Profitability Index

The profitability index is the simplest method of including capital rationing in investment analysis. It is particularly useful for firms that have a constraint for the current period only, and relatively few projects. A scaled version of the net present value, the profitability index is computed by dividing the net present value of the project by the initial investment in the project.3

3 There is another version of the profitability index, whereby the present value of all cash inflows is divided by the present value of cash outflows. The resulting ranking will be the same as with the profitability index, as defined in this chapter.

Profitability Index = Net Present Value / Initial Investment The profitability index provides a rough measure of the net present value the firm gets for each dollar it invests. To use it in investment analysis, we first it for each investment the firm is considering, and then pick projects based on the profitability index, starting with the highest values and working down until we reach the capital constraint. When capital is limited and a firm cannot accept every positive net present value, the profitability index identifies the highest cumulative net present value from the funds available for capital investment.

Although the profitability index is intuitively appealing, it has several limitations. First, it assumes that the capital rationing constraint applies to the current period only and does not include investment requirements in future periods. Thus, a firm may choose projects with a total initial investment that is less than the current period's capital constraint, but it may expose itself to capital rationing problems in future periods if these projects have outlays in those periods. A related problem is the classification of cash flows into an initial investment that occurs now and operating cash inflows that occur in future periods. If projects have investments spread over multiple periods and operating cash outflows, the profitability index may measure the project's contribution to value incorrectly. Finally, the profitability index does not guarantee that the total investment will add up to the capital rationing constraint. If it does not, we have to consider other combinations of projects, which may yield a higher net present value. Although this is feasible for firms with relatively few projects, it becomes increasing unwieldy as the number of projects increases.

Illustration 6.7: Using the Profitability Index to select projects

Assume that Bookscape, as a private firm, has limited access to capital, has a capital budget of $100,000 in the current period. The projects available to the firm are listed in Table 6.4.

Table 6.4: Available Projects

Project

Initial Investment (in 000s)

NPV (000s)

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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