Profitability Index and Ranking

Question 1

Describe the profitability index (also called cost/benefit ratio or present value index).

Answer 1

Ranks projects by taking into account both the net present value of each project and the cost of each project; computed as: PI = NPV/Project Cost

Question 2

When using the profitability index, how are projects ranked relative to each other?

Answer 2

The projects are ranked according to the computed Profitability Index (i.e., NPV/Project Cost) for each project; the higher the PI, the higher the rank of the project

Question 3

Will the profitability index and the net-present-value approach (to capital budgeting) result in the same ranking of multiple projects?

Answer 3

No. Since the Net Present Value Approach does not explicitly consider the difference in initial cost of one project compared to another project, it does not give the same ranking as the Profitability Index, which considers both the Net Present Value and the initial cost of the project by getting an NPV per dollar invested.