How do you compute profitability index and take investment decision based on profitability index?

The Profitability Index (PI) is a capital budgeting tool used to evaluate the desirability of an investment project. It is computed as:

$$\text{Profitability Index (PI)}=\frac{\text{Present Value of Future Cash Flows}}{\text{Initial Investment}}$$

Steps to Compute PI and Take Investment Decision

1. Calculate the Present Value (PV) of all future cash inflows using the required rate of return (discount rate).
2. Divide the PV of future cash flows by the initial investment (outlay).
3. Interpret the PI:
   • PI > 1: Accept the project (positive NPV, beneficial).
   • PI = 1: Indifferent (NPV = 0, break-even).
   • PI < 1: Reject the project (negative NPV, unprofitable).

Example Calculation

Assume:

• Initial investment = Rs. 10,000
• Future cash flows = Rs. 6,000 (Year 1), Rs. 5,000 (Year 2), Rs. 4,000 (Year 3)
• Discount rate = 10%

$$\text{PI}=\frac{12,588}{10,000}=1.2588$$

Since PI = 1.2588 > 1, the project is acceptable.