Profitability Index Calculator
Profitability index calculator helps you decide the potential profitability or viability of an investment or project. Every day you are faced with decisions on how best to spend your money or ration your budget between competing needs; firms experience this too.
Profitability index is a measure investors and firms use to determine the relationship between costs and benefits before embarking on a proposed project or investment. It ensures that capital is committed to the best investment option for maximum profit when considering multiple choices.
If you want to learn how to calculate your project's profitability index or learn how discounting works, keep reading! This article addresses how to use the profitability index calculation to rank project investments and quantify the enterprise value created.
What is profitability index?
Companies and investors operate on the principal business tenet of maximizing the return on invested capital. They are always faced with the problem of choosing the best investment or project for implementation after identifying the cost, life span, and future benefit stream of such a project. Profitability index (PI) is a capital budgeting tool that measures an investment or project's potential profitability. It is useful as an appraisal method for ranking investment projects and quantifying the economic value created per unit of investment.
To assess the profit of a proposed investment, you can calculate PI as the ratio between the discounted benefit or present value of future expected cash flows and the discounted cost or initial amount invested in the project. Hence, it is also known as the profit investment ratio (PIR), value investment ratio (VIR), or benefit-cost ratio (BCR).
It would be best if you decided to choose an investment or project based on the size of the PI. There are three possibilities:
PI < 1: Project is not viable. Signifying that the cost of the project outweighs the potential benefits or expected return, and therefore, reject the project.
PI > 1: Project is viable. Signifying future discounted cash inflows of the project are greater than the initial investment. Therefore, you should undertake the project.
The higher the PI value, the more profits the project will return.
How to calculate profitability index?
The profitability index formula calculates a project's profitability based on its future discounted returns relative to the initial investment. The formula is:
PI = PV of future cash flows / Initial investment,
PI = Discounted benefit / Discounted cost,
PV is the present value of future cash flows. PV is a method of discounting future cash to its current value. The discounting or deduction from the future cash is made because $1 today is worth more than the value of $1 received in the future since you have the potential to earn more investing it now. PV considers all the returns over the life span of the project using the time value calculation.
- Discount rate: You need a discount rate to discount future cash flows successfully. A discount rate is the interest rate you will need to earn the future cash if you had the cash today. Therefore, the rate helps you determine the present value of future cash flows. Discount rates are determined by the cost of the capital needed to implement a project. If you want to learn more about how to determine discount rates, check out the Weighted average cost of capital (WACC) calculator.
Initial investment is the cost of capital needed to initiate the project, recorded as the only outflow (-).
It is important to note that the profitability index should not override our judgment on decisions to undertake a project. Even if the result is greater than 1, you still need to consider other merits (or demerits) of the project before implementing. Consequently, PI's primary limitation is that it does not consider the full scope of an investment or project. Analysts mitigate this limitation by using PI in tandem with other forms of analyses, such as the net present value (NPV).
Since NPV is the difference between the present value of future cash flows and initial investment, the profitability index can also be expressed in terms of NPV as follows:
PI = 1 + NPV / initial investment.
Notwithstanding, when comparing the attractiveness of different independent projects, to maximize limited financial resources, you must accept the project with the highest PI. Because unlike PI, NPV does not consider the initial investment tied up in a project.
For instance, two projects may be viable because they have positive NPV values of
$1,000 even though one has an initial investment of
$1,000 while the other has an initial investment of
$1,000,000. But we know that the project with a lower upfront amount is a far better investment. Thus, we need their PI values, which reflect this vital information such that the lower upfront investment has a PI of
2.00 while the higher upfront investment has a PI of
1.01. The profitability index calculator is a great tool to help you analyze your options.
Example 1: How to calculate PI when the PV of future cash flows is known
Using the PI calculator in simple mode
After drawing up a business plan, a farmer determined that the initial investment of $500,000 is needed to expand his poultry farm if he wants to meet the demand from restaurants in a new town. When the future cash flows of five years from the poultry sales are discounted at a rate of 10%, the total sum of the present value (PV) is $800,000.
To determine this project's profitability index, you can input the initial investment cost and the present value given into the PI calculator in simple mode.
PI = PV of future cash flows / initial investment PI = $800,000 / $500,000 = 1.6
Based on the profitability index rule, the project would proceed.
Example 2: How to calculate PI when the PV of future cash flows is not given
Using the PI calculator in Advanced mode
Supposing that the company Nike is considering between increasing its production of a new line of Airforce 1s or the Nike Cortez. The initial investment and predicted annual cash flows for the next 5 years summarised in the table below:
|Life span||Airforce 1||Nike Cortez|
|Year 0 (Initial Investment)||-$25,000,000||-$20,000,000|
We can use the profitability index calculator in advanced mode to choose which line of products would be most beneficial to undertake.
Step 1: Determine the present value of each future cash flow using the discount rate.
|Life span||Airforce 1||Nike Cortez|
|Discount rate||10%||Cash/(1 + 10%)^t||12%||Cash/(1 + 12%)^t|
|Year 0 (Initial Investment)||-$25,000,000||Discounted cash flow||-$20,000,000||Discounted cash flow|
Step 2: Sum the Present value of future cash flows.
PV for Airforce 1 = $26,599,648 PV for Nike Cortez = $19,901,882
Step 3: Compute the profitability index of the investments.
PI for Airforce 1 = $26,599,648 / $25,000,000 = 1.06 PI for Nike Cortez = $19,901,882 / $20,000,000 = 0.99
Using the PI calculator in Advanced mode, you simply:
- Input the discount rate;
- Select the number of years or term of the project;
- Input the cash flow for each year to automatically compute the total PV; and
- Finally, enter the initial investment to get the PI of the project.
TIP: The order of inputting the values don't matter. You'll still get your result!
According to the PI results, Nike should invest in producing more Airforce 1s because it creates value – Nike would expect a return of
$1.06 for every
$1.00 spent on financing the production.
The Nike Cortez shows a result <1 but very close to a breakeven point of 1. Perhaps some price adjustments will make the product profitable.
Benefits and Limitations of Profitability Index
- PI is the most preferred guideline in capital budgeting because, unlike other investment analyses, it indicates a comparable figure, i.e., ratio, instead of an absolute figure to rank projects.
- PI provides a glimpse of value created or destroyed per unit of investment.
- The PI calculation is similar to the return on investment calculation, but it goes further to consider the time value of money formula and the risk of cash inflows in the future by discounting it with the capital cost.
- Profitability index does not regard the full scope of a project, e.g., the project size. Therefore, capital intensive projects may result in lower profitability index result if their profit margins are not as high.
- PI is not wholesome in decision making when passing on projects with high NPVs.
There is uncertainty in results for mutually exclusive projects if initial investments and discount rates are different.
- Investments with a sound profitability index still need time to become profitable. Sometimes this is not adequately accounted for in PI calculation due to the unpredictable nature of market forces; hence the project's profitability is prolonged.
- Considering that investors would usually prefer projects that provide a return in a short lifespan, the profitability index does not annualize net returns for the sake of like comparison. Thus, it makes it difficult to compare projects with different terms or lifespan.
- Projects with the same PI do not reveal which has more initial investment tied into it.
- The actual initial investment to execute a project is difficult to estimate.