Profitability index is a ratio that identify and compares the relationship between the total costs involved in the project and the profit returned from that project. The ratio of profitability index can be shown in the form of formula as under:-
Profitability Index Formula
Profitability Index = 1 + PV (Present Value) of Future Cash Flows/ Initial Investment
The index can be used to weigh or rank projects in terms of cost involved and the total rate of return associated with the projects. When the profitability index showed the value of 1 that means that the project can achieve the breakeven point where there is no profit and no loss. The value of Profitability index less than 1 show that project won’t be able to recover its initial investment and will incur loss for the company. The increased value of profitability index indicates that project is financially attractive and it will be going to yield the profits for the company.
The criteria of selecting the project on the bases of Profitability Index is that
If PV >1 Accept the project as it is profitable
If PV < 1 reject the Project as it is not profitable
For example let us assume that a company is going to start a project where the total cost of the project is $ 50 million and the expectations of the future cash flows from the project are $ 65 million. The profitability index of the given projected with these projected values can be calculated as:-
Formula : (How to calculate Profitability Index )
Profitability Index = $65 M / $50 M = 1.3
Net Present Value = PV of future cash flows – Initial Investment
NPV = 65- 50 = 15 Million Dollars
As the Profitability index is greater than 1 that means the project is profitable and one can invest without any concerns.
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