What is Profitability index?
In short
The profitability index is the present value of a project's future cash flows divided by the initial investment. A value above 1 means the project has a positive net present value.
Key takeaways
- It helps rank projects when capital is limited (capital rationing).
- It gives the same accept-or-reject decision as net present value for a single project.
- It can favor small projects with high ratios but little total value.
Example
Cash flows with a present value of $130,000 for an investment of $100,000: the index is 1.3.
Where it's tested
BAR: Financial Forecasting, Budgeting & Valuation — study notes, a five-minute revision sheet and practice questions.
Practise: 3 questions
Question 1 of 3 · 0 answered
A product sells for $80 with variable costs of $50 per unit. Fixed costs are $360,000. How many units must be sold to earn a target operating profit of $90,000?