Definition: Profitability index, also known as profit investment ratio, is an investment tool that the financial professionals use to determine if an investment should be accepted or not based on the time value of money concept.
What Does Profitability Index Mean?
What is the definition of profitability index? This index computes the present value of the expected cash flows that the investment can generate. Depending on the outcome of the calculation, financial professionals decide if they should accept the project or not. More specifically:
- if the profit index > 1, the project should be undertaken
- if the profit index < 1, the project should be abandoned
- f the profit index = 1, the project is indifferent, i.e. it makes no difference accepting or rejecting it.
To calculate the profitability index formula, we need to know the present value of the expected cash flows and the initial investment.
Let’s look at an example.
Company ABC is a leading technology company. The management is open to new market opportunities, and it seeks to invest in a foreign market. To that end, it investigates two technology projects for a cost of $25 million each. The present value of the expected cash flows is $31 million for project A and $28 million for project B.
The manager of the company wants to know the profit index for each project to take the final investment decision.
Project A: Profit Index = PV of expected cash flows / initial investment = $31 / $25 = 1.24
Project B: Profit Index = PV of expected cash flows / initial investment = $28 / $25 = 1.12
In both cases, the profit index is > 1. However, the project with the highest profit index should be selected, i.e. Project A. Therefore, the index is a helpful investment tool for ranking investment projects based on the amount of valued that a project creates per unit of investment.
Define Profitability Indexes: Profitability index means a financial calculation that investors use to measure the value of an investment based on its present and future values.