Introduction:
A tool of capital budgeting that gauges the potential profit of an investment or a project is called a Profitability index (PI) or Profit Investment Ratio (PIR) or Value investment Ratio (VIR). This formula is useful for ranking a project’s financial outlook with other investments and also used as an appraisal technique or is applied to potential capital outlays. It enables the investors to quantify the value of the amount created per unit of investment.
Formula:
The calculation of the profitability index is simply done by dividing the present value of future cash flows by the initial investment of the project. The initial investment includes the cash flow required to get the team and the project off the ground. The initial cost/investment is not included in the future cash flow. The method of the present value of future cash flows is used for discounting future cash to its current value, time value of money calculation is required to be implemented. The reason is this discount is because the current value of $1 is not equivalent to the value of $1 to be received in the future. The value of the money received closer to the present time is considered to have more value than the money t be received in the future.
A profitability index of 1 means breaking even, it indicates indifferent results for potential investors. The investment should be avoided if the result is less than 1.0 as it means the project’s cost may outweigh the potential profits whereas if the result is greater then 1.0 investors can likely go on to consider the other merits of the project. And if the profitability index is 1.2 then the investor can expect a return from the investment, for example, a return of $1.20 for every 100$ spent on the investment of the project can be expected.
Application:
The ranking of a firm’s investment and projects is done by using the profitability index. It helps to maximize the limited financial resources and profits of shareholders. It is natural that every investor wants to invest in such projects which are short-term for maximizing limited financial resources. It becomes easier to decide when projects are ranked high to low when there are multiple of investment projects available for investors. A project can be passed over on the base of other financial calculations even when a project offers high net present value
There is one problem with the use of the profitability index, it doesn’t allow the business owner to consider the full scope of the project. To lessen this problem the net present value method of evaluating investment projects can be used but raises other details worth considering. The project should be profitable is a persistent concern for investors, and market factors can elongate the time table in unpredictable ways.
Using the formula
PV = Present Value of future cash flow
NVP = Net Present Value of the initial investment
Profitable Index = P / initial investment
Or
NVP + Initial investment / Initial investment
Example:
A company made an investment of $20,000 in a project and expected NVP of $5,000 from that project.
Profitability Index = (20,000 + 5,000) divided by 20,000 = 1.25
As the result is greater than 1 the company should the investment project.