Regards to npv vs pi (profitability index), I do not understand the disadvantage
ID: 2801818 • Letter: R
Question
Regards to npv vs pi (profitability index), I do not understand the disadvantage stated on the net. The net said that the disadvantage associated with this method again is its relativity. A project can have same PI with different investments and the vast difference in absolute dollar return. Npv has an upper hand in this case... Can someone explain to me what does it really means? Regards to npv vs pi (profitability index), I do not understand the disadvantage stated on the net. The net said that the disadvantage associated with this method again is its relativity. A project can have same PI with different investments and the vast difference in absolute dollar return. Npv has an upper hand in this case... Can someone explain to me what does it really means?Explanation / Answer
Profitability index is defined as the Present value of future cash flow divided by initial investment. This can be further broken down into,
(1 + NPV/Initial investment).
So in effect, we see that PI depends upon ration of NPV to Initial investment as is not dependent on absolute value of NPV or Initial investment.
For example if we make an initial investment of $10,000 and expect to have NPV of $1000 from a project, then its PI would be (1 + 1000/10000) = 1.1
Now consider another project which requires initial investment of $20,000 and gives an NPV of $2,000. PI in this case is (1 + 2000/20000) = 1.1.
In both cases PI is 1.1, however second project gives a higher absolutely dollar return of $2,000.
Had we consider NPV methodology, we would have chosen second project as this would have given us better return but with PI method, we are indifferent for project.