Question

What is the relationship between the profitability index (PI) and the NPV? Are there any situations in which you might prefer one method over the other? Explain.

Answer 1

Profitability index (PI)=(NPV+Initial Investment)/(Initial Investment)=NPV/Initial investment + 1
Profitability index>1 is preferred.
Profitability index method is better while ranking the projects.
We won't know by how much the shareholder's value will increase when we use profitability index. So, we would prefer NPV method over profitability index (PI).
Example:
Case 1: NPV=$75 and initial investment=$40
Profitability index=($75+$40)/$40=2.875
Case 2: NPV=$7000 and initial investment=$4000
Profitability index=($7000+$4000)/$4000=2.75

Now, the value of profitability index in case 1 is more than profitability index in case 2, however we would prefer case 2 because the value of NPV is higher in case 2 and if we accept case 2, the increase in the shareholder's value will be higher.