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Profitability Index is the ratio of the present value of future cash flows of the project to the initial investments in the project. This index helps in cost-benefit analysis of investment projects and helps them rank in order of the best return on initial investments.
In this article, we will discuss how you can use this index to find out whether a project is worthy of investment or not.
In this article, we will talk about the following –
- What is Profitability Index?
- Profitability Index Formula
- Components of the Formula
- Calculate Profitability Index
What is Profitability Index?
Imagine that you need to make an investment. What do you need to do? You need to make a cost-benefit analysis to understand whether this investment that you are about to make is profitable for you or not. The same goes for companies. Every company when it decides to invest into a project needs to know beforehand whether the investment would be profitable or not. If not why should they invest their money into the project? It doesn’t make sense, right!
So, how do they know whether the investment would be good for them to invest in? Simply when the benefit from the investment will exceed the cost of the investment! And there lies the issue. When the company will receive the benefit, it will be in the future (not now). But if they compare the expected future value with the current investment, then there would be a missing link and as a company, it’s foolish to expect that nothing would change in future. So, the solution is to find out the present value of future cash flows and then compare it with the current investment. And if the present value of future cash flows seem more than what the company is investing into the project, then the company can go ahead and invest into the project.
This is called the Profitability Index (PI). PI is the ratio of the present value of future cash flows of the project to the initial investments in the project. This ratio helps in cost-benefit analysis of investment projects and helps them rank in order of the best return on initial investments.
In the sections below, we will go further and understand how a company decides whether they should accept a project by using PI.
Profitability Index Formula
The profitability index formula is important because by using this you or any company would be able to calculate profitability index and thus, would be able to decide whether to invest in a project or not.
Profitability Index Formula #1 –
So, let’s have a look at the formula first –
Profitability Index Formula = Present Value of Future Cash Flows / Initial Investment Required
The profitability index formula does look very simple. All you need to do is to find out the present value of future cash flows and then divide it by the initial investment of the project.
However, there is another way through which we can express PI and that is through net present value. Net present value method is a good measure as well to consider whether any investment is profitable or not. But in this case, the idea is to find a ratio, not the amount.
Profitability Index Formula # 2
Let’s have a look at the PI expressed through Net Present Value –
Profitability Index Formula = 1 + (Net Present Value / Initial Investment Required)
If we compare both of these profitability index formulas, they both will give the same result. But they are just different ways to look at the PI
Components of Profitability Index Formula
Here you need to pay heed to few components which you need to use while you calculate profitability index (PI).
#1 – Present Value:
We will take a simple example to illustrate this. Let’s say that you want to loan some money to one of your friends. Your friend said that he would return the money after a year with 10% interest if you give the loan to him. You know the expected future value (the expected amount you would receive after one year) is $100. Now you need to find out the present value of that amount. How would you do it? Here’s a simple thing you should do.
Use this formula, PV = FV/ (1+i) ^n.
You are simply considering 1 as the “principal” amount, i as the interest, n as the number of years.
So by using the simple formula, you can find out how much you should loan to justify the investment.
- PV = FV/ (1+i) ^n
- PV = $100/ (1+0.1) ^1
- PV = $91 (approx.)
- So if you loan him $91, it would justify the investment.
#2 – Initial Investment Required:
The initial investment required is the amount you want to let go of because you want to enhance your wealth. To say it in a different manner, you are investing your money into a project because you find it more profitable than any other project at this moment.
#3 – Net Present Value:
In simple terms, the net present value is the difference between the present value of cash inflow and the present value of cash outflow. For example, if you calculate the present value of future cash inflow of a project to be $1000 and your initial investment required is $900. Then the net present value is $100. It’s said that if you want to invest in a project, the Net Present Value should always be positive. You shouldn’t invest in a project if the project offers you negative or neutral net present value. You can consider neutral NPV if all other projects offer your negative NPV. In the example section, we will see examples of NPV so that you can understand how to calculate it.
Interpretation of Profitability Index
There is a straight cut interpretation of Profitability Index. Rather, we can say that the usefulness of PI is in its interpretation. Let’s have a look at the interpretation below –
- If the index is more than 1, then the investment is worthy because then you may earn back more than you invest in. So if you find any investment whose PI is more than 1, go ahead and invest in it.
