Profitability Index

Posted in Finance, Accounting and Economics Terms, Total Reads: 958
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Definition: Profitability Index

Profitability index is an investment appraisal technique. It is defined as the ratio of the present value of all the future payoffs to the investment made in the project. Profitability index of 1 indicates break-even.


Profitability index can be used to accept / reject any project proposal as follows:

If profitability index <1: then reject the project

If profitability index >1: This implies the present value of the returns is greater than the investment being made currently and that the project will be profitable


If more than one project has profitability index greater than one, and the funds for investment are limited, then select the project with the highest profitability index.


For e.g. Consider a project which requires an investment of USD 10 mm currently. Consider the discount rate as 10%. The cash inflows for the next 5 years are as follows:

 

Year

Cash Inflow (USD mn)

1

4 mn

2

4mn

3

4mn

4

4mn

 

The present value of the future cash inflows = USD 12.67 mm

Profitability index = 12.67 / 10 = 1.267


 

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