Profitability index definition
/What is the Profitability Index?
The profitability index measures the acceptability of a proposed capital investment. It does so by comparing the initial investment amount to the present value of the future cash flows associated with that project. A higher profitability index increases the attractiveness of a prospective investment. In situations where the amount of cash available is limited, the profitability index can be used to rank a set of proposed investments, where funds are assigned to the highest-ranking proposals and the rest remain unfunded. 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.
Calculation of the Profitability Index
The formula for the profitability index is as follows:
Present value of future cash flows ÷ Initial investment = Profitability Index
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.
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Example of the Profitability Index
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.
Additional Investment Considerations
There are a number of other considerations besides the profitability index to examine when deciding whether to invest in a project. For example, one should consider whether the business may not have access to sufficient funds to take advantage of all potentially profitable projects; it is possible that it may not be possible to invest in projects that have a profitability index that exceeds 1.0. A related concern is that a project requiring a massive investment may soak up all available funds.
Another consideration is that a risk averse management team might decide to turn down a project with a high profitability index, if the associated risk of loss is too great. Or, management might be forced to make an investment with a low profitability index, because there are legal requirements that the investment be made. For example, a coal-fired power plant might be required by law to install smokestack scrubbers.
A major concern is that investments should have a positive impact on total company throughput. If a proposed investment is not related to a company’s bottleneck operation, it should probably be rated lower in priority than one that increases the capacity of the bottleneck. This approach should maximize profitability levels while reducing the total investment made in a business.
A final issue is that 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.