- If the index is less than 1, then it’s better to step back and look for other opportunities. Because when PI is less than 1 that means you would not get back the money you would invest. Why bother to invest at all?
- If the index is equal to 1, then it’s an indifferent or neutral project. You shouldn’t invest in the project until and unless you consider it better than other projects available during the period. If you find that the PI of all other projects to be negative, then consider investing in this project.
Calculate Profitability Index
We will take a couple of profitability index examples to illustrate this concept in detail.
Profitability Index Example # 1
N Enterprise has decided to invest in a project for which the initial investment would be $100 million. As they are considering whether it’s a good deal to invest into, they have found out that the present value of future cash flow of this project is 130 million. Is it a good project to invest into in the first place? Calculate Profitability Index to prove that.
- Profitability Index Formula = Present Value of Future Cash Flow / Initial Investment Required
- PI = US $130 million / US $100 million
- PI = 1.3
We will use another method to calculate Profitability Index.
- Profitability Index Formula = 1 + (Net Present Value / Initial Investment Required)
- PI = 1 + [(Present Value of Future Cash Flow – Present Value of Cash Outflow)/ Initial Investment Required]
- PI = 1 + [(US $130 million – US $100 million)/ US $100 million]
- PI = 1 + [US $30 million / US $100 million]
- PI = 1 + 0.3
- PI = 1.3
So, in both ways, the PI is 1.3. That means it’s a great venture to invest in. But the company also needs to consider other projects where the PI may be more than 1.3. In that case, the company should invest into a project that has more PI than this particular project.
Profitability Index Example # 2
Let’s say that ABC Company invests into a new project. Their initial investment is US $10000. And here’s the cash inflow for the next 5 years –
- We need to calculate Profitability Index and find out whether this project is worthy of their investment or not.
- So, we can find out the present value of future cash flows in two ways. Firstly, we can compute by adding up all the present values of future cash flows and secondly, the relatively easier way is to find out the discounted cash flow each year.
So, we will take the second approach and add another column to the above statement, and that would be of discounted cash flows –
Now, you may wonder how we got these figures under the head discounted cash flows. We simply took separate present values of future cash flows. For example, in the first year, the future cash flow is $2000, the cost of capital is 10% and the number of year is 1. So the calculation would be like this –
- PV = FV / (1+i) ^1
- PV = 4000 / (1+0.1) ^1
- PV = 4000 / 1.1
- PV = 3636.36
We found out all of the above-discounted cash flows by using the same method. Only the cost of capital changed due to the increase in the number of years.
Now, we would do the profitability index calculations
Now putting the values in the PI formula, we get –
Profitability Index Formula = PV of Future Cash Flows / Initial Investment Required
We will use the NPV method as well to illustrate the same so that we can understand whether we have come to the right conclusion or not and we will also get to know how to calculate NPV.
To calculate NPV all we need to do is to add up all discounted cash flows and then deduct the initial investment required.
So the NPV in this case would be = (US $6277.63 – US $5000) = US $1277.63.
By using NPV method, we would now calculate profitability index (PI) –
- Profitability Index Formula = 1 + NPV / Initial Investment Required
- PI = 1 + 1277.63 / 5000
- PI = 1 + 0.26
- PI = 1.26
From the above computation, we can come to the conclusion that ABC Company should invest in the project as PI is more than 1.
Limitations of Profitability Index
Even if PI is widely used for doing cost-benefit analyses, PI is not free of demerits. As every good side has its limitations, PI also has couple of limitations.
- The first is the estimation of future cash flows. As forecasts are not always accurate, there are always chances that the expected future cash flows can be drastically different in the forecasting than in actuality.
- PI of two projects can be similar even if the initial investment and the return are completely different. So in that case, the best method to judge whether to invest into a project or not is Net Present Value Method (NPV).
In the final analysis
PI is a great metric to use when you need to decide whether you need to invest in something or not. If you have a company and you are on a tight budget, this metric would help you decide whether you should consider investing in a new project or not.
This is a guide to what is Profitability Index? Here we look at the two profitability index formulas and the different components of its formulas. we also calculate profitability index with practical examples of projects. You can learn more from the following articles on Corporate Finance –