Profitability Index Formula

Profitability Index Formula (Table of Contents)

Profitability Index Formula
Examples of Profitability Index Formula (With Excel Template)
Profitability Index Formula Calculator

Profitability Index is a measure used by firms to determine a relationship between costs and benefits for doing a proposed project.

Here’s the Profitability Index formula –

Profitability Index = PV of Future Cash Flows / Initial Investment

Examples of Profitability Index Formula (With Excel Template)

Let’s take an example to understand the calculation of Profitability Index formula in a better manner.

You can download this Profitability Index Formula Excel Template here – Profitability Index Formula Excel Template

Profitability Index Formula – Example #1

Let’s take the example of Project A whose cash flows are depicted below: –

Profitability Index is calculated using given below formula

Profitability Index = PV of Future Cash Flows / Initial Investment

Profitability Index = (Net Present Value + Initial Investment) / Initial Investment

First, we calculate Net Present Value

Then, we calculate Profitability Index

Profitability Index = ($21148.13 + $30000) / $30000

Profitability Index = $1.70

Profitability Index Formula – Example #2

Let’s take an example of Reliance which as a Project X whose cash flows are depicted below: –

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Profitability Index is calculated using given below formula

Profitability Index = PV of Future Cash Flows / Initial Investment

Profitability Index = (Net Present Value + Initial Investment) / Initial Investment

First, we calculate Net Present Value

Then, we calculate Profitability Index

Profitability Index = (593262.10 + 10000000) / 10000000

Profitability Index = 1.06

Profitability Index Formula – Example #3

Let’s take the example of Company Apple which has a Project Z whose cash flows are depicted below: –

Profitability Index is calculated using given below formula

Profitability Index = PV of Future Cash Flows / Initial Investment

Profitability Index = (Net Present Value + Initial Investment) / Initial Investment

First, we calculate Net Present Value

Then, we calculate Profitability Index

Profitability Index = ($17.49 + $50 million) / $50 million

Profitability Index = $1.35

Explanation of Profitability Index Formula

Profitability Index is a measure used by firms to determine a relationship between costs and benefits for doing a proposed project. This measure is used to rank projects based on their value created per unit of investment.

Present Value of Future Cash Flows – As the name indicates, the time value of money concept is used to determine the present value of future cash inflows for the project. Discounting takes into account that $1 received in future is not equal to $1 today and hence a proper discounting factor must be used to determine what is the value of future $1 today.
Initial Investment – It is the initial capital outlay for the project. This is the outlay at only the beginning and other outlays at different points of the project are not considered as an initial investment.

Relevance and Uses of Profitability Index Formula

As stated, Profitability Index = PV of future cash flows / Initial Investment

This can be further broken down to: –

Profitability Index = (Net Present Value + Initial Investment) / Initial Investment

So based on the above formula: –

If profitability index is > 1 then the company should proceed with the project as it generates value for the company
If profitability index is < 1 then the company should not proceed with the project as it destroys value for the company
If profitability index is = 1 then the company should be indifferent between proceeding with the project or not since it does not create additional value for the company or destroys value for the company

This measure can be used to determine which project should be done. If there are multiple projects, then the project with the highest profitability index should be chosen. This is done when there is limited capital and projects are mutually exclusive. For this reason, it is called a benefit-cost ratio. This differs from the concept of accepting the project with the highest Net Present Value. 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 usage of company assets.

There are certain advantages and disadvantages of using the Profitability Index as a measure to decide to proceed with which project.

Advantages: –

The PI index can indicate whether the supposed project to be undertaken can create or destroy value for the company.
The PI index considers the time value of money and the risk of cash inflows in the future and discounts it with a cost of capital
When there is a need for capital rationing, PI index is useful for ranking projects

Disadvantages: –

The PI index requires the cost of capital which is generally difficult to estimate.
There is ambiguity in results for mutually exclusive projects if initial investments are different.