What is the Profitability Index?
Profitability index shows the relationship between company projects future cash flows and initial investment by calculating the ratio and analyzing the project viability and it is calculated by one plus dividing the present value of cash flows by initial investment and it is also known as profit investment ratio as it analyses the profit of the project.I
Formula #1 –
Profitability Index = Present Value of Future Cash Flows / Initial Investment Required
The 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. NPV 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.
Formula # 2
Let’s have a look at the PI expressed through Net Present Value –
Profitability Index = 1 + (Net Present Value / Initial Investment Required)
If we compare both of these formulas, they both will give the same result. But they are just different ways to look at the PI.
How to Interpret the Profitability Index?
- 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
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 in, they have found out that the present value of the future cash flow of this project is 130 million. Is it a good project to invest in in the first place? Calculate Profitability Index to prove that.
- PI = 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 the Profitability Index.
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- PI 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 in a project that has more PI than this particular project.
Example # 2
Let’s say that ABC Company invests in a new project. Their initial investment is the US $10000. And here’s the cash inflow for the next 5 years –
- We need to calculate the 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 the 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 –
PI 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 the NPV method, we would now calculate profitability index (PI) –
- PI 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.
Even if the PI is widely used for doing cost-benefit analyses, the PI is not free of demerits. As every good side has its limitations, PI also has a 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.
- The 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 in a project or not is the 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.
Profitability Index Video
This is a guide to what is Profitability Index and its definition. Here we look at how to interpret profitability index along with practical examples of projects. You can learn more from the following articles on Corporate Finance –