Profitability Index Method
Profitability Index Method Formula
Use the following formula where PV = the present value of the future cash flows in question.
Profitability Index = (PV of future cash flows) ÷ Initial investment
Or = (NPV + Initial investment) ÷ Initial Investment: As one would expect, the NPV stands for the Net Present Value of the initial investment.
Profitability Index Calculation
Example: a company invested $20,000 for a project and expected NPV of that project is $5,000.
Profitability Index = (20,000 + 5,000) / 20,000 = 1.25
That means a company should perform the investment project because profitability index is greater than 1.
Profitability Index Example
Texabonds Inc has decided to consider a project where they predict the annual cash flows to be $5,000, $3,000 and $4,000, respectively for the next three years. At the beginning of the project, the initial investment put into the project is $10,000. Use the Profitability Index Method and a discount rate of 12% to determine if this is a good project to undertake. In order to solve this problem, it is probably a good idea to make a table so that the numbers can be organized by year.
Using a PI table, the following PVIF’s are found respectively for the 3 years: .893, .797, .712. Once the PVIF’s are determined, simply multiply the cash flows and the PVIF’s together in order to get the PV of cash flows for each respective year ($4,465, $2,391, $2,848). Adding up all the PV’s will get the total present value of the project which is $9,704. Divide that final number by the original investment $10,000 and the PI has been determined: .9704. As one can see, the Profitability Index is less than 1 so the project should be scrapped. The NPV can also be determined by subtracting the initial investment ($10,000) from the total PV of the project ($9,704) and you are left with -$296. In this case, because the number is negative, NPV also says that the project should be rejected.
Profitability Index Formula Table
A table for the problem is shown below:
Year Cash Flow PVIF at 12% PV of Cash Flow 1 $5,000 .893 $4,465 2 3,000 .797 2,391 3 4,000 .712 __2,848__
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