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The profitability index.. The term is also known as the value investment ratio or the investment-earnings ratio. It is the indicator that represents the relationship between the costs and benefits of the proposed project. The index can be viewed as the ratio between the real or current value of the expected future cash flows and the initial amount invested in the project. The higher the value of the index, the more attractive the project is to investors.
The profitability index is useful in classifying and evaluating multiple and different projects because it allows investors to determine the value allocated to each investment unit. The profitability index can be viewed as a standard technique or tool applied to potential capital expenditures, where cash inflows are divided by cash inflows. Cash Outflows to determine the profitability indicator of the project.
Profitability Index Elements
- The present value of future cash flows (PV of Future Cash Flows) or the value of the numerator: Knowing the present value of future cash flows requires calculating the time value of money, where the value is determined based on the number of time periods that are necessary for an equation involving future cash flows at current cash levels. The value of one dinar at the present time, for example, is not equal to the value of the dinar in previous years or in subsequent years. The value varies from one period of time to the next, which means that money at the present time offers the investor a greater chance of making profits than money and money invested in future savings accounts.
- Initial investment required or denominator: the cash outflows are considered the initial capital expenditures of the project, as the required initial investment refers to the cash flows needed at the beginning of the project, while all other additional expenditures are deducted at any stage of the project. They are taken into account when calculating the terminal value, and additional capital expenditures include both tax-related interest and the rate of depreciation.
How to calculate the profitability index
The formula used in calculating the profitability index can be explained as follows:
Profitability Index = Present Value of Future Cash Flows/Initial Investment
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If the inferred or calculated ratio is higher than 1.0, this means that the present value of the future cash flows derived from the project is higher than the value of the initial investment. From a financial perspective, this result indicates the possibility of implementing the investment project on the ground and its great potential for success and returns. The higher the value of 1.0, this indicates the attractiveness of the investment project, and the lower the value of 1.0, the lower the attractiveness of the project. This ratio, known as the profitability index, is used to classify and rank projects according to the amount of money that the company will allocate and the appropriate value for the investment.
Pros of the profitability index
- The profitability indicator determines whether the investment project is beneficial or not and whether it will add value to the company.
- The profitability index looks at the time value of money and the proportion of risks surrounding future cash flows.
- The profitability index is an effective standard tool for evaluating various investment projects and selecting the best and most appropriate in terms of their economic feasibility.
Cons of the profitability indicator
- The profitability indicator requires a full estimation of the capital expenditures that will be included in the mathematical equation, and this comes with a multiplier of time and effort for the company.
- The profitability indicator may not give correct results, and this in turn affects the efficiency of the company in making the right decisions, especially when the initial investments in exclusive projects differ.
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