The technique which is used to represent the relationship between the profit of the proposed project and the initial cost of that project is known as the “Profitability Index”. And the formula which is used to calculate the profitability is called as the “Profitability Index Formula (PI)”. The PI can be also termed as the “Value Investment Ratio (VIR)”, or “Profit Investment Ratio (PIR)”.
Let us see what is the profitability index exactly and how it is calculated. This is calculated by two parameters, i.e. the net present value of the cash flow of all the projects and the initial amount invested in the project.
It is said that the net present values give us the total value of the particular project, hence this amount cannot be compared with the investment of the project. For example, let us assume that there are two projects X and Y, with the initial investment of Rs. 10 lakhs each and the net present value of these projects are Rs. 2 lakhs and Rs. 2.5 lakhs each. Here the initial investment is the same while the net present value is different and as compared to X, Ys net present value is more, but still we can’t judge that the Y is a good project based on its net present value. Here comes the need to calculate the profitability index (PI).
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The projects having the highest PI are good, but it should be also concluded that the net present value should be maximized according to the available funds.
The formula for the calculation of the PI is as below:
PI = (NPV / Initial Investment)
NPV = the present value of cash flow – initial investment
∴ the formula can be written as the sum of initial values and net present values
i.e., PI = (Initial Investment + NPV)/Initial Investment
∴ PI = 1 + (NPV/Initial Investment)
Let us see how the PI is calculated in the example given below,
ABC company has Rs. 100 lakhs available for the investment in some of the projects as per given below :
|P||Rs. 5 lakhs||Rs. 15 lakhs|
|Q||Rs. 15 lakhs||Rs. 50 lakhs|
|R||Rs. 10 lakhs||Rs. 10 lakhs|
|S||Rs. 20 lakhs||Rs. 60 lakhs|
|T||Rs. 12 lakhs||Rs. 35 lakhs|
Find the profitability and also rank the projects according to the profitability.
Let us find the PI of each of the projects
For Project P : PI = 1 + (5/15)
Similarly, for the other projects
For Project Q : PI = 1 + (15/50)
For Project R : PI = 1 + (10/10)
For Project S : PI = 1 + (20/60)
For Project T : PI = 1 + (12/35)
In the above example when calculated the highest PI is of the R project. The ranking of the projects can be done as
3rd P & S
Here, on 3rd rank there are 2 projects as both of them are having similar PI.
The PI is used to rank the company’s investment. This is for the maximization of the financial resources and the profits for the shareholders/stakeholders.