What is profitability index? Define it as 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.
Profitability index can be explained 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.
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.
Profitability Index = PV of Cash Inflows / PV of Cash Outflows
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 include:
- Evaluates all cash flows
- Shows whether an investment increases firm value
- Evaluates multiple projects
- Compares time values of cash flows
- Uses cost of capital as a comparison to projects
Profitability index disadvantages include:
- Does not work well with evaluations in which only one project can happen at a time
- Cost of capital is required to calculate PI
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?
Present value of cash inflows for the project = $5,000,000 Present value of cash outflows for the project = $10,000,000
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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