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.
How to Calculate the Profitability Index
To calculate the profitability index, divide the present value of estimated future cash flows for a proposed project by the amount of the initial investment. The formula 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.
Advantages of the Profitability Index
There are several key advantages associated with the profitability index, which are as follows:
Considers the time value of money. The profitability index uses discounted cash flows, thereby ensuring that future earnings are evaluated in today’s value. This makes it superior to methods that ignore the time value of money (e.g., payback period).
Helps for ranking investment projects. The profitability index provides a clear ranking system for projects, which can result in a higher return per dollar invested when there are more projects available than investable funds.
Accounts for risk. Since the profitability index is based on discounted cash flows, it considers the project's risk level through the discount rate (cost of capital).
Useful for comparing different-sized projects. Unlike net present value, which shows absolute value, the profitability index measures efficiency, which makes it easier to compare projects with different investment amounts.
In short, the profitability index is a valuable tool for making investment decisions, especially when capital is limited. It combines the strengths of net present value and the internal rate of return, while being simple to interpret.
FAQs
How Does the Profitability Index Differ from Net Present Value (NPV)?
The profitability index shows the value created per dollar invested, while net present value measures the total dollars of value created. The profitability index helps compare efficiency across projects of different sizes. NPV is better for evaluating the overall contribution a project will make to the company.