Profitability index

Profitability index A profitability index is the ratio of the present value of the expected net cash inflows (after taxes) divided by the initial cash outlay (or present value of cash outlays if future outlays are required). The profitability index formula is: 

\text{Profitability index} =\dfrac{\text{Present value of net cash inflows}}{\text{Initial cash outlay (present value of cash outlays if future outlays are required)}} 

Management should consider only those proposals having a profitability index greater than or equal to 1.00. Proposals with a profitability index of less than 1.00 cannot yield the minimum rate of return because the present value of the projected cash inflows is less than the initial cost.

To illustrate use of the profitability index, assume that a company is considering two alternative capital outlay proposals that have the following initial costs and expected net cash inflows after taxes:

 

Proposal X

Proposal Y

Initial outlay

Expected net cash inflow (after taxes):

$7,000

$ 9,500

Year 1

$5,000

$9,000

Year 2

4,000

6,000

Year 3

6,000

3,000

Management's minimum desired rate of return is 20 percent.

The net present values and profitability indexes can be computed as follows, using Table A.3 in the Appendix at the end of this book:

Present value

 

Proposal X

Proposal Y

Year 1 (net cash inflow in year 1 x 0.83333)

$4,167

$7,500

Year 2 (net cash inflow in year 2 x 0.69444)

2,778

4,167

Year 3 (net cash inflow in year 3 x 0.57870)

3,472

1,736

Present value of net cash inflows

$ 10,417

$ 13,403

Initial outlay

7,000

9,500

Net present value

$ 3,417

$ 3,903

 

 

Proposal X

Proposal Y

Profitability index

$ 10,417 =1.49

$ 13,403

1 = 1.41

 

$ 7,000

$9,500

 


When the net present values are compared, Proposal Y appears to be more favorable than Proposal X because its net present value is higher. However, the profitability indexes indicate Proposal X is the more desirable investment because it has the higher profitability index. The higher the profitability index, the more profitable the project per
dollar of investment. Proposal X earns a higher rate of return on a smaller investment than Proposal Y.

Another technique for evaluating capital projects that accounts for the time value of money is the time-adjusted rate of return method. The next section discusses this method.


An accounting perspective:
Business insight

Like US managers, Japanese managers incorporate the cost of capital into their capital investment decisions. However, Japanese managers tend to rely more on consensus decision making, less on the numbers. Discount rates in Japan are generally lower than in the United States.