How to Calculate a Profitability Index
The profitability index compares an investment's benefit to its cost and is used to make investment decisions. A profitability index that is greater than one means an investment is expected to earn an acceptable return. A profitability index that is less than one means an investment is expected to earn an unacceptable return. The profitability index equals the sum of the present values of an investment's future cash flows divided by the initial investment. Present value is today's dollar value of a future cash flow. Convert, or discount, future cash flows into today's value using a discount rate, which is the return on a similar investment.
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Instructions
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Calculate the present value of the first year's cash flow using the equation: c/[(1 + r)^n]. In the equation, c is the cash flow amount, r is the discount rate and n is the year. For example, divide $50 by [(1 + .12)^1] on the calculator for an investment with a 12 percent discount rate that receives $50 of cash flow in the first year. This equals $44.64.
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Calculate the present value of the second year's cash flow of $60 by dividing $60 by [(1 + .12)^2] on the calculator: $60 divided by [(1 + .12)^2] equals $47.83.
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Add the present values of the cash flows in years one and two on the calculator: $44.64 plus $47.83 equals $92.47.
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Divide the sum of the present values of the cash flows by the initial investment amount on the calculator. For example, if the investment required an initial investment of $75, divide $92.47 by $75, which equals 1.23. This profitability index is greater than one, which means the investment's expected return is greater than the discount rate.
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Tips & Warnings
Rank different investment opportunities by their profitability index to determine which investments will get more benefit for each dollar invested.
