Economics Capital Budgeting Questions Medium
The profitability index ranking rule is a technique used in capital budgeting to evaluate and rank investment projects based on their profitability. It is also known as the profitability index (PI), profit investment ratio (PIR), or value investment ratio (VIR).
The profitability index is calculated by dividing the present value of cash inflows by the present value of cash outflows for a particular investment project. The formula for calculating the profitability index is as follows:
Profitability Index = Present Value of Cash Inflows / Present Value of Cash Outflows
The profitability index ranking rule states that investment projects with a profitability index greater than 1 should be accepted, as they are expected to generate positive net present value (NPV) and create value for the company. On the other hand, projects with a profitability index less than 1 should be rejected, as they are expected to result in negative NPV and destroy value.
When using the profitability index ranking rule in capital budgeting, projects are ranked based on their profitability index values. The higher the profitability index, the more attractive the investment project is considered. Therefore, projects with higher profitability index values are given priority over projects with lower profitability index values.
However, it is important to note that the profitability index ranking rule should not be the sole criterion for decision-making in capital budgeting. It should be used in conjunction with other evaluation techniques, such as net present value (NPV), internal rate of return (IRR), and payback period, to make informed investment decisions.