Profit is equal to revenues minus expenses, but the revenues and expenses must be denominated in the same unit of measurement in order for this comparison to hold true. For investments that produce cash inflows and outflows across multiple periods, the cash inflows and outflows must be reduced to their present value before profit can be calculated, present being the period in which the investment began. Present value is calculated by dividing the sum in question over 1+i, where i is the interest rate for the period between the present and the date when the sum is received.
Estimate the cash inflows and outflows of the investment in question. For example, if an investment costs $100 and is expected to pay $100 in Year 1 and Year 2, that is a cash outflow of $100 in Year 1 and one cash inflow of $100 each in Years 1 and 2.
Reduce all cash inflows and outflows to their present value. Using the example above and assuming that interest rates are 10% and 20% for Years 1 and 2, the $100 in Year 1 can be calculated to be worth $90.91 or 100/1.1 and the $100 in Year 2 can be calculated to be worth $75.76 or 100/1.1/1.2.
Add up present values of all cash inflows and outflows in order to produce the net present value. Still using the above example, net present value is $66.67 or 90.91+75.76-100. A positive net present value means that the investment is profitable while a negative net present value means that it is not. The higher the figure, the more profitable or not profitable it is.
Profitability index is calculated as the sum of present values of future cash flows dividd by the initial investment cost. In this case, PI is 1.6667 or 166.67 divided by 100. A PI of 1 means that the investment breaks even; higher than 1 means that it is profitable while lower than 1 means that it is not.
Alan Li started writing in 2008 and has seen his work published in newsletters written for the Cecil Street Community Centre in Toronto. He is a graduate of the finance program at the University of Toronto with a Bachelor of Commerce and has additional accreditation from the Canadian Securities Institute.