Profitability Index Formula

Publication Date :

03 Feb, 2019

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What is the Profitability Index Formula?

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)

What is the Profitability Index Formula

Steps to Calculate Profitability Index

Below are the steps to calculate profitability index -

Firstly, the initial investment in a project has to be assessed based on the project requirement in terms of capital expenditure for machinery equipment and other expenses, which are also capital in nature.
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 factor, the present value of the future cash flows from the project can be calculated.
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

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.

Relevance and Use

The concept of profitability index formula is very important from the point of view of project finance. 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.