# Tag Archives | profitability index method

## 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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