What is the profitability index? How to calculate it?
Should I invest my money, or not? In order to answer this question, you must first calculate the profitability index of the project. In this case, the investor will not have to blame himself for making the wrong decision when investing capital in an enterprise that was obviously unprofitable.
Application of investment yield index at the initial stage
The investment return index is an indicator of the profitability of an investment project. You need to familiarize yourself with the procedure for its calculation in order to properly dispose of funds for investment and at the same time minimize risks.
The profitability index PI is the ratio of discounted income to the amount of investments made in the first stage. For the calculation required to use the following formula:
- PI = PV: I, where
PV - discounted income
I - the amount of cash investments in the investment project.
The value of the calculated indicator must exceed one. In this case, the project can be considered potentially effective.
Application of investment yield index for finished projects
However, the formula is desirable to use only at the initial stage of the project. To determine the profitability of an existing company, a more accurate method of calculation is intended. At the same time, indicators of net cash flow for a certain period, initial investment and cost of capital, which was allocated for an investment project, are used.
Using this method, it is possible to calculate the degree of profitability for the initial stage, as well as to determine how accurate the prediction data was. By calculating the profitability index, one can get more accurate data than with the net discounted income indicator. Particularly appropriate is the use of this method in situations where an investor chooses between several objects for investment. In this case, the PI indicator will show the degree of profitability of each of them. In this case, the investor will be able to choose the most suitable option.
The calculation by this method has one significant drawback.It lies in the fact that the risk exists even when the value of PI> 1. In this case, the formula does not take into account the time spent on the project. The cost of capital may increase when changing the refinancing rate of the Central Bank. This will cause negative discounting.
Discounted Yield Index
One of the ways to modify the concept of return on investment is the summation of the existing discounted cash flows when they are further divided by the corresponding investment costs. As a result, a discounted yield index will be obtained. It can also be found under the name "the ratio of income to costs." The indicator is expressed in current value.
Calculation of the discounted index
A formula is used to perform the calculation of the discounted profitability index, in which the real price of project income is divided by the amount of capital investment. This may also require the following indicators:
- DPI - investment return index, which is calculated by the share of units;
- CFt - cash flow for a certain period of time;
- It - the cost of investment for a certain period;
- r is the discount rate, expressed in fractions of units;
- n is the total number of periods taken into account.
You can define the profitability index as the ratio of the sum of all discounted investment income to the corresponding expenses. It will characterize the profitability of investments, expressed in relative values. If DPI> = 1.0, the investment will be quite acceptable. The greater the figure, the more reliable the project will be. The disadvantage of this calculation of the effectiveness of investments is the inability to compare cash flows with different durations. In addition, there is no accuracy in that income will be received at the barrier rate.
Application of discounted profitability index
This indicator can be used in economics and management in such cases:
- There is a choice between several projects.
- The economic situation in a particular market segment is analyzed.
- Analyzes the profitability of a particular company or project.
- It is necessary to calculate the cost of services and goods, as well as adjust the pricing policy of the company with a small profitability index.
- Predictions are made for developing business ideas or projects.
- The budget of the company is planned, and a decision is made to stop the investment or continue it.
- The development of a business plan and the definition of specific dates for the implementation of projects and ideas.
It may be necessary to calculate the index of profitability of investments in other situations.
Programs to perform the calculation
If it is difficult to determine the profitability index manually, computer programs can be used for this. The calculation is performed when the necessary function is introduced in one of simple programs, for example, Ms Excel.
There is also special software. With its help it is easy to perform complex calculations, as well as to build graphs that will reflect the situation on the project under study. These functions are partially available to users of the 1C program for accounting.
The correct calculation of the discounted profitability index will allow the investor to make the right choice between several projects and determine whether an investment will be profitable.