Profitability index

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Profitability index identifies the relationship of investment to payoff of a proposed project. The ratio is calculated as follows:

Profitability Index is also known as Profit Investment Ratio, abbreviated to P.I. and Value Investment Ratio (V.I.R.). Profitability index is a good tool for ranking projects because it allows you to clearly identify the amount of value created per unit of investment, thus if you are capital constrained you wish to invest in those projects which create value most efficiently first.

Nota Bene; Statements below this paragraph assume the cash flow calculated does not include the investment made in the project. Where investment costs are included in the computed cash flow a PV > 0 simply indicates the project creates more value than the cost of capital which is determined by the Weighted Average Cost of Capital (WACC).

A ratio of 1 is logically the lowest acceptable measure on the index. Any value lower than one would indicate that the project's PV is less than the initial investment. As values on the profitability index increase, so does the financial attractiveness of the proposed project.

Rules for selection or rejection of a project:

• If PI > 1 then accept the project
• If PI < 1 then reject the project

For Example, given:

• Investment = 40,000
• life of the Machine = 5 Years

CFAT  Year      CFAT

      1        18000
      2        12000
      3        10000
      4         9000
      5         6000

Calculate Net present value at 10% and PI:

     Year      CFAT      PV@10%       PV

      1        18000      0.909      16362 
      2        12000      0.827       9924   
      3        10000      0.752       7520
      4         9000      0.683       6147     
      5         6000      0.621       3726
              Total present value    43679
              (-) Investment         40000
                         NPV           3679

                         PI =  43679 / 40000
                            =  1.091
                            = >1 
                            = Accept the project

Detailed discussion on PI from an industry expert

References

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