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What is Profitability Index?


Profitability Index: It is a tool used to calculate whether investment project is accepted or not. It considers the time value of money. If profitability index is less than 1 that project is rejected and if it is more than 1 than that project is accepted and if it is equal to 1 than project is rejected. It is also known as Benefit-cost ratio.

Advantages of Profitability index:
·         It considers time value of money.
·         It is easy to calculate.
·         Highest the profitability ratio better will be the investment.
·         It includes all cash flows during investment period.

Disadvantages of Profitability Index:
·         It is calculated on the basis of estimated rate of return.
 It does not provide correct answer in two mutually exclusive projects.

Formula for Profitability Index:

Profitability Index = Present Value of future cash inflows/ Initial Investment
                                               OR
Profitability Index = 1+ (NPV/Initial Investment)
                     OR
Net Profitability Index = NPV/Initial Investment

NPV = Present value of future cash inflows-Initial investment

Whereas,
NPV = Net Present Value

Example: Find out the Profitability Index of following projects:

Years
Particulars
Project A (Rs.)
Project B (Rs.)
Project C (Rs.)
0
Original Investment
(90,000)
(80,000)
(75,000)
1
*FV
5,000
10,000
5,000
2
*FV
12,000
8,000
10,000
3
*FV
20,000
15,000
18,000
4
*FV
27,000
23,000
26,000
Discount Rate
7%
6%
8%
*FV= Future Value

Solution:

Years
Project A (Rs.)
FV
PV
Project B (Rs.)
FV
PV
Project C (Rs.)
FV
PV
1
5,000
4692.89
10,000
9433.96
5,000
4629.62
2
12,000
10526.31
8,000
7142.85
10,000
8573.38
3
20,000
16393.44
15,000
12605.04
18,000
14400
4
27,000
20610.68
23,000
18253.96
26,000
19117.64
TOTAL
52,223.32
47,435.81
46,720.64


Profitability Index =Present Value of future cash inflows/ Initial Investment

Project A:

= 52,223.32/90,000
= 58%

Project B:

= 47,435.81/ 80,000
= 59%

Project C:

= 46,720.64/75,000
= 62%

Project C profitability Index 62% is higher than project A and B profitability Index 58% and 59% respectively.

Sometimes we can also rank projects by profitability index rather than by NPV because both give  same answers.

Let’s take above example and find out NPV?

Project A (Rs.)
Project B (Rs.)
Project C (Rs.)
*NPV
-37776.68
-32564.19
-28279.36
*NPV = Present value of future cash inflows - Initial investment

Project C has higher NPV and profitability index in comparison to project A and B.

Example: Find out the profitability index from given information:

Initial investment
Rs. 10,000
Discount rate
6% compounded half- yearly
Future value
Rs. 8, 000
No. of years
9 years


Solution: Present value = FV / (1+r) n
 = 8, 000 / (1+0.03) 9*2
 = 8, 000 / 1.70
 =  4, 706

Profitability Index = Present Value of future cash inflows/ Initial Investment
= 4, 706 / 10, 000
= 0.47
= 47%
The NPV of this project is:
NPV = Present value of cash flow – Initial investment
= 4, 706 – 10, 000
= Rs. - 5, 294

This project shows 47% profitability index but the NPV shows negative cash flows. It means we or company cannot depend only on profitability index for taking a decision to accept the investment project or not.






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