Profitability index

Profitability index identifies the relationship of investment to payoff of a proposed project. The ratio is calculated as follows:

(PV of future cash flows) / (PV Initial investment) = Profitability Index

Profitability Index is also known as Profit Investment Ratio, abbreviated to P.I. and Value Investment Ratio (V.I.R.). Profitability index is a good tool for ranking projects because it allows you to clearly identify the amount of value created per unit of investment, thus if you are capital constrained you wish to invest in those projects which create value most efficiently first.

Nota Bene; Statements below this paragraph assume the cash flow calculated "DOESN'T" include the investment made in the project. Where investment costs are included in the computed cash flow a PV>0 simply indicates the project creates more value than the cost of capital which is determined by the Weighted Average Cost of Capital (WACC).

A ratio of one is logically the lowest acceptable measure on the index. Any value lower than one would indicate that the project's PV is less than the initial investment. As values on the profitability index increase, so does the financial attractiveness of the proposed project.

Rules for selection or rejection of a project:

If PI > 1 then accept the projectif PI < 1 then reject the project

For Example

Given:

Investment = 40,000life of the Machine = 5 Years

CFAT Year CFAT

1 18000 2 12000 3 10000 4 9000 5 6000

caculate NPV @10% and PI

Year CFAT PV@10% PV

1 18000 0.909 16362 2 12000 0.827 9924 3 10000 0.752 7520 4 9000 0.683 6147 5 6000 0.621 3726 Total present value 43679 (-) Investment 40000 NPV 3679

PI = 43679 / 40000 = 1.091 = >1 = Accept the project

[http://www.maxvalue.com/tip065.htm Detailed discussion on PI from an industry expert]

References