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 The profitability index is an index that attempts to identify the

relationship between the costs and benefits of a proposed project
through the use of a ratio calculated as:

 A profitability index of 1.0 is logically the lowest acceptable

measure on the index, as any value lower than 1.0 would indicate
that the project's present value (PV) is less than the initial
investment. As the value of the profitability index increases, so
does the financial attractiveness of the proposed project.
 Use the following formula where PV = the present value of the future cash flows in
question.
 Profitability Index = (PV of future cash flows) ÷ Initial investment
 Or = (NPV + Initial investment) ÷ Initial Investment: As one would expect, the NPV
stands for the Net Present Value of the initial investment.
 Example: a company invested $20,000 for a project and
expected NPV of that project is $5,000.
 Profitability Index = (20,000 + 5,000) / 20,000 = 1.25
 That means a company should perform
the investment project because profitability index is
greater than 1.
 An investment project or proposal is considered to be
profitable if it features a profitability index above 1. For
example, a profitability index of 0.89 indicates that the
project or investment will not make us any profits. On the
contrary, a profitability index equal to 1 indicates a break
even on the investments without making any profits.
The advantages of profitability index for a
firm are listed below:
 The profitability index tells about an
investment increasing or decreasing the
firm’s value
 The profitability index takes into
consideration all cash flows of the project.
 The profitability index takes the time value
of money into consideration.
 The profitability index also considers the
risk involved in future cash flows with the
help of cost of capital.
 The profitability index is also helpful in
ranking and picking projects while rationing
of capital.
There are also certain disadvantages
featured by the profitability index. These
include:
 An estimate about the cost of capital is
required so as to calculate the profitability
index of a firm.
 The profitability index of a firm might not,
sometimes, provide the correct decision
while being used to compare mutually
exclusive projects under consideration