Question

• Profitability index – Write a paper about the use of the profitability index. It is a ratio that provides information about the present value of net cash flows to the net investment. It provides a measure of the relative present value return for each dollar of initial investment. Discuss its usefulness. Should managers rely upon it? Consider its usefulness in a capital rationing situation (capital investment under conditions of financial restraint).
• Requirements:
  500 words,

Answer 1

Profitability Index

In our day to day routine we take decisions based on return. We measure each and every step of ours. Such a measurement when expressed in monetary terms is called cost and benefit analysis. The most important work of big companies is based on this only. Whenever, a company takes up a project they are supposed to do a profit analysis in order to gauge that they should invest in the particular project or not. This analysis is called profitability index wherein, future cash flow is discounted and compared with capital outlay and a decision is undertaken.

Profitability index= PV of net cash flow

Net Investment

Meaning of the ratio- This ratio implies that all the benefits accruing from the project in the future is discounted to find the Present Value of the same.

Important question- Why is this cash inflow discounted?

This cash inflow is discounted as we need to compare it with Net Investment. Net investment is done in the current period and so cash flow should also be brought in current period so as to get a proper ratio. Present value is calculated by discounting the future cash inflow recurring after a particular time period.

Now suppose in order to undertake a project the initial cash investment is 10000 and cash inflow is 1000,4000, 5000,6000 for year 1,2,3 and 4 respectively. Now we need to calculate profitability index with the cost of capital being 10%.

Profitability Index- Cash flows discounted

Initial cash investment

=909.09+3305.78+3756.57+4098.08

10000

=1.20

Usefulness

Now we would be discussing the usefulness of this index.

This ratio is a very important analysis and helps a manager to take a decision that whether a project should be undertaken or not.

1. Profitability index > 1

If the profitability index is less than 1 then the management can be sure of that the project should not be undertaken as it is not giving viable returns, also it will be a burden on the management.

If the profitability index is more than one as in the above example then it means that the benefit that the management is getting by undertaking the project is more than the investment that they had to undergo in order to take up a project.Hence its a beneficial proposition and should be considered.

If the profitability index is equal to 1 then the management has to be neutral. They need to consider other project and other factors also.If any other project is reaping more in terms of profitability index then the management should go for the other project.

NOTE

If profitability index is same for two projects then the size of the project is to considered. In a big sized project the margin is generally low so the profitability index for a big project will also be less.Hence in this case the management needs to take a call between big project and small project.

Usefulness of Capital Rationing method

Ration as the term defines a fixed allowance of something. Capital rationing means a ceiling on capital.Every firm has a limitation on the funds it can secure for different project. Every firm needs to identify few projects in order to decide on which they should invest.They have to decide on 2 to 3 projects which can be actually beneficial for them so that there is an optimum utilization of their resources.This ranking can be done by profitability index. As we can see in the example mentioned below:

Hence if the management wants to take up 3 projects then it should take project C,A and D (based on the rankings done by profitability index)

We can thus conclude that profitability index is a very important measure for the management as its helps in taking decisions.

Regards.