Profitability index is a tool for assessing the projects’ viability while appraising investment opportunities. The index is calculated using the present value of cash inflows divided by the initial investment. If the index shows a value higher than 1.0 the project is worthwhile. The real use of profitability index during capital rationing situations and you have to choose between multiple projects having a profitability index of above 1.0.
|
Name of Project |
Project A |
Project B |
Project C |
|
Year 1 |
$10,000 |
$12,000 |
$15,000 |
|
Year 2 |
$10,000 |
$12,000 |
$15,000 |
|
Year 3 |
$10,000 |
$12,000 |
$15,000 |
|
Year 4 |
$10,000 |
$12,000 |
$15,000 |
|
Discount Rate |
10% |
12% |
15% |
|
PV of Cash flows |
$31,699 |
$36,448 |
$42,825 |
|
Initial Investment |
$30,000 |
$35,000 |
$40,000 |
|
Profitability Index |
1.06 |
1.04 |
1.07 |
In the above chart you can see that the project C has the highest profitability index, so it should be selected.
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