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What is Profitability Index?

See Also:
Financial Ratios
Profit Center
Net Profit Margin
Operating Income EBIT
Income Statement

What is Profitability Index?

What is profitability index? The profitability index definition is a tool for measuring profitability of a proposed corporate project by comparing the cash flows created by the project to the capital investments required for the project. It is also one of the most commonly used tools for evaluating investments. Profitability index is also called cost-benefit ratio, benefit-cost ratio, or capital rationing.


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Profitability Index Explanation

Explain profitability index as a measure of whether or not a proposed project will be profitable and simple or complicated depending on the scope of the project in question. If the money expected to be generated from the project exceeds the costs required to fund the project, then it will be a profitable investment. The profitability index is one of several methods used to measure and quantify the attractiveness of a proposed investment.

Profitability Index Formula

The profitability index formula is most commonly calculated as listed below. No simple profitability index calculator exists. So the profitability index equation will have to be calculated manually. Use the following formula to calculate profitability index:

Profitability Index = PV of Cash Inflows / PV of Cash Outflows

Profitability Index Calculation

Calculate the profitability index by dividing the present value of the expected cash flows from a project by the present value of the capital investments of a project. It is one of the more simple equations used in the finance world. The calculation yields a number, which is the profitability index.

PI = 1 The projects benefits are expected to equal its costs.
PI < 1 The projects costs are expected to exceed its benefits; reject the project.
PI > 1 The projects benefits are expected to exceed its costs; accept the project.

If the profitability index is one, then that means the project’s cash outflows are expected to equal its cash inflows. If the profitability index is any number less than one, then that means the project’s cash outflows are expected to exceed the project’s cash inflows. In other words, it is a bad investment. Generally speaking, a company would want to reject any project with a profitability index of less than one because investing in that project would be a money-losing venture.

If the profitability index is any number greater than one, then that means the project’s cash inflows are expected to exceed the project’s cash outflows. In other words, it is a good investment. Generally speaking, a company would want to accept any project with a profitability index greater than one because investing in that project would be a profitable venture. A higher number means a more attractive investment. For example, a project with a profitability index of 1.3 would be a more attractive investment than a project with a profitability index of 1.2.

Profitability Index Advantages

Profitability index advantages include the following:

Profitability Index Disadvantages

Profitability index disadvantages include the following:

  • Does not work well with evaluations in which only one project can happen at a time
  • Cost of capital is required to calculate PI

Profitability Index Example

For example, Lisa is part of the investment branch of a major corporation. She and her team spend their days choosing which corporate project will yield the most profits, thereby finding which project will be most beneficial to her company.

On their most recent evaluation, Lisa is deciding whether the company should open a new [Profit Center|profit center]. They expect income from the project to total $5,000,000. The profit center will also cost a total of $10,000,000 to build. What should she choose?

If:
Present value of cash inflows for the project = $5,000,000
Present value of cash outflows for the project = $10,000,000

Then:
Profitability Index = PV of Cash Inflows / PV of Cash Outflows Profitability Index = $5,000,000 / $10,000,000 = .5

The profitability index of the project Lisa is studying is .5. This is less than 1. Lisa has simply and quickly decided that the profit center does not need to be created. She prepares her presentation for why her corporation should not open the new center.

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Profitability Index Method

See Also:
Profitability Index Method Formula
Net Present Value Method
Net Present Value versus Internal Rate of Return
Time Value of Money
Adjusted Present Value (APV) Method of Valuation
Future Value

Profitability Index Definition

Profitability index method measures the present value of benefits for every dollar investment. In other words, it involves the ratio that is created by comparing the ratio of the present value of future cash flows from a project to the initial investment in the project. The Profitability Index Method is often times compared similarly to the Net Present Value Method for their close proximity. One should use caution when utilizing both the NPV and profitability index methods in tandem. Often times, it has been found that both methods can rank projects in a different way. One project could possibly be ranked number 1 for one of the methods while it ranks dead last in the other. Use digression when using both in tandem.

Application

Profitability index is primarily used as a tool to rank projects. The higher the value of profitability index, the more attractiveness of a proposed project is. For a single project, profitability index value of 1 or greater is acceptable. If a project has profitability index (>1), then a company should perform the project. However if a project has profitability index (<1), a company should reject the project.

There is relationship between profitability index and net present value method. If profitability index >1, the NPV is positive. If profitability index <1, NPV is negative. The profitability index is a relative measure of an investment’s value while NPV is an absolute measure. The profitability index method can be a useful substitute for NPV method when presenting a project’s benefits per dollar of investment. It makes the most sense to look at the concept from a project-by-project basis. The profitability index gives a company the opportunity to determine whether a project should be pursued or not. If the profitability index is above one, then a company can execute and pursue the project. If the profitability index is below one, then the project should be scrapped for the detrimental cash flow problems

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Profitability Index Method

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