In capital budgeting world sunk costs costs incurred before you start a project. Hence, these costs might be huge and ignoring these costs might sometimes become very difficult for the corporate finance team.
Determining the rate at which the cash flows are to be discounted might be tough for the corporate finance team. A firm should not use the overall WACC of the company as a whole as a discounting rate. Why so? Inappropriate discounting rates may lead to higher or lower PI. Corporate finance team needs to sit with the management of the company to take into account the business scenario. Management might be too optimistic about their project and therefore cash flow projections might be too high.
Thus, there can be an upward bias in estimating the PI. In order to determine the exact cost of starting a project; we need to account for the opportunity costs. Opportunity costs are those costs which are incurred by not accepting other alternatives which may generate positive inflows.
Estimating these alternatives and their costs might be difficult and hence, might distort the result. Calculations that equal 1. When using the profitability index exclusively, calculations greater than 1. When limited capital is available, and projects are mutually exclusive, the project with the highest profitability index is to be accepted as it indicates the project with the most productive use of limited capital.
The profitability index is also called the benefit-cost ratio for this reason. Although some projects result in higher net present values, those projects may be passed over because they do not have the highest profitability index and do not represent the most beneficial usage of company assets.
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List of Partners vendors. Your Money. Personal Finance. Your Practice. Popular Courses. Key Takeaways The formula for PI is the present value of future cash flows divided by the initial cost of the project.
The PI rule is that a result above 1 indicates a go, while a result under 1 is a loser. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation.
This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Profitability Index The profitability index PI is a technique used to measure a proposed project's costs and benefits by dividing the projected capital inflow by the investment. What Is a Hurdle Rate?
A hurdle rate is the minimum rate of return on a project or investment required by a manager or investor. Partner Links. Related Articles.
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