# Profitability Index Method Formula

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:

```YearCash FlowPVIF 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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Access your Strategic Pricing Model Execution Plan in SCFO Lab. The step-by-step plan to set your prices to maximize profits. ### 9 Responses to Profitability Index Method Formula

1. kumar April 14, 2016 at 12:34 pm #

can profitability index be used in decision making when two projects with different NPV and PI. Will it give same result as NPV of both project is it possible one project is NPV greater and other project PI is greater then what to do

• blessed September 19, 2016 at 3:18 pm #

you can try another method like the IRR. and the you are recommended to choose the project which will get support from more formulae.

• Shesman April 25, 2018 at 10:41 am #

IRR is not always valid when chosen one project out of two. The best thing to modify the IRR I.e. the incremental cash flows

2. victoria January 18, 2017 at 1:38 am #

thanks a bunch

3. Stanley May 6, 2017 at 3:09 am #

Is profitability index the same as cost-benefit ratio?
what are the shortcomings of this method when compared with the IRR for instance.
Thanks

4. Mauli May 11, 2017 at 2:27 pm #

NPV is the best method for decision making.

5. Ajith Ben George March 19, 2018 at 3:50 am #

What is difference in cash inflow or effect in profitability index if scrap value is given in the question?

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