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!