Profitability Index: How Businesses Evaluate Investment Opportunities

 Not all investments that may seem to be good ideas will be value adding for a business. Projects could be the same size, but one may provide much higher returns over a long period of time. Thus, investment appraisal techniques are used by financial managers before deciding on investing the money of the company in any opportunity.

Profitability Index (PI) is one of the most useful tools employed in the process of capital budgeting. The profitability index shows the value gained, per dollar invested, as opposed to the total profit which is the value gained in general. This is particularly valuable when the business doesn't have a lot of money, and the projects have to be done that provide the highest returns.

Profitability Index

Profitability index: It is a financial ratio, which compares the present value of future cash inflows against the initial investment in the project. Rather than considering profit alone, it is an indicator of the efficiency of the investment.

PI > 1 indicates the project will create value which is greater than the cost of the project. < 1.0 means that the predicted returns are not enough to make up for the time value of money.

The profitability index is also employed by many organisations in determining the processes associated with long-term investments, in addition to Net Present Value (NPV) and Internal Rate of Return (IRR).

Components of the Profitability Index

The profitability index is easy to compute, but there are a number of important factors to consider.

The first element is the investment that is needed to start the project, including the total investment. This could include the costs of equipment, installation, software, facilities etc. or start-up costs in general.

The second part is the cash inflows the project will generate in the future throughout its useful life. The estimates need to be realistic and for good business assumptions.

The third is the discount rate which adjusts the future cash flows as if they were valued now. Discounting allows us to appreciate money being received in the future in a way that makes sense given that money received now is more valuable than money received in the future.

All these elements are needed to enable business to make a valid cost comparison of projects.

Profitability Index Formula

The profitability index is defined to be the ratio of:

Profitability Index measures the net value of the investments made: based on very simplified assumptions, the value of the investment in the future equals the present value of the cash flows it generates.The profitability index is a measure of the net value of investments made: under very simple assumptions, the future value of the investment equals the present value of the cash flows it generates.

Any number greater than 1.0 is generally considered a ‘good return' as the discounted cash flow (DCF) inflows are greater than the initial cash outflows.

If the result is 1.0, the project is likely to break even, after taking into account the time value of money.

When the ratio is lower than 1.0, that investment is usually not as appealing as it is projected to come back to the investor a bit less than what they invested.

Calculate Profitability Index

The first step in using the profitability index to calculate the profits of a business is to estimate all future cash inflows that the project is expected to bring in. These cash flows then are discounted back to their present value using a proper discount rate.

After calculating the PV, it is divided by the initial investment.

This way, managers can use a metric to efficiently compare projects of differing sizes. This is especially helpful for companies that have multiple investments but only a certain amount of capital, to use for funding.

Profitability Index Calculation

Let's assume that a business is looking to invest in new production machinery which will cost $250,000.

The projected cash flows are analysed and the present value of all the future cash inflows is estimated to be $315,000.

The calculation becomes:

Profitability Index = $315,000 ÷ $250,000 = 1.26

The profitability index is 1.26, which indicates the project will yield $1.26 in PV for each $1.00 invested in the project.

This doesn't mean that the investment will make money, but it means that the investment will likely make money on the basis of current expectations.

Profitability Index Example

Suppose there is a business which has sufficient funds for investment in one out of two projects.

Project A would need $400,000 of investment and would have a profitability index of 1.15.

Project B needs a $400,000 investment, and has a profitability index of 1.35.

Both projects have a positive return; however, Project B has a higher return per dollar invested. Other things being equal, the management would presumably prefer Project B over Project A.

This is the reason why the profitability index is frequently applied in such situations where companies have to prioritize projects and/or have limited investment funds.

Conclusion

The profit index is an effective tool that companies can utilize to assess the value that can be created from an investment. The comparison of the present value of future cash inflows with the initial cash outlays by the managers can help them determine the projects which are best suited by available capital. The profitability index can be used along with other investment appraisal techniques like the Net present value (NPV) and Internal rate of return (IRR) and can offer a more well-rounded picture of project performance, which can help make better long-term investment decisions.