Profitability index
Profitability index (PI) is a measure of the return on investment that takes into account the present value of future cash flows. It is calculated by dividing the present value of future cash flows by the initial investment. In other words, it is the ratio of the present value of a project's future cash flow to the current cost of the investment. By expressing the return on investment in this way, the PI allows investors to compare investments of different sizes and different time frames.
Example of Profitability index
Let's say we have an investment of $1000 and future cash flows of $3000. The present value of the future cash flows is $2500. The profitability index will be calculated by dividing the present value ($2500) by the initial investment ($1000):
In this example, the profitability index is 2.5, meaning that for every dollar invested there is a return of $2.50. This indicates that the investment is profitable.
Formula of Profitability index
The formula for the Profitability index (PI) is as follows:
Where:
- PV is the present value of future cash flows
- C_{0} is the initial investment
Therefore, PI is a measure of the return on investment that takes into account the present value of future cash flows. It is calculated by dividing the present value of future cash flows by the initial investment. This allows investors to compare investments of different sizes and different time frames.
When to use Profitability index
Profitability index can be useful in a variety of situations. Here are a few examples:
- When a company is considering whether to invest in a new project, the PI can be used to compare the potential return on the investment to the cost of the investment.
- When a company is deciding which of several projects to pursue, the PI can be used to compare the returns of the different projects and determine which one has the highest return on investment.
- When a company is considering an acquisition, the PI can be used to compare the potential return on the acquisition to the cost of the acquisition.
Types of Profitability index
There are three different types of Profitability Index:
- Internal Rate of Return (IRR): The Internal Rate of Return (IRR) is a measure of the return on investment of a project or investment, expressed as the rate of return on the investment. It is the rate at which the present value of the future cash flows from the investment equals the initial cost of the investment.
- Net Present Value (NPV): The Net Present Value (NPV) is a measure of the return on investment of a project or investment, expressed as the present value of the future cash flows from the investment minus the initial cost of the investment.
- Payback Period: The Payback Period is a measure of the return on investment of a project or investment, expressed as the amount of time it takes for the investment to pay back its initial cost.
Steps of Profitability index
The steps of calculating the profitability index are as follows:
- Step 1: Calculate the present value of the future cash flows: The present value of future cash flows can be calculated by discounting the future cash flows at a rate equal to the required rate of return.
- Step 2: Calculate the initial investment: This is the amount of money that is required to initiate the project.
- Step 3: Calculate the profitability index: The profitability index is calculated by dividing the present value of future cash flows by the initial investment.
Advantages of Profitability index
- The main advantage of the profitability index is that it is able to measure the return on investment for projects of different sizes and time frames. By expressing the return on investment as a ratio, investors can compare investments more accurately and make more informed decisions.
- Another advantage of the profitability index is that it can be used to evaluate projects with different levels of risk. By taking into account the present value of future cash flows, the PI can provide an indication of the risk associated with an investment.
- The profitability index also makes it easier to compare investments with different rates of return. By expressing the return on investment as a ratio, investors can compare investments with different rates of return more easily.
Limitations of Profitability index
Despite the usefulness of the profitability index, it has some limitations. These include:
- It does not consider the risk of the investment. The PI assumes that all cash flows are certain and equal, when this is often not the case.
- It ignores the cost of capital. The PI does not take into account the cost of capital, which is an important consideration when evaluating investments.
- It assumes that cash flows are reinvested at the same rate as the cost of capital. This is not always the case, and so it can lead to an overestimation of the return on investment.
There are other approaches related to profitability index that can be used to measure the return on investment. These include:
- Internal rate of return (IRR): The internal rate of return is the discount rate that equates the present value of future cash flows with the initial investment.
- Payback period: The payback period is the length of time it takes for an investment to pay back its initial cost.
- Net present value (NPV): The net present value is the present value of future cash flows minus the initial investment.
In summary, other approaches related to profitability index that can be used to measure the return on investment include the internal rate of return, the payback period, and the net present value.
Profitability index — recommended articles |
Payback period — Net present value (NPV) — Unlevered beta — Net asset value per share — RAROC — Return on investment — Liquidation value — Average annual growth rate — Modified internal rate of return |
References
- Gurau, M. A. (2012). The use of profitability index in economic evaluation of industrial investment projects. Proceedings in Manufacturing Systems, 7(1), 55-58.
- de Souza Rangel, A., de Souza Santos, J. C., & Savoia, J. R. F. (2016). Modified profitability index and internal rate of return. Journal of International Business and Economics, 4(2), 13-18.