What is the 'Profitability Index'
The profitability index is an index that attempts to identify the relationship between the costs and benefits of a proposed project through the use of a ratio calculated as:
PV of future cash flows/Investment
A ratio of 1.0 is logically the lowest acceptable measure on the index, as any value lower than 1.0 would indicate that the project's PV is less than the initial investment. As values on the profitability index increase, so does the financial attractiveness of the proposed project.
BREAKING DOWN 'Profitability Index'
Profitability index is an appraisal technique applied to potential capital outlays. The technique divides the projected capital inflow by the projected capital outflow to determine the profitability of a project. The main feature of using profitability index is the technique disregards project size. Therefore, projects with larger cash inflows may result in lower profitability index calculations because their profit margin is not as high.
Present Value of Future Cash Flows (Numerator)
The present value of future cash flows requires the implementation of time value of money calculations. Cash flows are discounted the appropriate number of periods to equate future cash flows to current monetary levels. This discounting occurs because the value of $1 does not equate the value of $1 received in one year. Because the $1 received now may be invested and gain value, money received closer to the present is considered to have more value than money received further in the future.
Investment Required (Denominator)
The discounted projected cash outflows represent the initial capital outlay of a project. The initial investment required is only the cash flow required at the start of the project; all other outlays may occur at any point in the project's life, and these are factored into the calculation through the use of discounting in the numerator. These additional capital outlays may factor in benefits relating to taxation or depreciation.
Profitability index calculations cannot be negative and must be converted to a positive figure before they are useful. Calculations greater than one indicate the future anticipated discounted cash inflows of the project are greater than the anticipated discounted cash outflows. Calculations less than one indicate the deficit of the outflows is greater than the discounted inflows and the project should not be accepted. Calculations that equal one bring about situations of indifference where any gains or losses from a project are minimal.
When using the profitability index exclusively, calculations greater than one are ranked based on highest calculation. When limit capital is available and projects are mutually exclusive, the project with the highest profitability index is to be accepted as it indicates the project with the most productive use of limited capital. Profitability index is also called the benefit-cost ratio for this reason. Although some projects result in a higher net present value, those projects may be passed over because they do not the highest profitability index and do not represent the most beneficial usage of company assets.