This is just to make you understand how to anlyse, ok?
Do the profitability index and the NPV criterion of evaluating investment proposals lead to the same acceptance-rejection and ranking decisions? In what situations will they give conflicting results?
In the most of the situations the Net Present Value Method (NPV) and Profitability Index (PI) yield same accept or reject decision. In general items, under PI method a project is acceptable if profitability index value is greater than 1 and rejected if it less than 1. Under NPV method a project is acceptable if Net present value of a project is positive and rejected if it is negative. Clearly a project offering a profitability index greater than 1 must also offer a net present value which is positive. But a conflict may arise between two methods if a choice between mutually exclusive projects has to be made. Consider the following example:
Project A Project B
PV of Cash inflows 2,00,000 1,00,000
Initial cash outflows 1,00,000 40,000
Net present value 1,00,000 60,000
P.I 2 2.5
According to NPV method, project A would be preferred, whereas according to profitability index method project B would be preferred. This is because Net present value gives ranking on the basis of absolute value of rupees. Whereas profitability index gives ranking on the basis of ratio. Although PI method is based on
NPV, it is a better evaluation technique than NPV in a situation of capital rationing.
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