Which of the following will be included when calculating a projects profitability index?

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=PV of Future Cash FlowsInitial InvestmentProfitability\ Index = \frac{PV\ of\ Future\ Cash\ Flows}{Initial\ Investment}Profitability Index=Initial InvestmentPV of Future Cash Flows​

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+NPVInitial InvestmentProfitability\ Index = 1 + \frac{NPV}{Initial\ Investment}Profitability Index=1+Initial InvestmentNPV​

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.

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.

The profitability index (PI), also known as the profit investment ratio (PIR) or value investment ratio (VIR), is a capital budgeting tool that gauges the potential profitability of an investment or project. It can be used as an appraisal technique or applied to potential capital outlays, and functions as a useful formula for ranking a project's financial outlook alongside other investments. The profitability index allows investors to quantify the amount of value created per unit of investment.

The Formula

The profitability index is calculated by dividing the present value of future cash flows by the initial cost (or initial investment) of the project. The initial costs include the cash flow required to get the team and project off the ground. The calculation of future cash flows does not include the initial investment amount.

Profitability Index = Present Value of Future Cash Flows ÷ Initial Investment in the Project.

The present value of future cash flows is a method of discounting future cash to its current value, and requires the implementation of the time value of money calculation. This discounting occurs because the current value of $1 is not equivalent to the value of $1 received in the future. Money received closer to the present time is considered to have more value than money received further in the future.

A profitability index of 1 indicates breaking even, which is an indifferent result for potential investors. If the result is less than 1.0, logic suggests that the investment should be avoided, as the project's costs outweigh the potential profits. If the result is greater than 1.0, investors will likely go on to consider the other merits of the project. If the profitability index of a project is 1.2, for example, investors would expect a return of $1.20 for every $1.00 spent on funding the project.

Application

The profitability index is often used to rank a firm's investments and/or projects alongside others. For the sake of maximizing limited financial resources and profits for shareholders, investors naturally want to spend money on projects with high short-term growth potential. When there are a multitude of investment projects available, would-be investors can use the profitability index (alongside other formulas) to rank the projects from high to low before deciding which is the best opportunity. Even when a project offers a high net present value, it may still be passed over based on the use of other financial calculations.

It's important to note that one problem with using the profitability index is that it does not allow a business owner to consider the full scope of the project. Using the net present value method of evaluating investment projects helps mitigate this problem, but raises other details worth considering. Certainly, the time a project requires to become profitable is a persistent concern for investors, and market factors can elongate the time table in unpredictable ways.

Treat the profitability index as a helpful guideline, but always use it in tandem with the net present value method and other forms of multifaceted analysis.

The formula for Profitability Index is simple and it is calculated by dividing the present value of all the future cash flows of the project by the initial investment in the project.

Profitability Index = PV of future cash flows / Initial investment

It can be further expanded as below,

• Profitability Index = (Net Present value + Initial investment) / Initial investment
• Profitability Index = 1 + (Net Present value / Initial investment)

Table of contents

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Steps to Calculate Profitability Index

Below are the steps to calculate profitability index –

1. Firstly, the initial investment in a project has to be assessed based on the project requirement in terms of capital expenditureCapital ExpenditureCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more for machinery u0026 equipment and other expenses, which are also capital in nature.
2. Now, all the future cash flows expected from the project are required to be determined. Then the discounting factor has to be calculated based on the current expected return from an investment of similar risk. Now, using the discounting factorDiscounting FactorDiscount Factor is a weighing factor most often used to find the present value of future cash flows, i.e., to calculate the Net Present Value (NPV). It is determined by, 1 / {1 * (1 + Discount Rate) Period Number}read more, the present value of the future cash flows from the project can be calculated.
3. Finally, the profitability index of the project is calculated by dividing the present value of all the future value of cash flow from the project (step 2) by the initial investment in the project (step 1).

Examples

You can download this Profitability Index Formula Excel Template here – 

Example #1

Let us take the example of company ABC Ltd which has decided to invest in a project where they estimate the following annual cash flows:

• $5,000 in Year 1
• $3,000 in Year 2
• $4,000 in Year 3

At the beginning of the project, the initial investment required for the project is $10,000, and the discounting rate is 10%.

