The profitabiltiy index is similar to the accounting rate of return to the exten that it looks to represent a business's return on investment. That is, for every dollar the company invests, how much will it get back? Unlike the accounting rate of return, the profitability index considers the concept of the time value of money, and discounts all future cash flows. The profitability index is often used to rank projects, and typically projects with the higher profitability index are accepted.

All future cash flows are discounted using the present value formula.

Where r = the discount rate

n = the period in with the cash flow occurs

The profitability index represents the ratio of profit to dollars invested. Therefore, a profitability index of less than 1 suggests that for every dollar that the business invests today, they will get less than a dollar back (in present value).

If P > 1, the project is profitability and can be accepted.

If P < 1, for every dollar invested, less than a dollar will be recaptured. The project should be rejected.

If P = 1, the project will break even.

In our Net Present Value example, we looked at an oven that would cost $10,000 today, but provide incremental cash flows of $2,500/year over a life of five years. Using a five percent discount rate, we can discount the cash flows as follows. The sum of the discounted cash flows = $1,959, $2,057, $2,160, $2,267, $2,381 = $10,824.

*Profitability Index = PV of Future Cash Flows/Inital Investment = $10,824/$10,000 = 1.082.*

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