Using Profitability Index

1. Using Profitability Index

So we've discussed net present value or NPV as a means of comparing various projects, but we want to improve on that a little bit by introducing the profitability index. So this techniques improves on the NPV. How? Well, by comparing the NPV to the amount of capital that needs to be invested in the project. So let's get even more specific now and define profitability index as being on the numerator, the NPV plus the initial investment, and we're dividing that by a denominator, which is the initial investment. So once we calculate a profitability index, we wanna look at whether or not it's greater than or less than 1. So if it's greater than 1, then the project will create value for the company. If the profitability index, however, is less than 1, the project will destroy value for the company. So we wanna think about the profitability index as being one more common metric that we can use to compare projects for investment, and we wanna also think about it as an improvement on just looking at the NPV. So it's great to understand this theory, but now let's see how we can apply it in Excel to a real example.

2. Let's practice!

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