When it comes to investments, the question always arises of their feasibility. Profitability index will help to evaluate the project financing It makes it possible to calculate what the ratio of investor income and expenses will be in the planning period. Using the profitability index, the amount of profit that each monetary unit of investments will bring to its owner is expressed in numbers.
Project profitability
Using the project profitability index, an assessment of its profitability is carried out. These calculations are applicable to any level and type of economic activity.
The project profitability index allows you to determine the level of project profitability. If there are several of them, this indicator will make it possible to choose one in which the minimum costs will lead to the maximum possible profit for the investor.
The indicator under consideration is universal, i.e., it allows you to assess the profitability of the project at both the micro and macro levels. The scale for him does not matter. Also, the indicator in question is also called the index of return on invested capital.
The ability to draw adequate conclusions about investing depends on the accuracy and quality of the calculations. The financial managers are responsible for conducting data collection and analysis.
Profitability index
What is he like? Profitability Index (from the English. Profitability Index, PI) is one of the tools of financial analysis in assessing the implementation of investment activities. It is associated with another important concept.
The essence of calculating the profitability index is the modification of such an indicator as NPV (Net Present Value) - the discounted present value.
The difference between these two indicators is the ability of PI (profitability index) to take into account the initial investment. NPV estimates only future discounted (net) cash flow.
This situation indicates the advantage of PI, if you want to choose one of several possible options. Ranking the existing investment paths using the profitability index formula is profitable with limited financial resources.
Index calculation
The profitability index, the formula of which is presented below, allows you to get the ratio of the expected value of the investor's investments.
PI = NPV / I, where:
- NPV - net cash flows;
- I - investment.
Investments in this case are considered as a financial indicator and are taken into account without minus.
NPV = CFn / (1 + r) n, where:
- CFn - cash flow in the n-period;
- r is the discount rate;
- n is the investment period.
Sometimes the profitability index is calculated for large projects in which investments are made unequally in time. In this case, the investments are discounted at the average annual rate of return.
If PI> 1, the project is cost-effective, it is accepted for further consideration. It happens PI = 1. This indicates the need to evaluate the business plan for other indicators. Such actions will help to understand, reject it or accept.
In the case when the profitability index PI is less than 1, the project is unprofitable and is withdrawn from consideration.
Study design
A study to determine the return on investment should be carried out according to a certain scheme.
Initially, you should determine how much financial resources an investor or enterprise can direct into circulation without harming itself and its core business. It should be understood that capital is invested in order to increase revenues in the field of the main activity.Therefore, for calculations only the amount of income of the main activity is taken into account.
The next step is to perform a risk assessment. The higher they are, the more income an investor should receive.
Based on the analysis, the discount rate is determined. After that, the profitability index, the formula of which was considered above, will allow you to calculate the most effective methods of action.
The last stage consists in calculating the value of future reduced cash flows that will come from investment activities.
Calculation difficulties
The external simplicity of such calculations has its own difficulties. One of them is determining the discount rate. 
The profitability index is determined over a certain period. During this time, the discount rate is influenced by many factors that are sometimes very difficult to predict. It can be the most various internal and external political, economic and even natural events.
The longer the project life span, the stronger the uncertainty factor becomes. This can lead to erroneous calculations using the PI index.
It is also difficult to predict the size of future income from the implementation of the investment project.
Discount rate
In order for the calculations to be carried out correctly, it is necessary to evaluate the planned discount rate. For example, when making an investment in the form of credit funds, the bottom line of the discount rate will be the interest rate on the loan.
In the case when an investor finances a project from personal funds, the rate of return on these investments should be higher or equal to the rate of return on his existing capital. Therefore, in the case under consideration, the discount rate should be less than the tax rate on the profit of working capital.
To make the calculations as correct as possible, the analysis should be carried out immediately for several indicators.
Having familiarized yourself with such a concept as a profitability index, you can calculate the return on investment taking into account the amount of funds financed. This indicator will also help to rank several projects and highlight the most acceptable. The indicator should be used in the analysis along with a number of other indicators.
