What is the Profitability Index Rule
The profitability index rule is 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 can proceed. Conversely, if the profitability ratio or index is below 1, 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: since it is a ratio, it 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, yet stakeholders would not know the initial capital expenditure required.
Profitability Index Rule, Net Present Value, and Internal Rate of Return (IRR)
Like the profitability index rule, both net present value (NPV) and internal rate of return (IRR) also measure if a company should invest in a particular new project or initiative. Broken down further, the net present value discounts after-tax cash flows of a potential project by the weighted average cost of capital (WACC).
To calculate NPV:
1. First identify all cash inflows and cash outflows.
2. Next, determine an appropriate discount rate (r).
3. Use the discount rate to find the present value of all cash inflows and outflows.
4. Take the sum of all present values.
The NPV method reveals exactly how profitable a project will be in comparison to alternatives. When a project has a positive net present value, it should be accepted; if negative, it should be rejected. When weighing several positive NPV options, the ones with the higher discounted values should be accepted.
In contrast the IRR rule states that if the internal rate of return (IRR) on a project is greater than the minimum required rate of return, or the cost of capital, then the project or investment should proceed. Conversely, if the IRR is lower than the cost of capital, then the best course of action may be to reject it.