Profitability index steps the acceptability of the proposed capital purchase. It does so by comparing the initial investment to the current value of the longer term cash flows regarding that project. Formula is:
When the outcome of the ratio is greater than 1. 0, because of this the present importance of future cash flows being derived from the project is greater than the amount of the initial purchase. At least coming from a financial perspective, a score greater than 1. 0 indicates make fish an investment should be made. As the credit score increases above 1. 0, so too really does the attractiveness in the investment. The ratio may very well be used to create a ranking of initiatives, to determine the order where available funds are going to them.
For example, a financial market analyst is reviewing a projected investment that requires a $100,000 preliminary investment. At the company’s standard discount rate, the present value of the cash flows expected from the project is $140,000. This results in a strong profitability index of 1.4, which would usually be received.
There are a number of further considerations besides the profitability index to observe when deciding whether to invest in a project. Other considerations contain:
- The accessibility to funds. A business may not have access to sufficient funds to reap the benefits of all potentially lucrative projects.
- The scale from the investment. A massive project may soak up all available cash.
The perceived riskiness of the project. A risk averse management team risk turning down a project that has a high profitability index should the associated risk connected with loss is way too great.
- The affect the bottleneck operation of the business. The best investments employ a positive impact about total company throughput.
- Any legal obligations that must be fulfilled. A legal requirement to invest overrides the success index.
- Mutual exclusivity. The index is not used to rank projects which might be mutually exclusive; that is certainly, only one investment or another would be selected, which is any binary solution. In this particular situation, a project that has a large total net present value might be rejected if it is profitability index were a lesser amount than that of any competing but a lot smaller project.
The profitability index is usually a variation on the net present value strategy. The only difference is so it results in any ratio, rather than the usual specific number regarding dollars of net present value.