What is the difference between PI and NPV?
Generally speaking, a positive NPV will correspond with a PI greater than one, while a negative NPV will track with a PI below one. The main difference between NPV and profitability index is that the PI is represented as a ratio, so it won't indicate the cash flow size.
PI differs from NPV in one important respect: Since it is a ratio, it provides no indication of the size of the actual cash flow. For example, a project with an initial investment of $1 million and a present value of future cash flows of $1.2 million would have a profitability index of 1.2.
When a firm can undertake all independent and profitable projects, using the PI will lead to the same decision as the NPV. However, if the projects are mutually exclusive and have different scales, the decision maker should not use the PI.
Net Present Value - NPV, Profitability Index - PI, & Internal Rate of Return
NPV calculates the present value of future cash flows. IRR ignores the present value of future cash flows. PB method also ignores the present value of future cash flows. The PI method calculates the present value of future cash flows.
Conclusion. NPV is the most successful and reliable method of investment evaluation, compared to other methods such as the payback period, the rate of return, internal rate of return (and Profitability Index).
Such a project exerts a positive effect on the price of shares and the wealth of shareholders. So, NPV is much more reliable when compared to IRR and is the best approach when ranking projects that are mutually exclusive. Actually, NPV is considered the best criterion when ranking investments.
IRR is useful when comparing multiple projects against each other or in situations where it is difficult to determine a discount rate. NPV is better in situations where there are varying directions of cash flow over time or multiple discount rates.
Key Takeaways. Net present value, or NPV, is used to calculate the current value of a future stream of payments from a company, project, or investment. To calculate NPV, you need to estimate the timing and amount of future cash flows and pick a discount rate equal to the minimum acceptable rate of return.
NPV is the sum of all the discounted future cash flows. Because of its simplicity, NPV is a useful tool to determine whether a project or investment will result in a net profit or a loss. A positive NPV results in profit, while a negative NPV results in a loss.
What is PI method?
The profitability index (PI) is a measure of a project's or investment's attractiveness. The PI is calculated by dividing the present value of future expected cash flows by the initial investment amount in the project.
The formula for Profitability Index is simple and it is calculated by dividing the present value of all the future cash flows of the project by the initial investment in the project. It can be further expanded as below, Profitability Index = (Net Present value + Initial investment) / Initial investment.
- NPV = Cash flow / (1 + i)^t – initial investment.
- NPV = Today's value of the expected cash flows − Today's value of invested cash.
- ROI = (Total benefits – total costs) / total costs.
What Are NPV and IRR? Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. By contrast, the internal rate of return (IRR) is a calculation used to estimate the profitability of potential investments.
