Profitability Index Formula with Calculator

The problem is that this doesn’t factor in the magnitude of the investment requirement. Consider that we tell you there are two projects, which we’ll conveniently call Project A and Project B. Each of these components plays a crucial role in determining the PI and, ultimately, the attractiveness of an investment. We can use the profitability index calculator with the checkbox ticked to choose which line of products would be most beneficial to undertake. From the above computation, we can come to the conclusion that ABC Company should invest in the project as PI is more than 1.

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Discounted cash flows may unexpectedly differ in the future, which immediately makes us question the predictive accuracy of both PI and NPV figures as stand-alone metrics. To build solid decision-making criteria for investments, we often combine it with other ratios. To understand how to calculate profitability index, we use a simple formula. PI is the ratio of the present value of future cash flows to the initial investment cost. The profitability index measures the present value of future expected cash flows and the initial amount invested in a project. The PI, known as the value investment ratio (VIR) or profit investment ratio (PIR), represents the relationship between the costs and benefits of a proposed project.

How to calculate profitability index

Therefore, projects with larger cash inflows may result in lower profitability index calculations because their profit margins are not as high. The first thing you notice is that Project I has a larger scale compared to Project II — it requires larger initial investment and returns higher cash flows. The first project will return cash flows for a period of 10 years, while the second one is expected to deliver for 8 years only. But we know that the project with a lower upfront amount is a far better investment. Thus, we need their PI values, which reflect this vital information such that the lower upfront investment has a PI of 2.00 while the higher upfront investment has a PI of 1.01. The profitability index calculator is a great tool to help you analyze your options.

This article describes how to determine the profitability index, its formula, and why it differs from net present value (NPV). We will also provide examples to give you an understanding of the concept. At the end of this guide, you will learn how to calculate the profit index and how it is used in financial decision-making.

• Consequently, PI’s primary limitation is that it does not consider the full scope of an investment or project.
• That’s why it’s a good idea to learn how to leverage PI investment for maximum profitability.
• Therefore, the formula divides the present value (PV) of the project’s future cash flows by the initial investment.
• To calculate IRR, solve the NPV equation for the discount rate where NPV equals zero.
• Suppose further that the company has only $40,000 available to invest and all the projects are independent, not mutually exclusive.

Example Calculation

ABC Company has decided to invest in a project for whichthe initial investment would be ₹10 Crore. As they are considering whetherit’s a good deal to invest in, they have found out that the present value ofthe future cash flow of this project is ₹13 Crore. However, actual decision should attempt to maximize the total net present value of the project keeping in view the available funds for initial investment using capital rationing. The profitability index formula runs into the same problems that the NPV does.

Notwithstanding, when comparing the attractiveness of different independent projects, to maximize limited financial resources, you must accept the project with the highest PI. Because, unlike PI, NPV does not consider the initial investment tied up in a project. If you want to learn how to calculate your project’s profitability index or learn how discounting works, keep reading! This article addresses how to use the profitability index calculation to rank project investments and quantify the enterprise value created.

On the grounds of the positive NPV figures, we consider both projects to be acceptable. Should these be mutually exclusive investments, the second project will be preferable, even though it has a lower PI. This is how, if examined in isolation, PI ignores the size and added shareholder value of a given project.

And between NPV and the Profitability Index, you’re probably better off applying the rule or investment appraisal criteria using profitability index rather than NPV. In other words, in this particular example, the interpretations/results from the PI are consistent with the results from the NPV capital budgeting tool. Investing in Archer will allow Garch Ltd to earn $80,000 in annual cash flow for the next 5 years. The projects require investments of $300,000; $200,000; and $600,000 for Archer, Brochure, and Catcher respectively. We’d say that for every £1 pound that you invest in A, you earn £1.50 in cash flow, in present value terms.

( . Project 1 and project 2 are both independent projects:

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• The profitability index, in fact, is another way of representing the net present value model.
• Well, it just means that for every £1 pound you invest in Project A, you earn 50p.

A less than 1 PI ratio means that the project’s present value would not recover its initial investment or cost. Theoretically, it reveals unprofitability of a proposed investment and suggests rejection of the same. In general terms, the higher the PI metric, the more attractive a proposed investment is. The new factory project is expected to cost $2 million and generate cash flows of $300,000 per year for the next 5 years, also with a discount rate of 10%. While the net present value gives us the absolute value that a project adds, it is wrong to compare the net present values of different investments directly. Let’s say there are two projects, A and B, each with initial investment outlay of $10 million and net present values of $2 million and $2.2 million respectively.

Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.

However, even if the PI is widely used for doing cost-benefit analyses, it is not free of demerits. As every good side has its limitations, PI also has a couple of limitations. Below is a break down of subject weightings in the FMVA® financial analyst program. As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy. Suppose further that the company has only $40,000 available to invest and all the projects are independent, not mutually exclusive.

The common sense here dictates that the company should choose both project 2 and 3, and leave the first one. We can see that the PI number obtained through our incremental analysis is greater than 1. Now that we have obtained the PI value for both the projects, let’s look into its application for appraising projects. However, both PIs are less than 1.0, so the company may forgo either project.

PI is a ratio of the advantage of a project to its expense, thus helpful in prioritizing projects. NPV, however, is an absolute dollar amount a project will earn after it pays for itself. There is uncertainty in results for mutually exclusive projects if formula for profitability index initial investments and discount rates are different.

N Enterprise has decided to invest in a project for which the initial investment would be $100 million. As they are considering whether it’s a good deal to invest in, they have found out that the present value of the future cash flow of this project is 130 million. Firms follow the profitability index rule to obtain ratios that depict returns with respect to each investment dollars. Hence, it enables companies to choose projects that are best value for money. A ratio of 1 indicates that the present value of the underlying investment just equals its initial cash out outlay and is considered the lowest acceptable number for a proposal.

And lastly, similar story for Catcher; we expect to earn $0.02 for every $1 invested. Alternatively, you could calculate it as the ratio of PV to I, so that the PV (Present Value) is divided by the investment. Fundamentally, the Profitability Index shows us the amount of money we earn for every $1 / £1 invested. In the case of the two examples, since Project B has a slightly lower PI, then Project A is the most profitable project. Unfortunately, when two different investments have the same PI, this does not tell you which ties up more money initially. Often though, it isn’t always this simple to see that everything is equal except for the term.

In the energy sector, companies might use PI when deciding on infrastructure projects like building new power plants or expanding renewable energy sources. Given the substantial initial investments and long-term horizons of such projects, PI serves as a vital indicator of future profitability. Capital budgeting, specifically Level 1 and Level 2 of the CFA program, encompasses it. Profitability index, or PI, is a valuable investment analysis tool that allows finance professionals to assess projects in terms of their present value compared to cost. CFA candidates need to recognise PI’s contribution to investment decision-making.