Budgeting Basics and Beyond

20.6. Profitability Index

The profitability (ranking) index, also called excess present value index, or cost-benefit ratio, is a net instead of an aggregate index and is employed to differentiate the initial cash investment from later cash inflows. If a company has budget constraints, proposals of different dollar magnitude can be ranked on a comparative basis. Use the index as a means of ranking projects in descending order of attractiveness.

Rule of thumb: Accept a proposal with a profitability index equal to or greater than 1.

Caution: A higher profitability index does not always coincide with the project with the highest net present value.

Key point: The internal rate of return and the net present value approaches may give conflicting signals, when competing projects have unequal times. The profitability index gives the correct decision, however, and is superior under these circumstances.

Capital rationing takes place when a business is not able to invest in projects having a net present value greater than or equal to zero. Typically, the firm establishes an upper limit to its capital budget based on budgetary constraints.

NOTE

With capital rationing, the project with the highest ranking index, rather than net present value, should be selected for investment.

Exhibit 20.4 shows the capital rationing decision process.

Example 10

You have this information regarding two proposals: ...