Profitability index

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  • Опубликовано: 7 авг 2024
  • Why would you use the profitability index method in capital budgeting, when other tools like return on investment and net present value already exist? To answer that question, let’s see what return on investment (ROI) and net present value (NPV) provide us. ROI relates the payoff (the expected project benefits) to the investment (the initial cash outlay or cost). NPV consider the time value of money, and considers cash flows over the entire life of the project. The profitability index (pi) incorporates all three of these elements. The profitability index is closely related to ROI and NPV. Once you understand how to calculate ROI and NPV, it is very easy to calculate the profitability index next.
    ⏱️TIMESTAMPS⏱️
    0:00 Why use the profitability index method
    0:55 How to calculate ROI
    1:58 How to calculate NPV
    4:09 How to calculate the profitability index
    4:45 How to interpret the profitability index
    5:22 Profitability index formula
    Let’s calculate the profitability index for project A: put the sum of the present values of the future benefits in the numerator, and divide by the amount of the initial investment in the denominator. Working with present value equivalents is how the profitability index resembles the NPV method. Dividing by the amount of the initial investment is how the profitability index resembles the ROI method. $1035 divided by $1000 gives us a profitability index of 1.035. Now that we have calculated that profitability index outcome, is this a good or a bad number? You can look at this in absolute terms: projects with a profitability index higher than one create value for the company. You could also look at this in relative terms: maybe there are many other project proposals with a profitability index far higher than 1.035, in that case project A might not be the most attractive, especially when the investment budget is tight and not every project with a profitability index higher than one might end up getting selected.
    There are several ways to write down the #profitabilityindex formula. You could express it as the sum of the present values of the future benefits divided by the amount of the investment. You could also express it as the sum of NPV plus investment, divided by the investment. Or as NPV divided by investment, plus 1. When you plug in the numbers from our profitability index example, you see that these versions of the profitability index formula are all equivalent. $1035 divided by $1000 is 1.035. The sum of $35 and $1000 is $1035. Divide this by $1000, and you get 1.035. $35 divided by $1000 is 0.035. Add 1 to this, and you get 1.035. Different ways of writing the profitability index formula, same outcome.
    Philip de Vroe (The Finance Storyteller) aims to make accounting, finance, #capitalbudgeting and investing enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better investing decisions. Philip delivers #financetraining in various formats: RUclips videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!
    Want to get access to bonus content, and/or express your gratitude by buying me a cup of tea? Join my channel as a member through / @thefinancestoryteller

Комментарии • 40

  • @TheFinanceStoryteller
    @TheFinanceStoryteller  3 года назад +1

    Enjoyed this video? Then subscribe to the channel now, and watch my video on NPV IRR and payback method scenarios next: ruclips.net/video/1ZTIwmn1Cm0/видео.html

  • @igorbolev1553
    @igorbolev1553 3 года назад +9

    As usual, a like for your hard job for enlightening people on finance. Keep it up

  • @SuryaBudimansyah
    @SuryaBudimansyah 3 года назад +4

    Wow I didn't know you made it this fast, thank you!! :)
    My analysis tells that your Days Comments Outstanding (DCO, where you reply a new comment) and Days Suggestion Outstanding (DSO, where someone suggest a topic for future video and you actually made it) both are less than a week
    Keep 'em coming!! :)

    • @TheFinanceStoryteller
      @TheFinanceStoryteller  3 года назад +1

      😎 I love those metrics!!! Profitability Index actually turned out to be the answer to a nagging question in my mind on how to put NPVs into perspective. Thanks for the suggestion!

    • @TheFinanceStoryteller
      @TheFinanceStoryteller  3 года назад

      Hello Surya! Any more suggestions for topics I can cover?

    • @SuryaBudimansyah
      @SuryaBudimansyah 3 года назад +1

      @@TheFinanceStoryteller Hey, I didn't know you would ask. :) Well I have some ideas, don't know they have video potential in them or not but here they are:
      1 Softwares you must at least know, better master them, for those who work/are going to work in the realm of accounting and finance. Like, accounting softwares eg QuickBooks, MYOB, etc, or ERP softwares eg SAP, Oracle etc, or even programming softwares like Java, Phyton, C++ , and any others (Ms Excel I think is a must, whether you work in accounting/finance or not :)
      2 Certification in accounting and finance. I know there is CPA, ACCA, and maybe like Management Accountant, Financial Analyst, Fraud Examiner, Internal Auditor, etc
      3 About short term financial market (as opposed to long term ones like bonds and stock market); concept, instruments, and maybe how exactly we can "get into" the market
      4 & 5 These two are my comment on another video, please do them whenever you feel like it :)

    • @TheFinanceStoryteller
      @TheFinanceStoryteller  3 года назад

      @@SuryaBudimansyah Thanks for the input! There's very little that I have to say about 1 and 2, but I might give 3 a shot!

