Welcome to Alanis Business Academy.
I'm Matt Alanis and this is How to Calculate the Profitability Index.
The profitability index is a capital budgeting tool used to assist a business in evaluating
their various project alternatives.
As with any capital budgeting tool, the business is hoping to identify the project that is
going to provide the most long-term value.
Calculating the profitability index is very similar to calculating the net present value
of a project.
In fact, both the profitability index and the NPV often lead to the same decision as
to whether accept or reject a project.
So if you are already familiar with how to calculate NPV, you will likely have an easy
time with the profitability index.
While NPV expresses the return of a project in dollars generated by subtracting the amount
of the initial investment from the present value of cash flows, the profitability index
expresses this relationship as a ratio.
We calculate the profitability index by determining the present value of future cash flows and
dividing that value by our initial investment for the project.
As with NPV, we need to project our future cash flows and then discount them to their
respective present values.
Well now that we understand some of the basic surrounding the profitability index, lets
walk through how to calculate the index.
Lets assume that we're investing $25,000 in a project and that we expect to receive $8,000,
$10,000, and $13,000 in future cash flows in years one through three respectively.
Since the $25,000 represents money that we are paying or a cash outflow we express that
value in parenthesis.
Due to the time value of money, we know that $8,000 one year from now is not that same
as if we had $8,000 today.
If you're not familiar with the concept of the time value of money, I recommend watching
the video The Time Value of Money so that you understand why we go through the process
of discounting.
If you've seen any of my prior videos on capital budgeting tools you know that I prefer to
display the process of discounting as follows.
Although this isn't absolutely necessary, I find it helps me to stay organized and provide
a clearer picture of what is actually going on in the problem.
When discounted future cash flows you can utilize a financial calculator, Microsoft
Excel, or even the present value formula, which is PV = FV divided by 1 plus i to the
nth power.
As far as the discount rate or interest rate, I'm going to assume a fairly conservative
rate of 5 percent.
For the discount rate firm's often use the rate that they could've earned if they had
the money in their possession or even their weighted average cost of capital.
Discounting each of the future cash flows by our discount rate of 5 percent should give
us present values of $7,619.05, $9,070.30, and $11,229.89 respectively for years one
through three.
These values are the result of rounding to the nearest hundredth as well.
Now to this point the process that we've undertaken to calculate the profitability index has been
identical to that of NPV.
But here is where the two methods diverge.
Under NPV, we should add up our discounted future cash flows and subtract our initial
investment.
If the resulting value is positive, meaning greater than zero, we know that the project
produces positive cash flow and is something worse considering.
If the resulting value is negative, meaning less than zero, we know that the project is
a money loser and probably something we don't want to move forward with.
However, with the profitability index we actually divide our present value of future cash flows,
which is $27,919.24, by our initial investment of $25,000.
This gives us a profitability index of1.12 after rounding to the nearest hundredth.
This ratio can be expressed as we generate $1.12 for every $1 that we invest in this
project.
In order to determine whether or not a project is acceptable or at least worth considering
we use the following.
A profitability index greater than 1.0 is profitable and considered to be an acceptable
project.
A profitability index less than 1.0 is unprofitable and not considered to be an acceptable project.
A project that produces a profitability index of less than 1.0 indicates that the present
value of future cash flows generated by the project is less than the investment needed
to generate those cash flows.
In short, we're throwing good money after bad.
Now simply because a project produces a profitability index greater than 1.0 does not automatically
mean that you should move forward with that project.
Rather, by comparing the profitability index with other projects you can identify the project
that has the greatest potential to produce the most long-term benefit.
Furthermore, it's usually best to not make a decision as important where to allocate
resources on one measure alone.
Using other capital budgeting tools such as IRR, NPV, the payback period, and others will
help you more accurately identify the best project.
This has been How to Calculate the Profitability Index.
For questions please leave them in the comment box below and I'll do my best to get back
to those in a timely fashion.
If you're interested in learning more about capital budgeting, check out the playlist
titled Capital Budgeting 101 and also subscribe to Alanis Business Academy for videos on other
business topics.
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Thanks for watching.