Chapter 22.6, Problem 1CC

Summary Introduction

To discuss: The profitability index rule of thumb.

Introduction:

Profitability index is a payoff ratio of the investment on a planned project. It is utilized for ranking the projects. The relationship between Net Present Value (NPV) and profitability index are as follows:

$\mathrm{Profitability}\text{index}=\frac{\left(\text{NPV}–\text{Initial investment}\right)}{\text{Initial investment}}$

If the profitability index is greater than 1, then NPV is positive.

If the profitability index is less than 1, then NPV is negative.

If a company has many positive NPV projects and is subjected to capital restrictions, then the profitability index might give a fair measure of ranking for the projects.