PI differs from NPV in one important respect: Since it is a ratio, it provides no indication of the size of the actual cash flow. Based on the profitability index rule, the project would proceed, even though the initial capital expenditure required are not identified. Internal rate of return IRR is also used to determine if a new project or initiative should be undertaken. Broken down further, the net present value discounts after-tax cash flows of a potential project by the weighted average cost of capital WACC.
To calculate NPV:. The NPV method reveals exactly how profitable a project will be in comparison to alternatives. When a project has a positive net present value, it should be accepted.
If negative, it should be rejected. When weighing several positive NPV options, the ones with the higher discounted values should be accepted. In contrast, the IRR rule states that if the internal rate of return on a project is greater than the minimum required rate of return or the cost of capital , then the project or investment should proceed.
If the IRR is lower than the cost of capital, the project should be killed. Tools for Fundamental Analysis. Investing Essentials. Corporate Finance. Financial Ratios. As the value of the profitability index increases, so does the financial attractiveness of the proposed project.
The profitability index is an appraisal technique applied to potential capital outlays. The method divides the projected capital inflow by the projected capital outflow to determine the profitability of a project. As indicated by the aforementioned formula, the profitability index uses the present value of future cash flows and the initial investment to represent the aforementioned variables. When using the profitability index to compare the desirability of projects, it's essential to consider how the technique disregards project size.
Therefore, projects with larger cash inflows may result in lower profitability index calculations because their profit margins are not as high. The profitability index can be computed using the following ratio:. The present value of future cash flows requires the implementation of time value of money calculations. Cash flows are discounted the appropriate number of periods to equate future cash flows to current monetary levels.
Cash flows received further in the future are therefore considered to have a lower present value than money received closer to the present. The discounted projected cash outflows represent the initial capital outlay of a project.
The initial investment required is only the cash flow required at the start of the project. All other outlays may occur at any point in the project's life, and these are factored into the calculation through the use of discounting in the numerator. These additional capital outlays may factor in benefits relating to taxation or depreciation. Because profitability index calculations cannot be negative, they consequently must be converted to positive figures before they are deemed useful. Calculations greater than 1.
Calculations less than 1. Calculations that equal 1. A final issue is that the index cannot be used to rank projects that are mutually exclusive; that is, only one investment or the other would be chosen, which is a binary solution. In this situation, a project with a large total net present value might be rejected if its profitability index were lower than that of a competing but much smaller project. Capital Budgeting Constraint Management.
Accounting Books. Finance Books. Operations Books. Articles Topics Index Site Archive. The step-by-step plan to get ahead of your cash flow. Click here to access your Execution Plan. Not a Lab Member? Leave Us A Review! CFO Training. Download The Know Your Economics Worksheet Profitability Index Explanation Explain profitability index as a measure of whether or not a proposed project will be profitable and simple or complicated depending on the scope of the project in question.
Profitability Index Formula The profitability index formula is most commonly calculated as listed below. Profitability Index Advantages Profitability index advantages include the following: Evaluates all cash flows Shows whether an investment increases firm value Evaluates multiple projects Compares time values of cash flows Uses cost of capital as a comparison to projects Profitability Index Disadvantages Profitability index disadvantages include the following: Does not work well with evaluations in which only one project can happen at a time Cost of capital is required to calculate PI Profitability Index Example For example, Lisa is part of the investment branch of a major corporation.
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