Profitability index is a financial tool which tells us whether an investment should be accepted or rejected. It uses the time value concept of money.
This concept is useful for ranking and choosing between projects when capital is rationed.
The rule is that a profitability index or ratio greater than 1 indicates that the project should proceed.
Formula to calculate profitability index.
If the initial investment of a project was $ 50,000 and the present value of the cash flow is $ 60,000. Calculate the project’s profitability index.
Therefore, the profitability index of the project is 0.8333. This ratio dictates that this project should be abandoned as it is less than 1.