# Project profitability index

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.

The profitability index is closely related to: At first glance, investment Y may seem the reasonable choice, but suppose that the payback period for investment X is 1 year and investment Y is 10 years. The payback period formula is used for quick calculations and is generally not considered an end-all for evaluating whether to invest in a particular situation.

IRR does provide "safety margin" information. The profitability index is determined by dividing the present value of each proposal by its initial investment. Suppose a situation where there are two choices to choose from where investment X has a payback period of 1 year and investment Y has a payback period of Project profitability index years.

You are trying to determine whether to accept project A or project B. NPV measures the dollar benefit of the project to shareholders. He is a graduate of the finance program at the University of Toronto with a Bachelor of Commerce and has additional accreditation from the Canadian Securities Institute.

I and II only B. Money can be used to earn more money. In case of such mutually exclusive decisions, the net present value method NPV should be preferred for reasons explained earlier for superiority of NPV over IRR method.

Now attempt exercise 6. Cash outflows are treated as negative cash flows since they represent expenditures of the company to fund the project. Thus, there is a conflict in ranking of the two mutually exclusive proposals under the two methods.

Table below contains the complete cash flow analysis. If the cash inflows were paid annually, then the result would be 5 years. Capital Rationing Method The method of capital rationing can be bifurcated in four steps.

I and III only C. The capital ceiling for investment is, say, Profitability index is calculated as the sum of present values of future cash flows dividd by the initial investment cost. In these circumstances, we would suggest the firm to take up project X which gives higher net present value in absolute terms because in doing so the firm would be able to maximize the wealth of the shareholders.

Both some positive net present value projects to be rejected; and some projects with negative net present values to be accepted. Graphing the NPVs of mutually exclusive projects over different discount rates helps demonstrate: These additional capital outlays may factor in benefits relating to taxation or depreciation.

As indicated by the formula above, the profitability index uses the present value of future cash flows and the initial investment to represent the aforementioned variables. The advantages of the payback method of project analysis include the: The PI indicates the value you are receiving in exchange for one unit of currency invested.

Try it yourself for a while. Add up present values of all cash inflows and outflows in order to produce the net present value. Reject if IRR is less than or equal to the hurdle rate. Reject if payback is greater than benchmark. In other words, the analysis must not only be right, it must also be understandable to decision makers, and the presenter-Harry, in this case-must be able to answer all questions, ranging from the performance characteristics of the equipment to the assumptions underlying the capital budgeting decision criteria.

Read this article to learn about the differences between net present value and profitability index. A situation in which accepting one investment prevents the acceptance of another investment is called the:.

Post Payback Profitability Index = (Post Payback Period Cash Inflow / Initial Investment) x Generally, post payback profitability index is expressed in percentage.

NOTE: While calculating the post payback period cash inflows, the salvage value of the proposed project should be added. What is profitability index? It is a tool for measuring profitability of a proposed corporate project (also called cost-benefit ratio or benefit-cost ratio).

Profitability Index The NPV of a project divided by the amount of a resource (such as capital) consumed. When there is a limited resource (such as capital), projects should be selected in order of profitability index ranking starting with the project with the highest index and moving down the ranking until the resource is consumed. Project profitability index