  • @marianeladiaz9
    @marianeladiaz9 2 года назад +1

    Brilliant explanation. I just finally understood this topic. Thank you 🙏

    • @TheFinanceStoryteller
      @TheFinanceStoryteller  2 года назад

      Great to hear, Marianela! There might be more useful videos for you in my NPV IRR WACC playlist: ruclips.net/video/N-lN5xORIwc/видео.html

  • @austinnhernandezz6293
    @austinnhernandezz6293 3 года назад +2

    Great video! Thank you.

  • @ceylanpolat
    @ceylanpolat Месяц назад +1

    Many thanks for the video, it explains very clearly. what would be the formula/approach if our initial investment spent in three years-not in year?

    • @TheFinanceStoryteller
      @TheFinanceStoryteller  Месяц назад

      You could do separate calculations for the present value of the investment cash outflows, and separately calculate the present value of the future benefits (cash inflows). That way, you still get one number to put into the denominator of the calculation.

  • @user-uu3gd8eo1c
    @user-uu3gd8eo1c 7 месяцев назад +1

    always a pleasure to watch your videos

  • @user-wx2ne2el2m
    @user-wx2ne2el2m 2 года назад +3

    Thanks for good job! Need help on exam...

    • @user-uw1nk8uk6m
      @user-uw1nk8uk6m 2 года назад

      Need help too😪🙇‍♂

    • @TheFinanceStoryteller
      @TheFinanceStoryteller  2 года назад +1

      Wishing you lots of success!!! I hope the videos in this playlist are useful for you: ruclips.net/video/N-lN5xORIwc/видео.html

  • @appucreations7830
    @appucreations7830 3 года назад +2

    Thank you so much sir

  • @nealshah9575
    @nealshah9575 Месяц назад +1

    Again Great Video Sir....Could you make a video on MIRR and why MIRR is Better than IRR

    • @TheFinanceStoryteller
      @TheFinanceStoryteller  Месяц назад

      Thanks for the kind words. Number of potential views on MIRR is relatively low, I will put it on the "maybe" list....

    • @nealshah9575
      @nealshah9575 Месяц назад +1

      @@TheFinanceStoryteller will be grateful to learn

  • @Cptn8993
    @Cptn8993 Год назад

    Great work although I do not understand how ROI ties into this. Have we ever used it after calculating it?

    • @TheFinanceStoryteller
      @TheFinanceStoryteller  Год назад

      The Profitability Index is a very effective "mix" of the ROI and NPV approaches to evaluating investment projects. The idea is to perform the calculations for all available investment projects, and prioritize the one(s) with the most attractive expected payoffs.

  • @Bruhlifting
    @Bruhlifting 8 месяцев назад +1

    For the NPV, what if there’s depreciation? Do we include that in the calculations?

    • @TheFinanceStoryteller
      @TheFinanceStoryteller  8 месяцев назад +1

      If you keep your calculations on a pre-tax basis, then depreciation is irrelevant in NPV calculations. NPV calculations are cash flow based: when is cash going out, and when is cash going in. Depreciation is purely an accounting allocation to spread the amount you paid initially for e.g. a machine over the years of usage. No cash changes hands when depreciation is recorded, it's a "non-cash entry": a debit to depreciation expense in the income statement and a credit to accumulated depreciation on the balance sheet.
      If you do your NPV calculations on an after-tax basis, then there is a small benefit to recording depreciation: as depreciation is a deductable cost for corporate income tax, there will be a little less cash outflow for tax payments.

  • @avronilbanerjee5302
    @avronilbanerjee5302 Год назад +1

    😍😍

  • @msotoval
    @msotoval Год назад

    When calculating the PI, would you consider an initial loan amount as part of the initial investment, or just the equity contributions?

    • @TheFinanceStoryteller
      @TheFinanceStoryteller  Год назад +1

      Hi! NPV and PI consider the total amount of the investment, regardless of how that is financed (debt or equity). The discount rate used (20% in the example) is where you can express the financing structure.

    • @msotoval
      @msotoval Год назад +1

      @@TheFinanceStoryteller Thank you for your reply, really helpful. Most examples I found consider an "initial" investment, but don't detail that part. Appreciate it.

  • @bloodywanker781
    @bloodywanker781 2 года назад

    3:21 shouldnt we substract 1000?

  • @taoriq3632
    @taoriq3632 3 года назад

    Can you kindly explain cash flow, run sales, run rate sales and profitability in details please
    Thank you

    • @TheFinanceStoryteller
      @TheFinanceStoryteller  3 года назад +1

      Hi Taoriq! I have a playlist with various videos on cash flow: ruclips.net/video/mZBjsIYrLvM/видео.html and I think my best videos on profitability are the one where I explain the income statement ruclips.net/video/Hq-44PHgAiU/видео.html and the one reviewing gross margin and operating margin ruclips.net/video/VCMJzG1AaXA/видео.html
      Regarding run rates, this is where you extrapolate/annualize based on the actual results so far. I don't have separate videos on those topics.

    • @taoriq3632
      @taoriq3632 3 года назад +1

      @@TheFinanceStoryteller thanks