Profitability Index

The Profitability Index is a method of choosing most best alternative or profitable project. 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).

The Profitability Index is an appraisal technique applied to potential capital outlays. The method divides the projected capital inflow by the projected capital outflow to determine the profitability of a project. As indicated by the aforementioned formula, the profitability index uses the present value of future cash flows and the initial investment to represent the aforementioned variables. When using the profitability index to compare the desirability of projects, it's essential to consider how the technique disregards project size. Therefore, projects with larger cash inflows may result in lower profitability index calculations because their profit margins are not as high.

Method of Selection - Rejection Process

Profitability index helps in ranking investments and deciding the best investment that should be made.

PI > 1 indicate that present value of future cash inflows from the investment is more than the initial investment, thereby indicating that it will earn profits.

PI < 1 indicates loss from the investment. PI equal to one means that there are no profits. Thus, profitability index helps investors in making decisions about whether or not to make a particular investment.

Formula:

Profitability Index = Present Value of Future Cash Flow / Initial Investment
Profitability Index = (Net Present Value + Initial Investment) / Initial Investment

Examples(a):

Your company has ₹10 Crore available for investment in the following potential investment opportunities:

Project	NPV	Initial Investment
A	₹5 L	₹15 L
B	₹15 L	₹50 L
C	₹10 L	₹10 L
D	₹20 L	₹60 L
E	₹12 L	₹35 L

Solution:

Rank the projects based on profitability and identify the projects that should be accepted keeping in view the company’s capital budget constraints.

Let’s first find profitability indices of each project:

A	1+5/15	1.33
B	1+15/50	1.30
C	1+10/10	2.00
D	1+20/60	1.33
E	1+12/35	1.34

The ranking based on profitability index is: Project C, Project E, Project A and D and Project B. Now, we need to maximise total net present value that can be achieved using ₹10 Crore investment by applying the concept of capital rationing.

Examples(b):

ABC Company has decided to invest in a project for which the initial investment would be ₹10 Crore. 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 ₹13 Crore. Is it a good project to invest in in the first place? Calculate Profitability Index to prove that.

Solution:

PI Formula = 1 + (Net Present Value / Initial Investment Required)

PI = 1 + [(Present Value of Future Cash Flow – Present Value of Cash Outflow)/ Initial Investment Required]

PI = 1 + [( ₹13 Crore – ₹10 Crore)/ ₹10 Crore]

PI = 1 + [ ₹3 Crore / ₹10 Crore]

PI = 1 + 0.3

PI = 1.3

So, in both ways, the PI is 1.3. That means it’s a great venture to invest in. But the company also needs to consider other projects where the PI may be more than 1.3. In that case, the company should invest in a project that has more PI than this particular project.