Profitability Index
Profitability Index Calculator is developed for efficient calculation of profitability index in order to analyze different capital investment opportunities. PI is a capital budgeting technique useful in evaluating various investment proposals available with the investors. A project having PI greater than or equal to 1 fall in the category of investments that will pay off the costs. This technique of investment appraisal takes into account the concept of the time value of money, which makes decision-making more simplified for the management. Also, the profitability index plays a great role in capital rationing decisions.
Formula for Calculating Profitability Index
In order to calculate the profitability index, one has to calculate the PV of expected cash inflows and the total initial investment of the project. The formula for calculating the profitability index is as follows:
Profitability Index (PI) = PV of Expected Cash Inflows / Initial Investment
About the Calculator
The PI Calculator provides a quick result of the calculation. The users just have to provide the following data to the calculator.
- Present value of future / expected cash inflows.
- Initial investment.
Calculator
How to Calculate using Calculator
The user simply has to insert the following figure in the calculator to obtain the result of the profitability index.
Present Value of Future / Expected Cash Inflows
The expected returns or future cash inflows are discounted at a rate to find out the PV of cash flows. The time value of money plays a major role in calculating the present value.
Initial Investments
The costs incurred initially plus the PV of cost, if any, expected to be incurred in the future are taken into account.
Example of Profitability Index
Let us try to understand this concept with the help of an example. A company has invested $50,000 in a project for a period of 5 years. Expected cash flow at the end of 1st, 2nd, 3rd, 4th and 5th year is $20,000, $24,000, $27,000, $15,000 and $10,000 respectively. The expected rate of return is 10%. Calculate Profitability Index.
| Year | Expected Cash Flows ($) | PV @ 10% ($) |
| 1 | 20,000 | 18,182 |
| 2 | 24,000 | 19,835 |
| 3 | 22,000 | 16,529 |
| 4 | 15,000 | 10,245 |
| 5 | 10,000 | 6,209 |
| Total | 91,000 | 71,000 |
Therefore, initial investment = $50,000
Present value of expected cash flows = 71,000
Profitability Index = 71,000/50,000 = 1.42
Interpretation of Profitability Index
If the PI of the project is greater than or equal to 1, it is treated to be a good project and can be accepted for execution. In the example above, the profitability index is 1.42, which is greater than 1. This means that the project is worth accepting.
Cautions
Profitability Index is a relative indicator, and hence, it does not provide a proper basis for making a comparison between two different projects having a vast difference in terms of values. Therefore, the net present value is a better investment appraisal technique than the profitability index. Also, the profitability index method does not consider opportunity costs which may lead to great differences while evaluating projects.
To know more about NPV – Net Present Value.
