We’d say that for every £1 pound that you invest in A, you earn £1.50 in cash flow, in present value terms. The PI ratio will result in a number that is 1, less than 1 or bigger than 1. Generally the PI ratio of 1 is least acceptable as it represents the break even point of a project, which defines the point where total sales (revenue) equal to the total cost. A PI ratio of less than 1 is completely undesirable as it represents that a project will cost more than it is expected to earn. Using the PI formula, Company A should do Project A. Project A creates value – Every $1 invested in the project generates $.0684 in additional value. The higher the profitability index (PI) ratio, the more attractive the proposed project is, and the more likely it will be pursued.
- Profitability index is a modification of the net present value method of assessing an investment’s potential profitability.
- When it comes to the numerator, it involves calculating the time value of money, where cash flows are discounted in a certain number of periods.
- In general terms, the higher the PI metric, the more attractive a proposed investment is.
You will then have to make a decision on what’s going to be best for your business moving forward. The result can be a higher return on https://www.wave-accounting.net/ investment and an increase in potential profitability. It divides project capital cash inflows based on projected capital cash outflow.
Profitability Index (PI) Calculator
The profitability index stands as a pivotal financial indicator leveraged by firms while evaluating possible investment ventures. And lastly, investing in Catcher will earn Garch understanding the difference between revenue vs profit Ltd $155,000 in annual cash flow for the next 5 years. The projects require investments of $300,000; $200,000; and $600,000 for Archer, Brochure, and Catcher respectively.
However, if they are added together, the sum total is larger than project 1’s NPV. The common sense here dictates that the company should choose both project 2 and 3, and leave the first one. We can see that the PI number obtained through our incremental analysis is greater than 1. Now that we have obtained the PI value for both the projects, let’s look into its application for appraising projects. The On-Base Percentage is calculated by adding up all of the bases a player gets and dividing that by the number of at-bats they had….
This measure is essential for comparing the return on investment across different projects, especially when these projects vary significantly in size. There are some factors that affect this ratio such as absence skunk cost, difficulty in assessing the appropriate rate of return and the projects may be projected unrealistically positive. However, the profitability index ratio can be very helpful in assessing the profitability of the projects when used along with other measures of profitability assessment. To calculate the profitability index, you would divide the present value of $10,000 by the initial investment of $5,000. In corporate finance, the primary use case for the PI ratio is for ranking projects and capital investments. In short, the profitability index (PI) measures the attractiveness of a potential project or investment to guide decision-making.
Profitability Index Calculation Example (PI)
The cost of funding the project is $10 million, and the amount of cash flows generated in Year 1 is $2 million, which will grow by a growth rate of 25% each year. Therefore, the metric quantifies the economic feasibility of a project (or investment), which can then be ranked to comparable opportunities to allocate capital toward the most profitable option. The profitability index is also called the profit investment ratio (PIR), cost-benefit ratio, or the value investment ratio (VIR). In the case of limited funds, we should rank projects according to profitability index (PI) ratios and not on the basis of their net present values (NPVs). Since project 2 and 3 both have higher PI values than project 1, they should be ranked ahead of project 1 while rationing the available capital.
PV of Future Cash Flows (Numerator)
The PI is most effective when a project’s cash flow pattern is conventional, meaning that a series of inflows follow an initial outlay. In situations where there are many potential investment opportunities and resources are limited, the profitability index can help identify which projects should be prioritized. Second, the profitability index gives us a ratio instead of an absolute value, thereby providing a relative measure of profitability.
Well, it just means that for every £1 pound you invest in Project A, you earn 50p. This shows you how much money you make for every one dollar or one pound you invest. And if you still are, well it’s almost certainly not as straightforward a decision/choice as you thought it was before. The problem is that this doesn’t factor in the magnitude of the investment requirement. Consider that we tell you there are two projects, which we’ll conveniently call Project A and Project B.
( . Project 1 and project 2 are both independent projects:
The index is a useful tool for ranking investment projects and showing the value created per unit of investment. It is a measure that companies use to determine the cost-benefit ratio before deciding to embark on more complex projects or investments. The Profitability Index (PI) bears an alternative name known by the acronym VIR, which denotes the ratio of investment value or investment to profit. If you do not know how to calculate profit, here is a great Profit Calculator you can use for that purpose. We can say that the profitability index measures the attractiveness of future projects. It is instrumental in ranking different projects because it provides data in the form of quantified values created per individual investment unit.
Alternatively, you could calculate it as the ratio of PV to I, so that the PV (Present Value) is divided by the investment. Fundamentally, the Profitability Index shows us the amount of money we earn for every $1 / £1 invested. The NPV method reveals exactly how profitable a project will be in comparison to alternatives. When weighing several positive NPV options, the ones with the higher discounted values should be accepted. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.
A profitability index greater than 1.0 is often considered to be a good investment, as it means that the expected return is higher than the initial investment. When making comparisons, the project with the highest PI may be the best option. In this example, the factory expansion project has a higher profitability index, meaning it is a more attractive investment. The company might decide to pursue this project instead of the new factory project because it is expected to generate more value per unit of investment. The NPV @ 14% in last column of the above table has been obtained by subtracting the initial investment at C0 date from the present value @ 14% discount rate.
Moreover, PI might not be the best tool for mutually exclusive projects with different sizes and timing of cash flows. Running a profitable business demands a lot of investments and assessing them for profitability is essential. The profitability index (PI), also known as profit investment ratio (PIR) is a method to describe the relationship between cost and benefits of a project. In contrast, the IRR rule states that if the internal rate of return on a project is greater than the minimum required rate of return or the cost of capital, then the project or investment should proceed. If the IRR is lower than the cost of capital, the project should be killed.
What Is a Good Profitability Index?
It is calculated by dividing the present value of future cash flows by the initial investment required. Making a wise investment requires carefully evaluating potential returns versus risks. The profitability index is a useful financial metric that helps determine if a project or investment is worthwhile. The above profitability index calculator evaluates an investment’s profitability based on the initial investment and future cash flows.
It’s crucial to consider that the profitability index’s calculation involves an analysis of the project’s cash flows against the cost of capital, also known as the discount rate. Internal rate of return (IRR) is also used to determine if a new project or initiative should be undertaken. Broken down further, the net present value discounts after-tax cash flows of a potential project by the weighted average cost of capital (WACC). The profitability index is calculated as the ratio between the present value of future expected cash flows and the initial amount invested in the project.