Question

What is the profitability index? Why is this better than the net present value method when you’re trying to compare investments of different sizes?

Answer 1

Capital budgeting techniques are evaluation techniques that helps in selection of a project proposal. For example, if we need to construct a plant or invest in any project , we make estimations on these proposals. Thus capital budegeting techniques are helpful in making these decisions.

Profitability index is a capital budgeting technique that helps in capital budgeting decisions. This depicts the benefits received per each dollar invested. This is calculated by dividing present value of cash inflow by present value of cash outflow.This take time value of money into consideration. This method is also known as benefit-cost method,as it takes benefits and cost associated with the project. When the calculated profitability index is more than one, we will accept the project and less than one, we will reject the project. The investor can act indifferent,when the index is zero.

Net present value is an another captal budgeting technique that compares the cash inflows and outflows related with the project. It also cosiders time value of money and all cash inflows and outflows are converted into the present value.When Net present value is more than one, we will accept the project and less than one, we will reject the project. The investor can act indifferent,when the value is zero. In case of two projects,higher Net present value is prioritized.

Net present value is the most useful measure that depicts the value generated from a project to the investors. But at sometimes Profitability index is used as a substitute for Net present value to measure the return per dollar. When we need to compare investments of different sizes ,capital rationing profitability index is used. That is,when many project propoosals are availabe and the investor have to limit the projects at a particular time Profitability index is used. When comparing two projects,that are mutually exclusive and gives same net present value with one project having higher initial outlay, in thaht case profitability index act as the purest measure.In that case net present value depicts that most projects are equally desirable, whereas profitability index measures the return per dollar invested ang gives the logical answer. When two projects have same net present value and one project with higher initial cost , the project witl lesser initial cost and higher profitability index is prefered.