR) could also be used to make a decision if a brand spanking new problem or initiative should be undertaken. Broken down further, the web supply worth discounts after-tax cash flows of a imaginable problem by means of the weighted affordable worth of capital (WACC).
To calculate NPV:
- First determine all cash inflows and cash outflows.
- Next, make a decision an acceptable discount rate (r).
- Use the discount rate to hunt out the existing worth of all cash inflows and outflows.
- Take the sum of all supply values.
The NPV manner reveals exactly how a hit a problem will probably be in comparison to alternatives. When a problem has a just right internet supply worth, it should be licensed. If antagonistic, it should be rejected. When weighing a variety of certain NPV alternatives, the ones with the higher discounted values should be licensed.
Against this, the IRR rule states that if the interior rate of return on a problem is greater than the minimum required rate of return or the cost of capital, then the problem or investment should proceed. If the IRR is not up to the cost of capital, the problem should be killed.
