The profitability index shows the potential benefit of an investment as a ratio. The index is calculated as the present value (PV) of future net cash flow divided by the first investment. Calculating the profitability index is important for investors to see the potential profitability of a project, among other calculations, and the index is commonly used to decide whether or not a project should proceed.
Calculating Profitability Index Video Tutorial With Examples
In a simple example, if a project has a $50,000 initial investment and is expected to have a net cash flow of $70,000, the profitability index is as follows.
PV of future cash flow / initial investment OR
$70,000 / $50,000 = 1.4
A positive profitability index suggests that the project is worth proceeding on. As a rule, the profitability index should be at least 1.0, which suggests that the project will at least return the initial investment. A profitability index that is less than 1.0 suggests that the project should be abandoned. The higher the profitability index, the more attractive the project is as an investment.
Calculating Profitability Index Video Example
Net Present Value
The net present value (NPV) of a project can be calculated by subtracting the initial investment from the PV of future cash flow.
NPV = PV of future cash flow – initial investment OR
$70,000 – $50,000 = $20,000
In the example above, the project has a $20,000 NPV, and in general if a profitability index is greater than 1, the NPV will be positive. Also, when the profitability index is less than 1, the net present value is usually negative.
The profitability index demonstrates the potential profitability of a company as a ratio. As a result, it is important to have both the NPV which demonstrates the volume of capital required for a project and its size of its net present value. The profitability index does not demonstrate this information and does not show the size of investment required for a project.
Other calculations are used to determine the potential profitability of a project. In many cases, the NPV and profitability index will be calculated for multiple projects and compared, and the projects with the highest profitability index and net present value will be selected.
The profitability index also considers the time value of money, as inflation and other factors that influence the time value of money should be taken into account when calculating the present value of future net cash flow.
The profitability index is also useful for determining investment capital rationing between two or more projects that are proceeding at once. For instance, the project(s) with a higher profitability index may be justified in receiving more capital initially, so that they can contribute profit sooner than the other projects that are starting at the same time.