The profitability index measures the acceptability of a proposed capital investment. It does so by comparing the initial investment to the present value of the future cash flows associated with that project. The formula is:
Present value of future cash flows ÷ Initial investment
If the outcome of the ratio is greater than 1.0, this means that the present value of future cash flows to be derived from the project is greater than the amount of the initial investment. At least from a financial perspective, a score greater than 1.0 indicates that an investment should be made. As the score increases above 1.0, so too does the attractiveness of the investment. The ratio could be used to develop a ranking of projects, to determine the order in which available funds will be allocated to them.
For example, a financial analyst is reviewing a proposed investment that requires a $100,000 initial investment. At the company's standard discount rate, the present value of the cash flows expected from the project is $140,000. This results in a strong profitability index of 1.4, which would normally be accepted.
There are a number of other considerations besides the profitability index to examine when deciding whether to invest in a project. Other considerations include:
- The availability of funds. A business may not have access to sufficient funds to take advantage of all potentially profitable projects.
- The scale of the investment. A massive project may soak up all available funds.
- The perceived riskiness of the project. A risk averse management team may turn down a project with a high profitability index if the associated risk of loss is too great.
- The impact on the bottleneck operation of the business. The best investments have a positive impact on total company throughput.
- Any legal obligations that must be fulfilled. A legal requirement to make an investment overrides the profitability index.
- Mutual exclusivity. The index cannot be used to rank projects that are mutually exclusive; that is, only one investment or the other would be chosen, which is a binary solution. In this situation, a project with a large total net present value might be rejected if its profitability index were lower than that of a competing but much smaller project.
The profitability index is a variation on the net present value concept. The only difference is that it results in a ratio, rather than a specific number of dollars of net present value.