Profitability Index Rule

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DEFINITION of 'Profitability Index Rule'

A regulation for evaluating whether to proceed with a project or investment. The profitability index rule states: If the profitability index or ratio is greater than 1, the project is profitable and may receive the green signal to proceed. Conversely, if the profitability ratio or index is below, the optimum course of action may be to reject or abandon the project.







BREAKING DOWN 'Profitability Index Rule'

The profitability index rule is a variation of the net present value (NPV) rule. In general, if NPV is positive, the profitability index would be greater than 1; if NPV is negative, the profitability index would be below 1. The profitability index differs from NPV in one important respect; Being a ratio, it ignores the scale of investment and provides no indication of the size of the actual cash flows.


For example, a project with an initial investment of $1 million, and present value of future cash flows of $1.2 million, would have a profitability index of 1.2. Based on the profitability index rule, the project would proceed.

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RELATED FAQS
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    As businesses grow, they look for new opportunities to expand operations. Whether it is launching a new product or moving ... Read Full Answer >>
  2. What are the disadvantages of using net present value as an investment criterion?

    While net present value (NPV) calculations are useful when you are valuing investment opportunities, the process is by no ... Read Full Answer >>
  3. Which is a better measure for capital budgeting, IRR or NPV?

    In capital budgeting, there are a number of different approaches that can be used to evaluate any given project, and each ... Read Full Answer >>
  4. What assumptions are made when conducting a t-test?

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  5. What is the difference between the return on total assets and an interest rate?

    Return on total assets (ROTA) represents one of the profitability metrics. It is calculated by taking a company's earnings ... Read Full Answer >>
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    In finance and accounting, financial statements represent the fundamental means of analyzing a company's financial position, ... Read Full Answer >>

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