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Profitability Index

The document discusses profitability index and internal rate of return (IRR), two methods used to evaluate investment projects. Profitability index is calculated by dividing the present value of future cash flows by the initial investment. It indicates how many times the initial investment is returned. IRR is the discount rate that makes the net present value equal to zero. The document provides formulas for calculating both measures and explains how to interpret the results using decision rules. An example calculation is given for each.

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Saira Ishfaq 84-FMS/PHDFIN/F16
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31 views3 pages

Profitability Index

The document discusses profitability index and internal rate of return (IRR), two methods used to evaluate investment projects. Profitability index is calculated by dividing the present value of future cash flows by the initial investment. It indicates how many times the initial investment is returned. IRR is the discount rate that makes the net present value equal to zero. The document provides formulas for calculating both measures and explains how to interpret the results using decision rules. An example calculation is given for each.

Uploaded by

Saira Ishfaq 84-FMS/PHDFIN/F16
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Profitability Index

Profitability index is an investment appraisal technique calculated by dividing the present value
of future cash flows of a project by the initial investment required for the project.

Formula:
Profitability Index
Present Value of Future Cash Flows
= 
Initial Investment Required
 
Net Present Value
=  1 + 
Initial Investment Required

Explanation:
Profitability index is actually a modification of the net present value method. While present
value is an absolute measure (i.e. it gives as the total dollar figure for a project), the profitbality
index is a relative measure (i.e. it gives as the figure as a ratio).

Decision Rule
Accept a project if the profitability index is greater than 1, stay indifferent if the profitability
index is zero and don't accept a project if the profitability index is below 1.

Profitability index is sometimes called benefit-cost ratio too and is useful in capital rationing
since it helps in ranking projects based on their per dollar return.

Example
Company C is undertaking a project at a cost of $50 million which is expected to generate future
net cash flows with a present value of $65 million. Calculate the profitability index.

Solution
Profitability Index = PV of Future Net Cash Flows / Initial Investment Required
Profitability Index = $65M / $50M = 1.3
Net Present Value = PV of Net Future Cash Flows − Initial Investment Required
Net Present Value = $65M-$50M = $15M.

The information about NPV and initial investment can be used to calculate profitability index as
follows:
Profitability Index = 1 + (Net Present Value / Initial Investment Required)
Profitability Index = 1 + $15M/$50M = 1.3

Internal Rate of Return (IRR)


Internal rate of return (IRR) is the discount rate at which the net present value of an investment
becomes zero. In other words, IRR is the discount rate which equates the present value of the
future cash flows of an investment with the initial investment. It is one of the several measures
used for investment appraisal.

Decision Rule
A project should only be accepted if its IRR is NOT less than the target internal rate of return.
When comparing two or more mutually exclusive projects, the project having highest value of
IRR should be accepted.

IRR Calculation
The calculation of IRR is a bit complex than other capital budgeting techniques. We know that at
IRR, Net Present Value (NPV) is zero, thus:

NPV = 0; or

PV of future cash flows − Initial Investment = 0; or

CF1 CF2 CF3


  1  +  2  +   + ...    − Initial Investment = 0
(1+r) (1+r) ( 1 + r )3

Where,
   r is the internal rate of return;
   CF1 is the period one net cash inflow;
   CF2 is the period two net cash inflow,
   CF3 is the period three net cash inflow, and so on ...

But the problem is, we cannot isolate the variable r (=internal rate of return) on one side of the
above equation. However, there are alternative procedures which can be followed to find IRR.
The simplest of them is described below:

1. Guess the value of r and calculate the NPV of the project at that value.
2. If NPV is close to zero then IRR is equal to r.
3. If NPV is greater than 0 then increase r and jump to step 5.
4. If NPV is smaller than 0 then decrease r and jump to step 5.
5. Recalculate NPV using the new value of r and go back to step 2.
Example
Find the IRR of an investment having initial cash outflow of $213,000. The cash inflows during
the first, second, third and fourth years are expected to be $65,200, $96,000, $73,100 and
$55,400 respectively.

Solution
Assume that r is 10%.
NPV at 10% discount rate = $18,372
Since NPV is greater than zero we have to increase discount rate, thus
NPV at 13% discount rate = $4,521
But it is still greater than zero we have to further increase the discount rate, thus
NPV at 14% discount rate = $204
NPV at 15% discount rate = ($3,975)
Since NPV is fairly close to zero at 14% value of r, therefore
IRR ≈ 14%

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