Answer
See explanation
Work Step by Step
The profitability index (PI) offers several advantages over directly comparing net present value (NPV) when evaluating multiple projects:
1. Accounts for relative investment size
PI = Present Value of Cash Inflows รท Initial Investment
This expresses value created per dollar invested, allowing a fair comparison between projects of different scales.
NPV alone can favor larger projects even if smaller projects generate more efficient returns per dollar invested.
2. Useful under capital rationing
When funds are limited, the PI helps prioritize projects that yield the highest return per unit of investment, maximizing the use of available capital.
3. Simple ranking method
Projects can be ranked by PI (highest to lowest), making it easier to select the most efficient combination of projects when resources are constrained.
So while NPV shows total value added, the profitability index shows efficiency of investment, which is especially helpful for comparing projects of unequal sizes or under capital constraints.