PV of cash flow in Year 1= $5,000 / (1+10%)1 = $4,545

PV of cash flow in Year 2 = $3,000 / (1+10%)2 = $2,479

PV of cash flow in Year 3 = $4,000 / (1+10%)3 = $3,005

So, Sum of PV of future cash flows will be:

Profitability Index of the project = $10,030 / $10,000

As per the formula of the profitability index, it can be seen that the project will create an additional value of $1.003 for every $1 invested in the project. Therefore, the project is worth investing since then it is more than 1.00.

Example #2

Let us take the example of a company A which is considering two projects:

Project A

Project A needs an initial investment of $2,000,000 and a discount rate of 10% and with estimated annual cash flows of:

• $300,000 in Year 1
• $600,000 in Year 2
• $900,000 in Year 3
• $700,000 in Year 4
• $600,000 in Year 5

Initial investment = $2,000,000

PV of cash flow in Year 1= $300,000 / (1+10%)1 = $272,727

PV of cash flow in Year 2 = $600,000 / (1+10%)2 = $495,868

PV of cash flow in Year 3 = $900,000 / (1+10%)3 =$676,183

PV of cash flow in Year 4 = $700,000 / (1+10%)4 = $478,109

PV of cash flow in Year 5 = $600,000 / (1+10%)5 =$372,553

So, Sum of PV of future cash flows will be:

Profitability Index of Project A = $2,295,441 / $2,000,00

Project B

The initial investment of $3,000,000 and discount rate of 12% and with estimated annual cash flows of:

• $600,000 in Year 1
• $800,000 in Year 2
• $900,000 in Year 3
• $1,000,000 in Year 4
• $1,200,000 in Year 5

PV of cash flow in Year 1= $600,000 / (1+12%)1 = $535,714

PV of cash flow in Year 2 = $800,000 / (1+12%)2 =$637,755

PV of cash flow in Year 3 = $900,000 / (1+12%)3 =$640,602

PV of cash flow in Year 4 = $1,000,000 / (1+12%)4 =$635,518

PV of cash flow in Year 5 = $1,200,000 / (1+12%)5 =$680,912

So, Sum of PV of future cash flows will be:

Profitability Index of Project B = $3,130,502 / $3,000,000

Using the formula of profitability index, it can be seen that Project A will create an additional value of $0.15 for every $1 invested in the project compared to Project B, which will create an additional value of $0.04 for every $1 invested in the project. Therefore, Company A should select Project A over Project B.

Profitability Index Calculator

You can use the following Profitability Index calculator-

PV of Future Cash FlowsInitial InvestmentProfitability Index Formula 

Profitability Index Formula =PV of Future Cash Flows=Initial Investment0=00

Relevance and Use

The concept of profitabilityThe Concept Of ProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more index formula is very important from the point of view of project financeProject FinanceProject Finance is long-term debt finance offered for large infrastructure projects depending upon their projected cash flows. Moreover, an investor has to form a Special Purpose Vehicle (SPV) to acquire the same. read more. It is a handy tool to use when one needs to decide whether to invest in a project or not. The index can be used for ranking project investment in terms of value created per unit of investment.

• The basic idea is that – the higher the index, the more attractive the investment.
• If the index is greater than equal to unity, then the project adds value to the company, or otherwise, it destroys value when the index is less than unity.

Recommended Articles

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• Calculate NPV in ExcelCalculate NPV In ExcelThe NPV (Net Present Value) of an investment is calculated as the difference between the present cash inflow and cash outflow. It is an Excel function and a financial formula that takes rate value for inflow and outflow as input.

  Which of the following will be included when calculating a project's profitability index?

  Profitability Index = (Net Present value + Initial investment) / Initial investment.

  What is the profitability index How is it calculated?

  The profitability index is calculated by dividing the present value of future cash flows that will be generated by the project by the initial cost of the project. A profitability index of 1 indicates that the project will break even. If it is less than 1, the costs outweigh the benefits.

  Which of the following is the formula for calculating profitability index quizlet?

  Which of the following is the formula used to calculate the profitability index? Profitability index = Present value of net cash flows ÷ Initial investment.

  Why profitability index is calculated?

  Description: Profitability index helps in ranking investments and deciding the best investment that should be made. PI greater than one indicates that present value of future cash inflows from the investment is more than the initial investment, thereby indicating that it will earn profits.