Financial Management: Principles and Applications, 13/e

11.3 Other Investment Criteria

Although the NPV investment criterion makes the most sense in theory, in practice financial managers use a number of criteria to evaluate investment opportunities. Criteria that we explore in this section include the profitability index, internal rate of return, modified internal rate of return, and payback period.

Profitability Index

The profitability index (PI) is a cost-benefit ratio equal to the present value of an investment’s future cash flows divided by its initial cost:³

3 While the initial outlay is a negative value because it is an outflow, we do not give it a negative sign in calculating the PI. Instead, the initial outlay is entered as a positive value, since we are interested only in the ratio of benefits ...