Calculating Profitability Index of a Project

The profitability index, also known as the profit investment ratio, is calculated as the ratio of the present value of the future cash flows and the initial investment in the project.

$Profitability\ Index = \frac{PV\ of\ Future\ Cash\ Flows}{Initial\ Investment}$

Since NPV is the difference between the present value of future cash flows and initial investment, the profitability index can also be expressed in terms of NPV as follows:

$Profitability\ Index = 1 + \frac{NPV}{Initial\ Investment}$

The firms use PI to decide whether to accept or reject a project.

PI > 1, Accept the project

PI < 1, Reject the project

Let's taken an example to understand how profitability index is calculated. Assume that a company invests $5,000 in a project, which generates the following cash flow in the next 5 years. The firm has a cost of capital of 10%. Column 3 presents the discounted cash flows.

Year	Cash Flow	Discounted Cash Flows
0	-5000.00
1	2000.00	1818.18
2	2,000.00	1652.89
3	2,000.00	1502.63
4	1,000.00	683.01
5	1,000.00	620.92

The total PV of future cash flows = 6277.64

Initial Investment = $5000

PI = 6277.64/5000 = 1.25

Since PI > 1, the project can be accepted.

The profitability index is a useful tool for capital rationing, as the projects can be ranked based on their PI.

Unlock Premium Content

Upgrade your account to access the full article, downloads, and exercises.

You'll get access to:

Access complete tutorials and examples
Download source code and resources
Follow along with practical exercises
Get in-depth explanations

Calculating Profitability Index of a Project

Unlock Premium Content

You'll get access to:

How to Calculate Discounted Payback Period

Conflict Between NPV and IRR

Topics

Related Groups

Course Downloads

Capital Budgeting