• Profitability Index (PI)

    Profitability index refers profitability of the project based on the initial investment. It is calculated as the present value of all the future cash flows from a project divided by the initial investment.

    Profitability Index = (Present Value of all the future cash flows/Initial Investment)

    Now we know that NPV = -CF0 + Present Value of all the future cash flows

    (CF0 = Initial Investment)

    Which derives to Present value of all the future investment = NPV + CF0

    We Profitability Index (PI) =  (NPV + CF0)/ CF0 = 1+ NPV/ CF0

    Now if NPV is > 0, PI > 1, then accept the project as per the NPV method

    If NPV < 0, PI < 1, then reject the project as per the NPV method

    Example

    Let us consider one example project X to calculate the PI for the same with the below information

    • For project X, the initial investment or cash outflow is 1000 USD.
    • Both the projects are for 5 years and will generate cash inflow for next 5 years. The cash inflows for project X are 400 USD, 350 USD, 300 USD, 250 USD and 200 USD respectively. Total Cash inflow will be 1500 USD over the next 5 years.
    • The required rate of return is 10%.
    • So the net present value of the project X will be

    NPVx = – 1000 + (400/(1+ 0.10)^1) +  (350/(1+ 0.10)^2) + (300/(1+ 0.10)^3) + (250/(1+ 0.10)^4) + (200/(1+ 0.10)^5) = -1000 + 363.64 + 289.26 + 225.39 + 170.75 +124.18 = 173.22 USD

    Profitability Index = 1 + 173.22/1000 = 1.17322

    As the profitability index is more than 1, the project should be accepted.

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