The key difference between Net Present Value (NPV) and Profitability Index (PI) is that while both are used to evaluate the attractiveness of a project, NPV expresses the value in monetary terms, while PI is a ratio indicating the value generated per unit of investment.
Similarities Between NPV and PI
- Time Value of Money: Both NPV and PI consider the time value of money by discounting future cash flows back to their present value.
- Capital Budgeting Tools: They are both used as decision-making tools in capital budgeting to help determine whether or not to invest in a project.
- Cash Flow Based: Both rely on the project's expected future cash flows to calculate their respective values.
- Generally Consistent Results: Generally, a positive NPV will correspond with a PI greater than 1, suggesting the project is acceptable. Conversely, a negative NPV will generally track with a PI less than 1, indicating the project should be rejected.
Differences Between NPV and PI
| Feature | Net Present Value (NPV) | Profitability Index (PI) |
|---|---|---|
| Definition | Present value of cash inflows minus initial investment. | Ratio of the present value of cash inflows to the initial investment. |
| Formula | ∑(Cash Flow / (1 + Discount Rate)^Year) - Initial Investment | (∑(Cash Flow / (1 + Discount Rate)^Year)) / Initial Investment |
| Units | Currency (e.g., dollars, euros) | Ratio (dimensionless) |
| Decision Rule | Accept project if NPV > 0 | Accept project if PI > 1 |
| Scale/Size | Indicates the absolute increase in value. | Does not indicate the cash flow size or absolute value added. |
| Project Ranking | Less reliable for ranking mutually exclusive projects when projects have different scales. | Can be useful in ranking projects, especially when capital is constrained. |
| Interpretation | The amount of value the project adds to the firm. | Value created per dollar invested. |
Example:
Consider two projects, A and B:
- Project A: Initial Investment = $100,000, PV of Cash Inflows = $150,000
- Project B: Initial Investment = $1,000,000, PV of Cash Inflows = $1,200,000
Calculating NPV:
- NPV (A) = $150,000 - $100,000 = $50,000
- NPV (B) = $1,200,000 - $1,000,000 = $200,000
Calculating PI:
- PI (A) = $150,000 / $100,000 = 1.5
- PI (B) = $1,200,000 / $1,000,000 = 1.2
NPV suggests Project B is more valuable since it adds $200,000 compared to Project A's $50,000. However, PI shows that Project A generates $1.5 of value for every $1 invested, whereas Project B generates $1.2 of value for every $1 invested. If capital is limited, Project A might be preferred due to its higher return per dollar invested.
In summary, both NPV and PI are valuable capital budgeting tools, but they provide different perspectives. NPV shows the absolute dollar value added, while PI shows the efficiency of the investment. PI can be particularly helpful when comparing projects with different investment amounts, especially when capital is constrained. However, NPV more directly measures the wealth created by a project.
