Profitability Index An Investment Appraisal Technique
Definition Profitability index is an investment appraisaltechnique calculated by dividing the presentvalue of future cash flows of a project by theinitial investment required for the project.
Formula Present value of Future Cash FlowProfitability Index= Initial Investment Required Present Value = 1+ initial Investment Required
ExplanationProfitability index is actually a modification ofthe net present value method. While presentvalue is an absolute measure (i.e. it gives asthe total dollar figure for a project), theprofitability index is a relative measure (i.e. itgives as the figure as a ratio).
Decision RuleAccept a project if the profitability index isgreater than 1, stay indifferent if theprofitability index is one and dont accept aproject if the profitability index is below 1.
ExampleCompany C is undertaking a project at a costof $50 million which is expected to generatefuture net cash flows with a present value of$65 million. Calculate the profitability index.
SolutionProfitability Index = PV of Future Net Cash Flows /Initial Investment RequiredProfitability Index = $65M / $50M = 1.3Net Present Value = PV of Net Future Cash Flows −Initial Investment RequiredNet Present Value = $65M-$50M = $15M.The information about NPV and initial investment canbe used to calculate profitability index as follows: Profitability Index = 1 + ( Net Present Value / InitialInvestment Required )Profitability Index = 1 + $15M/$65 = 1.3
Advantages of PI It considers time value of money. It takes into account the cash inflows and outflows throughout the economic life of the project. Though PI method is almost similar to NPV method and has got the same advantages, the former is still a better measure because PI measures the relative profitability and NPV, being an absolute measure. PI ascertains the exact rate of return of the project.
Disadvantages of PIIt is difficult to understand interest rate or discount rate.It is difficult to calculate profitability index if two projects having different useful life.