Calculations that equal one bring about situations of indifference where any gains or losses from a project are minimal. Although some projects result in a higher net present valuethose projects may be passed over because they do not have the highest profitability index and do not represent the most beneficial usage of company assets.
Cash flows are discounted the appropriate number of periods to equate future cash flows to current monetary levels.
Therefore, projects with larger cash inflows may result in lower profitability index calculations because their profit margins are not as high. When using the profitability index exclusively, calculations greater than one are ranked based on highest calculation. When limited capital is available and projects are mutually exclusivethe 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. Calculations less than one indicate the deficit of the outflows is greater than the discounted inflows and the project should not be accepted. These additional capital outlays may factor in benefits relating to taxation or depreciation.
The technique divides the projected capital inflow by the projected capital outflow to determine the profitability of a project. Calculations greater than one indicate the future anticipated discounted cash inflows of the project are greater than the anticipated discounted cash outflows.
The discounted projected cash outflows represent the initial capital outlay of a project.
Calculating and Interpreting the Profitability Index Profitability index calculations cannot be negative and must be converted to a positive figure before they are useful. 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 present value of future cash flows requires the implementation of time value of money calculations.The profitability index fixes that basic problem by allowing you to compare the profitability indexes of two or more projects to one another to find the project that creates the most value for.
Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of payoff to investment of a proposed project.
It is a useful tool for ranking projects because it allows you to quantify. The profitability index, also known as the profit investment ratio, is calculated as the ratio of the present value of the future cash flows and the initial investment in the project.
Profitability index is an investment appraisal technique calculated by dividing the present value of future cash flows of a project by the initial investment required for the project. The profitability index is a technique used to measure a proposed project's costs and benefits by dividing the projected capital inflow by the investment.
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).Download