 Hello and welcome to this session. This is Professor Farhad in which you would look at the profitability index or PI. What is the profitability index? It's a technique or an evaluation tool that's going to help you rank projects. Now, PI or profitability index is also known as the benefit cost ratio. And every time you hear this term, some ratio benefit cost, it means you're going to take the benefit of something divided by the cost. And we will see what does that mean? Because when you say benefit cost ratio, it means you are dividing those two figures starting with benefit. So how do we put this profitability index to use? Let's assume we are dealing with a project and we are computing its NPV. Remember, we only accept a project if NPV is positive. Simply put when we compute NPV. Now, if you don't know how to compute NPV, go to my previous recording where I discuss NPV, what's a capital budgeting technique, we'll take the present value of the cash inflows minus the present value of the cash outflows. And we hope that the difference is a positive. Simply put, we have more inflows than outflows. Now, for any particular company, you could have many projects, not one, but many projects with positive NPV. The question becomes which project to invest in? Now, if we have unlimited amount of money, unlimited amount of resources, guess what? We will invest in all projects. But obviously, that's not the case. We have scarcity, no company, no individual, no country, no anyone has unlimited amount of resources. Therefore, you have to rank your project. You have to say, I'm going to accept this one and not accept this one because I don't have enough resources. Now, having said so, let me show you how else can we determine whether a project is acceptable or not. If we take the cash inflows divided by the cash outflow and the answer is greater than one, what does that mean? We're going to take specifically, this is not only cash inflows, present value cash inflows and the present value cash outflows, since we are dealing with NPV, and we'll divide inflows by outflows, which is the benefit is the inflow. The cost is the outflow. This is what we mean by benefit cost ratio. If the project has a ratio greater than one, we accept the project. And what does that mean specifically? It means in the numerator, you have a number that's greater than the denominator. If the numerator is greater, so 10 divided by five equal to two, well, it's a greater than one. However, if we have inflows of five and outflows of 10, we're going to get 0.5. 0.5 means less than one. Well, what happened if we have 10 divided by 10? It's exactly equal to one. This is equal to NPV equal to zero if that's the case because your present value cash inflows and your present value cash outflows equal to zero. This is also called, remember, we talked about IRR. This will also be the rate of return that whatever rate of return we used, it's also the IRR internal rate of return because NPV equal to zero. Now, bear in mind, this profitability index doesn't tell you how soon you would recover your money, but it's going to tell you what is the ranking of your project, which one you should take first, second, so on and so forth. Now, the best way to illustrate this is to look at an example. Most likely, you are watching because you are either an accounting student or a CPA candidate and that's great. What you should do is go step further, go to farheadlectures.com where I have additional resources, lectures, multiple choice, true, false. That's going to help you with your CPA exam preparation. It doesn't matter which course you are using. My material is aligned with that and your accounting courses. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation like this recording, share it with other, connect with me on Instagram, Facebook, Twitter, and Reddit. So let's assume we have those four projects, investment proposal A, B, C, and D. And for the sake of illustration, we only have $130,000 to invest. Which in this project we will invest? Here are the outflows and inflows and this is the difference net present value. And notice the difference 36, 37, 30, and 40. This is the MPV. Well, at first, you're going to say, well, that's easy. If I have $130,000, the reason I gave $130,000 is because I can either take A, B, C, or D. So I have enough money to invest. And you would say, well, at face value, you might say, well, project D is giving me $40,000. I should accept project B because that's the highest amount of money it's giving me, highest MPV amount. Well, you have to be careful because what you need to do, you need to determine what is your profitability index. You need to compute, you need to rank those index. You need to rank those index. What does that mean? It means you have to compute the profitability ratio. And how do we compute the profitability ratio? We're going to take the inflows divided by the outflows. Obviously, now the outflow will be positive. Otherwise, this will be negative. So this is basically, so simply put, $139 is $128 divided by $92,000, not negative $92. The reason it's negative is to show you it's an outflow of cash. So you understand. But when I compute this ratio, I compute this ratio and get a positive number. So for project A, my profitability index is $1.34. For project B, my profitability index $1.35. For project C, $1.40. And for project D, $1.32. Now how do I do so? How do I do so? It means how do I use these figures to rank the projects? The higher the profitability index, the more the higher is the ranking of the project. What does that mean? Well, if I, the highest profitability index is project C, which has given me 1.40. Now, what does that mean? It means for project C, for every dollar I invest, I'm going to get $1.40 on average. Well, this is my best project. Why? Because it's given me the highest return for my investment. Okay. So this is why I will choose project C. So project C will be project number one. What's the next project? It will be project A, because $1.39. What's the third project? It will be project B. And the fourth project, project D. And notice project D, when we looked at it, initially, we thought that's going to be the first one. Actually, that's the last one. So simply put, if you have $300,000, let's assume you have $300,000, what would you invest your money? Well, I can only invest basically, well, if I have $300,000, let's see if I have enough money. Yes, I have enough money. If I have $300,000, I will invest first in C. So I'll take the $300,000, invest in C, and I'm left with $2.25. Now, from this project, I made $30,000, but I still have $225,000. Then I'm going to invest in A, which is A gives me $36,000. I only need $92,000. I'll invest in A. So let me see $225,000 minus $92,000. And I'm going to be left with $133,000. And this project will give me $36,000. Then with the $133,000, I'm going to invest in B, $133,000 minus $105,000. That's going to $133,000. What's left? Minus project C. I'm going to invest the money in $105,000. I'm going to be left with $28,000. There's not much I can do because I don't have a project that unless I can find something, and that's going to give me $37,000. So that's the best use of my money, splitting my money this way based on the profitability index. And this is how we use the profitability index to rank projects because we don't look only at the higher the MPV. We have to look at how much money that we have to commit to earn that MPV. And what should you do now? The best way is to go to farhatlectures.com and work MCQs about capital budgeting, how to rank project, to understand better this concept so you will do better in your accounting course, your CPA exam, CMA exam, whatever you are studying for. Good luck, study hard, and of course, stay safe.