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What is the Profitability Index?
Profitability Index (PI) is a measure of the ratio between the discounted cash flows and the initial investments for a given project. Another name for the profitability index is the Profit Investment Ratio (PIR) or Value Investment Ratio (VIR). Profitability index is prevalent in capital budgeting. Companies use it to measure an investment’s potential profitability.
Companies use the profitability index to compare various projects and show how much value they create for the investment. PI does not work for single projects as it does not give a definitive result. The profitability index isn’t only applicable to capital budgeting and companies. It is also common for investors to use PI to quantify the amount of value created for every unit of investment.
What is the formula for Profitability Index?
Companies can calculate the profitability index for a project by calculating the present value of future cash flows for it. They must also determine the initial cost of the project. Once they do so, they can use the following formula for profitability index calculation.
Profitability Index = Present Value of Future Cash Flows / Initial Investment in the Project
The decision rule for the profitability index depends on the various projects under consideration. The higher a project’s PI is, the more feasible it is for the company. When comparing, companies must select the project that has the highest profitability index.
Example
A company, Blue Co., is considering investing in one of two given projects. Both projects are for five years. The company uses a 10% discount rate to discount its cash flows.
The first project requires Blue Co. to invest $100,000. The discounted cash flows from the project are as below.
|
Year |
Cash Flows ($) |
Discount factor
(10%) |
Discounted Cash Flows
($) |
|
1 |
40,000 |
0.909 |
36,360 |
|
2 |
35,000 |
0.826 |
28,910 |
|
3 |
25,000 |
0.751 |
18,775 |
|
4 |
25,000 |
0.683 |
17,075 |
|
5 |
20,000 |
0.621 |
12,420 |
| Total |
145,000 |
113,540 |
Therefore, the project’s profitability index will be as follows.
Profitability Index = Present Value of Future Cash Flows / Initial Investment in the Project
Profitability Index = $113,540 / $100,000
Profitability index = 1.14
The second project requires an investment of $150,000. The discounted cash flows from the project are as follows.
|
Year |
Cash Flows ($) |
Discount factor
(10%) |
Discounted Cash Flows
($) |
|
1 |
60,000 |
0.909 |
54,540 |
|
2 |
55,000 |
0.826 |
45,430 |
|
3 |
50,000 |
0.751 |
37,550 |
|
4 |
40,000 |
0.683 |
27,320 |
|
5 |
40,000 |
0.621 |
24,840 |
| Total |
245,000 |
189,680 |
Therefore, the profitability index for the second project will be as follows.
Profitability Index = Present Value of Future Cash Flows / Initial Investment in the Project
Profitability Index = $189,680 / $150,000
Profitability Index = 1.26
Since the second project has a higher profitability index, it will be more feasible for the company to select it. Therefore, Blue Co. must select the second project.
What is the importance of Profitability Index?
Profitability index is crucial for several reasons. Firstly, it helps in the decision-making process for ranking various investments or projects. Similarly, it focuses on maximizing a company’s profits, particularly when it has limited resources. Comparatively, it makes the process of selecting projects with variable investment requirements easier.
Conclusion
Profitability index is a metric used to calculate a project’s profitability. It considers a project’s discounted cash flows in relation to the initial investment requirement. Profitability index is more effective if used comparatively. It has various applications for companies and focuses on maximizing profitability with limited resources.
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