The profitability index is an alternative way of stating the net present value (NPV).
It takes the present value of the cash-flows and divides them by the initial capital outlay.
i.e.: Profitability Index (PI) =Present value of cash flows / Initial cash outflow
Interpretation:
If the PI is more than one, then we should invest in the project as it represents a positive net present value.
Usefulness of Profitability Index:
The Profitability Index is useful tool for capital budget constraints and where the projects are divisible. This is true as you will have noticed that net present value (NPV) method tends to favor large investments over smaller one. However, in reality, a company is often operating under capital budget constraints, either fixed by the markets or by top management. This therefore makes NPV method as a less flexible tool.
Assuming the following scenario:
Budget constraints of $300,000
Total following investment cost of 5 projects more than $500,000
| Project | Investment | Present Value | Profitability Index | NPV |
| A | 100K | $141K | 1.41 (141/100) | $41K |
| B | 200K | $240K | 1.20 (240/200) | $40K |
| C | 82K | $120K | 1.46 (120/82) | $38K |
| D | 150K | $170K | 1.13 (170/150) | $20K |
| E | 50K | $85K | 1.70 (85/50) | $35K |
As we have the budget constraints of $300K, using the Profitability Index method, we should select the following projects to maximize our net present value:
Project E + Project C + Project A + part of Project B
Investment costs of $50K+$82K+$100K+$68K=$300K
NPV =$35K+$38K+$41K + pro-rate NPV of Project B=68/200×40K=$13.6=$127.6K
Limitation of Profitability Index:
As we have read above, the Profitability Index is merely another way of reinstating net present value. However, when coming to choose between two mutually exclusive projects which have a positive NPV and profitability indices of more than one, we see certain limitation of this index. This is similar to the situation mentioned in my earlier IRR’s article
Illustration:
| Project | Investment | Present Value | Profitability Index | NPV |
| A | $10K | $16K | 1.6 | $6K |
| B | $30K | $42K | 1.4 | $12K |
If we use the Profitability Index method, then we should select Project A which has a higher PI than Project B but then Project B actually has a very much higher net present value.
We can further verify this by using the incremental cash flow and seeing whether they fulfil the profitability index decision rule:
| Investment | Present Value | Profitability Index | NPV | |
| Differential between A & B | $20K | $26K | 1.3 | $6K |
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