When using a profitability index to select projects, a high value is preferred over a low value

As one company expands, it needs to take important decisions which involve extensive capital financing. This means making decisions regarding investment, taking assistance of Capital Budgeting means, or taking a call on the most profitable properties. 

Multiple constraints can vary from project to project, starting from valuable sources of capital, different costs, results, tax implications, management, and other factors.

And things are still never so clear-cut in practice. Practical capital budgeting is usually done with multiple metrics, but with Net Present Value (NPV) and Profitability Index (PI) being one of the most important.

What is the Profitability Index Method (PI)?

A profitability index is a financial tool that can tell us whether an investment should be accepted or declined. Also, with the Profitability Index formula (or profitability index calculator) we are able to estimate the ratio between the present value of future cash flows and the initial investment.

Is a Higher Profitability Index Better?

When the profitability index is greater than 1, the project automatically creates value, meaning that it generates a return greater than our required one. 

On the other hand, when some project’s profitability index is less than 1 – it is said that the project destroys its value because it generates a return less than our required return.

We also have the situation where the profitability index is equal to 1, which tells us that the project generates a return equivalent to the discount rate.

Calculating a Profitability Index – Profitability Index Formula

When we obtain the information from the net present value calculator, we can determine a profitability index for the investment. The profitability index is calculated with the following formula:

Profitability index = present value of future cash flows / initial investment

To calculate the profitability index, we need only to know the present value of the future cash flows. To get this number (the present value of all the future cash flow), we add up the present values (of the cash flows) that occur from Year 1 to Year 10.

In what situation is the profitability index a better option?

The Profitability Index can serve as a substitute for Net Present Value, once we determine the profits per dollar of investment. The profitability index method can also be a better-suited method when you need to employ Capital Rationing.

For example, in situations where two, mutually exclusive, projects deliver the same amount of money in terms of NPV, but one project costs twice as much as another. This is when the profitability index (PI) gives the best answer.

Also, when investors choose between two mutually independent projects with the same NPV, the one with lower initial cost or higher PI will be selected.

What is Net Present Value (NPV)?

As the name suggests, Net Present Value is nothing but the present value of cash inflows and outflows, but with reduced flows on a specified rate.

NPV calculator/NPV formula:

To determine the present value of the cash flows, we need to discount them at a particular rate, derived considering the return of investment with a similar risk of borrowing. 

Net Present Value takes into consideration the time value of money. 

This simply means that the money of today is worth more today than tomorrow, and the net present value method helps to decide whether it is worth taking some project based on its present value of the cash flows.

When is NPV considered a superior technique?

The net present value method is a comprehensive tool taking into consideration all aspects of the investment, such as: 

• all the inflows, 
• outflows, 
• period of time, and 
• risks involved. 

Therefore the NPV calculator is the most transparent way to measure the amount of shareholder value. The given NPV analysis is also easy to compare among projects. 

Net present value also considers the time value of money and takes care of the cash flows until the end of the project, even if that project has the same profitability index with different investments.

Wait – Is NPV the same as profit?

Well…

The Time Value of Money Is Important

The net present value calculator is known to be the tool for analyzing the profitability of a particular project. People like to take this into consideration when analyzing time and money spent somewhere.

The net present value method allows companies to compare similar projects judiciously. 

Let’s say Project A with a life span of 3 years has higher cash flows in the initial period, and that Project B with a life of 3 years has higher cash flows in the later years.

By using the NPV formula, the investor is able to choose Project A, knowing that inflows of “today” are more valued than inflows earned later on.

Value of Investment

The net present value definition not only states that a project can be profitable or not but also gives insight into the value of total profits. The tool quantifies the gains or/and losses from the investment, especially after discounting the cash flows.

What Are the Disadvantages of the NPV Method?

One of the central weaknesses of the analysis is that the size of the project has a big impact on the project’s NPV. 

The size of a project’s NPV is related to the size of the original investment, and it’s not used for determining which project has a higher return in percentage terms. 

The Profitability Index, on the other hand, fixes this basic problem by allowing you to compare the profitability indexes of two (or more) projects and find the scheme that creates the most value for every dollar you invest.

Considering the fact that many businesses have an established budget and sometimes two (or more) project options,  the NPV formula can not be used for comparing these projects in different periods of time, or even the risk involved in the projects.

The Main Limitation of Net Present Value Method

One of the strongest disadvantages of the NPV system is that the rate of return has to be determined in advance. 

