Profitability Index Formula

What is the Profitability Index Formula?

The formula for Profitability Index is simple and it is calculated by dividing the present value of all the future cash flows of the project by the initial investment in the project.

Profitability Index = PV of future cash flows / Initial investment

It can be further expanded as below,

  • Profitability Index = (Net Present value + Initial investment) / Initial investment
  • Profitability Index = 1 + (Net Present value / Initial investment)

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Source: Profitability Index Formula (wallstreetmojo.com)

Steps to Calculate Profitability Index

Below are the steps to calculate profitability index –

  1. Firstly, the initial investment in a project has to be assessed based on the project requirement in terms of capital expenditureCapital ExpenditureCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more for machinery u0026 equipment and other expenses, which are also capital in nature.

  2. Now, all the future cash flows expected from the project are required to be determined. Then the discounting factor has to be calculated based on the current expected return from an investment of similar risk. Now, using the discounting factorDiscounting FactorDiscount Factor is a weighing factor most often used to find the present value of future cash flows, i.e., to calculate the Net Present Value (NPV). It is determined by, 1 / {1 * (1 + Discount Rate) Period Number}read more, the present value of the future cash flows from the project can be calculated.

  3. Finally, the profitability index of the project is calculated by dividing the present value of all the future value of cash flow from the project (step 2) by the initial investment in the project (step 1).

Examples

You can download this Profitability Index Formula Excel Template here – Profitability Index Formula Excel Template

Example #1

Let us take the example of company ABC Ltd which has decided to invest in a project where they estimate the following annual cash flows:

  • $5,000 in Year 1
  • $3,000 in Year 2
  • $4,000 in Year 3

At the beginning of the project, the initial investment required for the project is $10,000, and the discounting rate is 10%.

PV of cash flow in Year 1= $5,000 / (1+10%)1 = $4,545

Profitability Index Example 1

PV of cash flow in Year 2 = $3,000 / (1+10%)2 = $2,479

Profitability Index Example 1-1

PV of cash flow in Year 3 = $4,000 / (1+10%)3 = $3,005

Profitability Index Example 1-2

So, Sum of PV of future cash flows will be:

p i 0

Profitability Index of the project = $10,030 / $10,000

profitability index formula

As per the formula of the profitability index, it can be seen that the project will create an additional value of $1.003 for every $1 invested in the project. Therefore, the project is worth investing since then it is more than 1.00.

Example #2

Let us take the example of a company A which is considering two projects:

Project A

Project A needs an initial investment of $2,000,000 and a discount rate of 10% and with estimated annual cash flows of:

  • $300,000 in Year 1
  • $600,000 in Year 2
  • $900,000 in Year 3
  • $700,000 in Year 4
  • $600,000 in Year 5

Initial investment = $2,000,000

PV of cash flow in Year 1= $300,000 / (1+10%)1 = $272,727

P I Example 1

PV of cash flow in Year 2 = $600,000 / (1+10%)2 = $495,868

P I Example 1.1

PV of cash flow in Year 3 = $900,000 / (1+10%)3 =$676,183

P I Example 1.2

PV of cash flow in Year 4 = $700,000 / (1+10%)4 = $478,109

P I Example 1.3

PV of cash flow in Year 5 = $600,000 / (1+10%)5 =$372,553

P I Example 1.4

So, Sum of PV of future cash flows will be:

P I Example 1.5

Profitability Index of Project A = $2,295,441 / $2,000,00

profitability index formula Example 1.6

Project B

The initial investment of $3,000,000 and discount rate of 12% and with estimated annual cash flows of:

  • $600,000 in Year 1
  • $800,000 in Year 2
  • $900,000 in Year 3
  • $1,000,000 in Year 4
  • $1,200,000 in Year 5

PV of cash flow in Year 1= $600,000 / (1+12%)1 = $535,714

p i 2

PV of cash flow in Year 2 = $800,000 / (1+12%)2 =$637,755

p i 2.1

PV of cash flow in Year 3 = $900,000 / (1+12%)3 =$640,602

p i 2.2

PV of cash flow in Year 4 = $1,000,000 / (1+12%)4 =$635,518

p i 2.3

PV of cash flow in Year 5 = $1,200,000 / (1+12%)5 =$680,912

p i 2.4

So, Sum of PV of future cash flows will be:

p i 2.5

Profitability Index of Project B = $3,130,502 / $3,000,000

p i 2.6

Using the formula of profitability index, it can be seen that Project A will create an additional value of $0.15 for every $1 invested in the project compared to Project B, which will create an additional value of $0.04 for every $1 invested in the project. Therefore, Company A should select Project A over Project B.

Profitability Index Calculator

You can use the following Profitability Index calculator-

PV of Future Cash Flows
Initial Investment
Profitability Index Formula
 

Profitability Index Formula =
PV of Future Cash Flows
=
Initial Investment
0
= 0
0

Relevance and Use

The concept of profitabilityThe Concept Of ProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more index formula is very important from the point of view of project financeProject FinanceProject Finance is long-term debt finance offered for large infrastructure projects depending upon their projected cash flows. Moreover, an investor has to form a Special Purpose Vehicle (SPV) to acquire the same. read more. It is a handy tool to use when one needs to decide whether to invest in a project or not. The index can be used for ranking project investment in terms of value created per unit of investment.

  • The basic idea is that – the higher the index, the more attractive the investment.
  • If the index is greater than equal to unity, then the project adds value to the company, or otherwise, it destroys value when the index is less than unity.

Recommended Articles

This has been a guide to Profitability Index Formula. Here we discuss how to calculate the profitability index along with practical examples, a calculator, and a downloadable excel template. You can learn more about excel modeling from the following articles –

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