Profitability index

Why would you use the profitability index method in capital budgeting, when other tools like return on investment and net present value already exist? To answer that question, let’s see what return on investment (ROI) and net present value (NPV) provide us. ROI relates the payoff (the expected project benefits) to the investment (the initial cash outlay or cost). NPV consider the time value of money, and considers cash flows over the entire life of the project. The profitability index (pi) incorporates all three of these elements. The profitability index is closely related to ROI and NPV. Once you understand how to calculate ROI and NPV, it is very easy to calculate the profitability index next.

⏱️TIMESTAMPS⏱️
0:00 Why use the profitability index method
0:55 How to calculate ROI
1:58 How to calculate NPV
4:09 How to calculate the profitability index
4:45 How to interpret the profitability index
5:22 Profitability index formula

Let’s calculate the profitability index for project A: put the sum of the present values of the future benefits in the numerator, and divide by the amount of the initial investment in the denominator. Working with present value equivalents is how the profitability index resembles the NPV method. Dividing by the amount of the initial investment is how the profitability index resembles the ROI method. $1035 divided by $1000 gives us a profitability index of 1.035. Now that we have calculated that profitability index outcome, is this a good or a bad number? You can look at this in absolute terms: projects with a profitability index higher than one create value for the company. You could also look at this in relative terms: maybe there are many other project proposals with a profitability index far higher than 1.035, in that case project A might not be the most attractive, especially when the investment budget is tight and not every project with a profitability index higher than one might end up getting selected.

There are several ways to write down the #profitabilityindex formula. You could express it as the sum of the present values of the future benefits divided by the amount of the investment. You could also express it as the sum of NPV plus investment, divided by the investment. Or as NPV divided by investment, plus 1. When you plug in the numbers from our profitability index example, you see that these versions of the profitability index formula are all equivalent. $1035 divided by $1000 is 1.035. The sum of $35 and $1000 is $1035. Divide this by $1000, and you get 1.035. $35 divided by $1000 is 0.035. Add 1 to this, and you get 1.035. Different ways of writing the profitability index formula, same outcome.

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