If a higher rate of return is assumed, it can show a false negative NPV. Also, if a lower rate of return is expected, it can show false profitability – hence resulting in wrong decision making.

The NPV method can spike a lot of assumptions in terms of inflows, outflows, with a lot of expenditure that will come to the surface when the project actually takes off.

Today software is used to perform the NPV analysis and assist in decision making, so in spite of all its limitations, the NPV method is a very useful and widely used tool in capital budgeting.

Now, do you need any more help understanding the topic or starting your investment? 

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The ratio between the present value of future cash flows to the initial investment

The Profitability Index (PI) measures the ratio between the present value of future cash flows and the initial investment. The index is a useful tool for ranking investment projects and showing the value created per unit of investment.

The Profitability Index is also known as the Profit Investment Ratio (PIR) or the Value Investment Ratio (VIR).

Profitability Index Formula

The formula for the PI is as follows:

or

Therefore:

• If the PI is greater than 1, the project generates value and the company may want to proceed with the project.
• If the PI is less than 1, the project destroys value and the company should not proceed with the project.
• If the PI is equal to 1, the project breaks even and the company is indifferent between proceeding or not proceeding with the project.

The higher the profitability index, the more attractive the investment.

Example of Profitability Index

Company A is considering two projects:

Project A requires an initial investment of $1,500,000 to yield estimated annual cash flows of:

• $150,000 in Year 1
• $300,000 in Year 2
• $500,000 in Year 3
• $200,000 in Year 4
• $600,000 in Year 5
• $500,000 in Year 6
• $100,000 in Year 7

The appropriate discount rate for this project is 10%.

Project B requires an initial investment of $3,000,000 to yield estimated annual cash flows of:

• $100,000 in Year 1
• $500,000 in Year 2
• $1,000,000 in Year 3
• $1,500,000 in Year 4
• $200,000 in Year 5
• $500,000 in Year 6
• $1,000,000 in Year 7

The appropriate discount rate for this project is 13%.

Company A is only able to undertake one project. Using the profitability index method, which project should the company undertake?

Using the PI formula, Company A should do Project A. Project A creates value – Every $1 invested in the project generates $.0684 in additional value.

Discounting the Cash Flows of Project A:

• $150,000 / (1.10) = $136,363.64
• $300,000 / (1.10)^2 = $247,933.88
• $500,000 / (1.10)^3 = $375,657.40
• $200,000 / (1.10)^4 = $136,602.69
• $600,000 / (1.10)^5 = $372,552.79
• $500,000 / (1.10)^6 = $282,236.97
• $100,000 / (1.10)^7 = $51,315.81

Present value of future cash flows:

$136,363.64 + $247,933.88 + $375,657.40 + $136,602.69 + $372,552.79 + $282,236.97 + $51,315.81 = $1,602,663.18

Profitability index of Project A: $1,602,663.18 / $1,500,000 = $1.0684. Project A creates value.

Discounting the Cash Flows of Project B:

• $100,000 / (1.13) = $88,495.58
• $500,000 / (1.13)^2 = $391,573.34
• $1,000,000 / (1.13)^3 = $693,050.16
• $1,500,000 / (1.13)^4 = $919,978.09
• $200,000 / (1.13)^5 = $108,551.99
• $500,000 / (1.13)^6 = $240,159.26
• $1,000,000 / (1.13)^7 = $425,060.64

Present value of future cash flows:

$88,495.58 + $391,573.34 + $693,050.16 + $919,978.09 + $108,551.99 + $240,159.26 + $425,060.64 = $2,866,869.07

Profitability index of Project B: $2,866,869.07 / $3,000,000 = $0.96. Project B destroys value.

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• The profitability index indicates whether an investment should create or destroy company value.
• It takes into consideration the time value of money and the risk of future cash flows through the cost of capital.
• It is useful for ranking and choosing between projects when capital is rationed.

Example: A company allocates $1,000,000 to spend on projects. The initial investment, present value, and profitability index of these projects are as follows:

The incorrect way to solve this problem would be to choose the highest NPV projects: Projects B, C, and F. This would yield an NPV of $470,000.

The correct way to solve this problem would be to choose the projects starting from the highest profitability index until cash is depleted: Projects B, A, F, E, and D. This would yield an NPV of $545,000.

Disadvantages of the Profitability Index

1. The profitability index requires an estimate of the cost of capital to calculate.
2. In mutually exclusive projects where the initial investments are different, it may not indicate the correct decision.

Related Readings

Thank you for reading this CFI guide. To continue learning, you may find the CFI resources listed below helpful: