# Profitability Index

Profitability index is an investment appraisal technique calculated by dividing the present value of future cash flows of a project by the initial investment required for the project.

## Formula:

 Profitability Index = Present Value of Future Cash Flows Initial Investment Required = 1 + Net Present Value Initial Investment Required

## Explanation:

Profitability index is actually a modification of the net present value method. While present value is an absolute measure (i.e. it gives as the total dollar figure for a project), the profibality index is a relative measure (i.e. it gives as the figure as a ratio).

## Decision Rule

Accept a project if the profitability index is greater than 1, stay indifferent if the profitability index is zero and don't accept a project if the profitability index is below 1.

Profitability index is sometimes called benefit-cost ratio too and is useful in capital rationing since it helps in ranking projects based on their per dollar return.

## Example

Company C is undertaking a project at a cost of $50 million which is expected to generate future net cash flows with a present value of$65 million. Calculate the profitability index.

Solution
Profitability Index = PV of Future Net Cash Flows / Initial Investment Required
Profitability Index = $65M /$50M = 1.3
Net Present Value = PV of Net Future Cash Flows − Initial Investment Rquired
Net Present Value = $65M-$50M = $15M. The information about NPV and initial investment can be used to calculate profitability index as follows: Profitability Index = 1 + (Net Present Value / Initial Investment Required) Profitability Index = 1 +$15M/\$50M = 1.3

Written by Obaidullah Jan, ACA, CFA