Profitability Index

Profitability index is an investment appraisal technique calculated by dividing the present value of future cash flows of a project by the initial investment required for the project.

Formula:

Profitability Index
Present Value of Future Cash Flows
Initial Investment Required
 
1 + Net Present Value
Initial Investment Required

Explanation:

Profitability index is actually a modification of the net present value method. While present value is an absolute measure (i.e. it gives as the total dollar figure for a project), the profibality index is a relative measure (i.e. it gives as the figure as a ratio).

Decision Rule

Accept a project if the profitability index is greater than 1, stay indifferent if the profitability index is 1 and don't accept a project if the profitability index is below 1.

Profitability index is sometimes called benefit-cost ratio too and is useful in capital rationing since it helps in ranking projects based on their per dollar return.

Example

Company C is undertaking a project at a cost of $50 million which is expected to generate future net cash flows with a present value of $65 million. Calculate the profitability index.

Solution
Profitability Index = PV of Future Net Cash Flows / Initial Investment Required
Profitability Index = $65M / $50M = 1.3
Net Present Value = PV of Net Future Cash Flows − Initial Investment Rquired
Net Present Value = $65M-$50M = $15M.

The information about NPV and initial investment can be used to calculate profitability index as follows:

Profitability Index = 1 + (Net Present Value / Initial Investment Required)
Profitability Index = 1 + $15M/$50M = 1.3

by Obaidullah Jan, ACA, CFA and last modified on

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