Profitability Index

Intermediate

The profitability index compares the present value of a project's future cash flows with its initial cost. A value above 1 means the project is expected to create value.

The profitability index divides the present value of future cash flows by the initial investment. It shows how much value is created for each unit invested.

For example, a project costing 50,000 whose future cash flows are worth 54,018 in today's money has a profitability index of about 1.08. Each unit invested is expected to return 1.08 in present-value terms. A project with an index of exactly 1 just covers its cost; one below 1 would destroy value.

The profitability index always agrees with net present value on whether a single project is acceptable, because an index above 1 means NPV is positive.

Its main use is ranking projects when money is limited. Suppose a company has 1 million to invest and several projects to choose from. Picking projects with the highest profitability index helps get the most total value from the limited budget. However, for comparing mutually exclusive projects of very different sizes, net present value is usually the better guide, because it measures the total amount of value created.

For worked examples and full lessons, visit notesbysara.org.