Profitability Index is a capital budgeting technique which can be defined as the ratio of the present value of cash flows at the required rate of return to the initial cash outflow on the investment. It is also called the benefit –cost ratio because it shows the present value of benefits per dollar of the cost. It is therefore a relative means of measuring a project’s return. It thus can be used to compare projects of different sizes.
- The profitability index (PI) is an investment appraisal method used to determine the attractiveness of a project.
- The PI is calculated by dividing the present value of future expected cash flows of an investment by the initial cash outlay of the investment.
- The investment is acceptable if the PI is greater than 1.0. Projects with higher values are more attractive.
- Under capital constraints and mutually exclusive projects, only those with the highest PIs should be undertaken.
A PI of less than 1 indicates that the present value of the investment’s inflows is less than its initial investment cost.
The components of profitability index are:
- Present value of future cash flows
- Initial investment cost
How to Calculate Profitability Index
PI can be calculated using the following formula:
Profitability Index = PV of future cash flows/initial investment
Based on the above formula, future cash flows of an investment requires the use of time value of money to get the present value. Future cash flows are discounted based on the number of periods of the project to get their present monetary value.
Example:
Dante Hospital wants to buy two mutually exclusive projects. Project A costs $1 million and generates cash flows of $200,000 annually for the next 5 years with a discount rate of 10%. Project B costs $2 million and generates cash flows of $300,000 per year for the next 5 years with a discount rate of 10%.
Project A:
Cash Inflows ($) | Calculation | PV ($) | |
Year 1 | 200,000 | 200,000/(1 + 0.10)^1 | 181,818 |
Year 2 | 200,000 | 200,000/(1 + 0.10)^2 | 165,289 |
Year 3 | 200,000 | 200,000/(1 + 0.10)^3 | 150,263 |
Year 4 | 200,000 | 200,000/(1 + 0.10)^4 | 136,603 |
Year 5 | 200,000 | 200,000/(1 + 0.10)^5 | 124,184 |
NPV | $758,157 |
Profitability index for project A = $758,157/$1,000,000 = 0.758
Project B
Cash Inflows ($) | Calculation | PV ($) | |
Year 1 | 300,000 | 300,000/(1 + 0.10)^1 | 272,727.27 |
Year 2 | 300,000 | 300,000/(1 + 0.10)^2 | 247,933.88 |
Year 3 | 300,000 | 300,000/(1 + 0.10)^3 | 225,394.44 |
Year 4 | 300,000 | 300,000/(1 + 0.10)^4 | 204,904.04 |
Year 5 | 300,000 | 300,000/(1 + 0.10)^5 | 186,276.40 |
NPV | 1,137,236.03 |
Profitability Index for project B = $1,137,236/$2,000,000 = 0.569
Since 0.758 > 0.569, Project A > Project B.
Project A is more attractive than Project B because project A has a higher profitability index. However, since the profitability index for both projects is less than 1, the company may not invest in any of the two projects and look for other opportunities.