# 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