Every business' ultimate goal is to reach a balanced, profitable bottom line. The choices a business owner makes today determine if capital investments in the company will reap a profit in the future. The profitability index measures the relationship between the current costs of a capital investment and its potential benefits. A profitability index of 1.0 indicates a capital investment as a "break-even" proposition, while those with lower ratios reflect investments that will not deliver sufficient returns.
Present Value of Future Cash Flows
A determining factor in calculating the profitability index is the present value of future cash flows the investment is expected to return. The present value formula measures the current value of a future amount to be received, given a specific time period and interest rate.
The present value can be calculated by the formula:
Vp= Vf / (1 + r)n
Vp= Value (present)
Vf = Value (future)
r = Interest rate
n = number of years
For instance, if an investment is expected to return $100,000 over 3 years at 3.5 percent interest, the present value calculation would look like this:
Vp= 100000/(1+0.035)3 = 100000/1.109 = $90,194.27
The calculation shows that $90,194.27 invested today at a 3.5 percent annual interest rate will be worth $100,000 three years from now.
Net Present Value
The net present value, or NPV, is the present value of future cash flows from that investment, less the amount invested. This figure shows the difference between what the business has to spend to deliver the desired return and what they will actually spend. The NPV uses the time value of money to determine if the amount spent today to deliver a future return will result in a profit. For example, if the actual amount invested is $85,000 and the present value of future cash flows is $90,194.27, the NPV is (90194.27-85000), or $5,194.27. The positive NPV shows that the investment will deliver a profit.
Calculation of Profitability Index
While the NPV shows if the investment will yield a profit (positive NPV) or a loss (negative NPV), the profitability index shows the degree of the profit or loss. Business owners can use either the Present Value of Future Cash Flows (PV) or the Net Present Value (NPV) to calculate the profitability index.
Profitability Index = (PV/Amount Invested) = 1 + (NPV/Amount Invested)
Using the example, a company expects to receive $100,000 three years from now on an $85,000 investment. The interest rate is expected to stay at 3.5 percent for those three years.
Profitability Index (PV) = ($90,194.27/$85,000) = 1.061
Profitability Index (NPV) = 1 + ($5,194.27/$85,000) = 1.061
Uses for Profitability Index
Business owners employ the profitability index to determine if a capital investment will be a profitable use of its resources. Investments with high profitability indexes can help a business earn maximum profits with a minimum of investment.
The previous example, with a profitability index of 1.061, would likely be considered a marginal investment. If the time span were extended from three years to five years, the PV calculation would look like this:
Vp= 100000/(1+0.035)5 = 100000/1.188 = $84,197.32
and the Profitability Index calculation would look like:
Profitability Index (PV) = ($84,197.32/$85,000) = 0.991
making it a marginally losing investment.