Profitability Index or P.I.
P.I. (benefit-cost ratio) = Present value of inflows / Present value of cash outlay
Whether P.I. is greater than 1.0, invest and whereas less than 1.0, reject.
Example
The following information was from XYZ feasibility studies. This has studied two ventures as:
a) Cost 100,000/= and 160,000/= on the starting of the 4^{th} year and it will create inflows 1-3^{rd} year 80,000/= and from 4-6^{th} year 50,000/= per annum.
b) Initial cost 200,000/= and 80,000/= on the starting of the 4^{th} year and it will create the following inflows:
1^{st} - 2^{nd} year -> Shs.100, 000 per annum
3rd - 6th year -> Shs.70,000 per annum
Using the cost of finance of 12 percent compute the P.I. of these two ventures, advise the company accordingly.
Solution
a) Outflows: 100,000/1 + 160,000 / (1.12)^{3} = 100,000 + 113,887 = 213,885
Inflows: 80,000 / (1.12)^{1}/80,000/ (1.12)^{2 }+ 80,000 / (1.12)^{3} + 50,000 / (1.12)^{4 }+ 50,000 / (1.12)^{5} + 50,000 / (1.12)^{6 }= Shs.277,626
P.I. = 277,626/213,885
P.I. = 1.298
b) Outflows: = 200,000 / 1 + 80,000 / (1.12)^{3 } = 256,944
Inflows = 100,000 / (1.12)^{1 }+ 100,000 / (1.12)^{2 }+70,000 / (1.12)^{3}+70,000 / (1.12)^{4 }+70,000 / (1.12)^{5 } +70,000 / (1.12)^{6 }
= Shs.338,501
P.I. = 338,501 / 256,944
= 1.32