Prior to accepting a position as the Director of Operations Strategy at DJO Global, Manu was a management consultant with McKinsey & Company in Houston. He served clients, including presenting directly to C-level executives, in digital, strategy, M&A, and operations projects. If any part of the profitability index formula isn’t quite clear, please re-read this article.
You learned that the Profitability Index formula overcomes the magnitude problem of the Net Present Value (NPV) by showing us how much we are in for every $1 invested (or £1 invested). 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. Alternatively, you could calculate it as the ratio of PV to I, so that the PV (Present Value) is divided by the investment.
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. Also, PI is based on estimated cash flows and discount rates, which could be inaccurate or subject to changes. Moreover, PI might not be the best tool for mutually exclusive projects with different sizes and timing of cash flows. This computation yields a ratio that becomes a beneficial tool in the decision-making process.
The computation of PI necessitates the initial determination of the present value of projected cash inflows. This step involves applying a discount rate – usually the cost of capital attributed to the project – to every future cash inflow. Profitability index is a modification of the net present value method of assessing an investment’s potential profitability.
However, if they are added together, the sum total is larger than project 1’s NPV. 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. In essence, the PI should serve as a component of a broader, comprehensive approach to investment analysis.
- The profitability index (PI) is a measure of the attractiveness of a project or investment.
- 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.
- The company might decide to pursue this project instead of the new factory project because it is expected to generate more value per unit of investment.
- On the grounds of the positive NPV figures, we consider both projects to be acceptable.
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Secondly, as a relative metric, it becomes beneficial in contrasting projects of varying magnitudes. If for whatever reason, Garch Ltd can’t find anything else to invest in, and the risk-free rate is lower than say inflation, then they should probably go ahead and invest in Catcher. Because the NPV / I approach shows us exactly how much money we make for every pound we invest. Well, it just means that for every £1 pound you invest in Project A, you earn 50p. This shows you how much money you make for every one dollar or one pound you invest.
How to Calculate Profitability Index?
The profitability index (PI), often referred to as the profit investment ratio or value investment ratio, serves as an essential tool in capital budgeting used to assess prospective investments or initiatives. The PI ratio uses discounting, the cash flows are discounted by an appropriate rate of return. For example, a project that costs $1 million and has a present value of future cash flows of $1.2 million has a PI of 1.2.
This is because projects with a profitability index greater than one generate value for the company. In contrast, those with a profitability index of less than one indicate that the project destroys value for the company. It may not always indicate the correct decision when ranking projects but would certainly provide an insight into the cost-benefit efficiency of one monetary unit invested. Despite its relevance, this index uses just an estimate of the cost of capital in its calculation, so it should not be reviewed on a stand-alone basis. Combined with the Payback Period, Discounted Payback Period, and the Accounting Rate of Return, this ratio provides meaningful data to work with. Internal rate of return (IRR) is also used to determine if a new project or initiative should be undertaken.
What Is the Profitability Index?
It’s crucial to consider that the profitability index’s calculation involves an analysis of the project’s cash flows against the cost of capital, also known as the discount rate. The discounted projected cash outflows represent the initial capital outlay of a project. The initial investment required is only the cash flow required at the start of the project. All other outlays may occur at any point in the project’s life, and these are factored into the calculation through the use of discounting in the numerator.
If the profitability index is greater than or equal to 1, it is termed a good and acceptable investment. The profitability index (PI) offers a way to measure the balance between an initial investment and its present value of future cash flows. It’s a simple ratio that indicates whether or not an investment project is likely to be profitable by showing the value created per investment unit. A general rule of thumb is that a PI greater than one indicates the project should go forward, while a PI below one indicates it will not be worth the investment. Ideally the PI ratio of more than 1 is expected from the project, which means the value of future cash flows will be greater than the initial investments and it reflects the profitability of a proposed project.
The index itself is a calculation of the potential profit of the proposed project. The rule is that a profitability index or ratio greater than 1 indicates that the project should proceed. Thus, the initial investment is the amount you have invested in the business for the profitability of the business. The main difference between NPV and profitability index is that the PI is represented as a ratio, so it won’t indicate the cash flow size. A profitability index number might be 1.5, but you wouldn’t necessarily know the capital expenditure required. The PI is most effective when a project’s cash flow pattern is conventional, meaning that a series of inflows follow an initial outlay.
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. Suppose further that the company has only $40,000 available to invest and all the projects are independent, not mutually exclusive. Because of cash constraint, It can’t undertake both project 1 and another from project 2 and 3. The PI is more than a simple binary indicator; it also aids in comparing multiple projects. The project boasting the highest PI could be deemed the most appealing investment as it offers the highest return relative to its cost.
What Is the Profitability Index (PI) Rule?
The numerator is the present value of cash flow that occurs after the initial funds have been invested into the project. The denominator consists of the total funds the firm initially needs to undertake the opportunity. It offers a comparative analysis of a project’s profitability by relating the present value of future cash inflows to the original investment expense, thereby aiding in resource optimization. Primarily, it accounts for the temporal worth of money, precisely depicting a project’s profit potential. In capital-constrained situations, organizations must invest in projects that promise the highest returns per unit of investment.
The basis of comparing projects with only the Net Present Value does not take into account what is the initial investment. Profitability Index compares the Net Present Value reached with the initial investment and shows the most accurate representation of the usage of company assets. 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. Where “PV of future cash flows” is the present value of cash flows, starting from period 1 until the end of the project, and NPV denotes the Net Present Value. Note that PI results are based on estimates rather than precise numbers taken from a firm’s major financial statements.
When assessing a possible investment’s viability, the profitability index is particularly beneficial for two main reasons. 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. And lastly, investing https://www.wave-accounting.net/ in Catcher will earn Garch Ltd $155,000 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.
Preference of the PI Formula
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. In the subsequent step, we can now calculate the small business financial solutions and wave project’s PI given the NPV from the prior step. Suppose we’re evaluating a proposed five-year project with the following assumptions. By contrast, comparisons of NPV between projects are not always functional (i.e. non-standardized metric).