Profitability index: the concept, the formula

The profitability Index shows how a particular project will be profitable (relatively), or how much cash will come in the course of this project. This takes into account only one unit attachment.

Investment and profitability index

Before you invest your money in a particular project, you should try to determine which of the options will bring a greater profit and how good the benefit you receive. It is in order to see this information, and there is a so-called index of investment profitability. This indicator is also called the profitability index, or PI.

What you need to know about the profitability index investment

It can be used to calculate the ratio between your current income and current expenditures exist. Also take into account those funds that have been invested in the project. In addition, the calculation is as real (in this case, it is calculated the funds that were received over the past period of time) and prognostic (when taking into account those revenues and expenses that will still take place).

If after calculations it turned out that PI is less than 1, then it can be argued that you have received from investing in the project net profit, which is less than those of funds that was invested in it. It gives the right to conclude that the investment was unprofitable.

If the index of profitability of investments is equal to 1, then the project can be profitable or not. But PI is greater than one, means that you have invested your money wisely and get a big enough income. It should be remembered that the greater the obtained value, the more stable and reliable is project. Also, remember that when calculating long-term projects, it often happens that the initial profit may not be more capital, so consider the time period.

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The Advantages and disadvantages of the index

The Index of profitability has its pros and cons. Among the advantages of this method, the most important is that it allows is to allocate time money. In addition, it can be used to determine which effects were a particular project for all time of its existence, and also to compare different-scale projects.

But he has his flaws. For example, the profitability index does not give no problem to rank the projects have different duration. But despite all the disadvantages, using a PI you can easily evaluate the effectiveness of a sufficiently long-term investment and to be able to calculate the profit.

The Formula for profitability index

If we talk about how to properly calculate PI, you will need a special formula that looks like this:

PI = PV_In / PV_Out

Or so

PI = 1 + NPV / PV_Out

In these formulas, PV_In (NPV) indicates the net present value of the project and PV_Out is the capital investment.

The index of the profitability formula which have been described above, does not mean that you will receive the absolute size of the net flow of money, because he only shows respect to the cost of investments.

If you are an investor and want to determine if how well a particular project, then you need to know that the more investment costs, the greater will be the amount of the net cash flow that you expect to receive. As the amount will affect the so-called investment costs for different time periods. Has an important influence on the amount of the flow of money and then, when it started operating stage. The discount rate has a significant impact on the value of the main indicators of the project in the sphere of investments.