Profitability Index

It is also called as profit investment ratio or value investment ratio. It is nothing but ratio of the investment to the payoff. It is an index that helps the investor in finding the relationship between the cost and the benefit from the investment. It is given by the formula

Profitability index = PV of future cash flows/Initial investment

The value must be more than 1. If it is lesser than 1 then it is said to be highly ineffective and useless in investing in that project and if it is more than 1 then it is worth investing. Higher the value of this calculated value the better is the return. The more the value the higher the investment attracts.  The investor usually ranks the various investment based on this outcome. The higher the value of Profitability index for the investment toper it goes in the ranking. For example the asset with a profitability index of 1.8 is more preferred than asset with profitability index 1.7 so automatically the first project gets a better ranking than the second one. Comparison of the two assets is best done using this method. This is also one of the capital budgeting techniques that are widely used by the financial manager in making financial decisions.

Financial managers usually confuse themselves with Profitability index and Net present value calculation. They both seem to be same if looked in general however there is a huge difference if we take a closer look at it. The profitability index calculates the relative value of the investment with respect to the return; however net present value calculates the actual value of the investment. In reality profitability index is considered to be less advantageous than Net present value method this is because Profitability index has its limitation which is more when compared to net present value. The profitability index does not take investment amount into consideration. This method cannot be used in places where investment amount is limited. However it is best fit in place where multiple investments are to be made and investments amount is unlimited. The investors use any one of the two methods based on the above conditions.

Questions

•  What are some of the constraint in profitability index method?
•  List the advantage in using this method?