Wondering what is the difference between the profitability index and net present value?
A profitability index presents a parallel between the costs and profits of a certain project. By dividing the present value of the property’s future cash flows by the initial investment, we get the profitability index. If the profitability index is over 1.0, then the profitability is positive, but if it is below 1.0 then the investment will probably fail. To put it another way, profitability index is constituted of the ratio between the present value of future cash flows and the initial investment.
A profitability index measure of 1.0 is likely the lowest desired number, and if it is lower than that, it signifies that the present value of the project is lower than the initial investment. Therefore, the project would probably be discarded.
Actually, both measures consider an investment property’s future CASH FLOW. However, net present value gives you the dollar difference, while the profitability index gives the ratio.
For example, let’s say that a commercial real estate investment property requires an investment of 1 million dollars. Its present worth with a revenue stream is $1,100,000. The net present value (NPV) would be $100,000, while the ratio would be 1.10. This demonstrates that the project is likely to be successful.
Even though these appear the same, understanding the difference between the two can help you compare commercial income properties quickly and easily. Because profitability index is a ratio, it is absolute: it tells you the proportion of dollars returned to dollars invested( instead of a specific amount). Profitability index allows you to compare the profitability of two properties without regard to the amount of money invested in each.
The profitability index shows how much value we would gain by investing. Here, each dollar gives $1.10. The profitability index is an alternative of the net present value. Profitability Index would be bigger than 1.0 if the net present value appears positive. Otherwise, it would be negative.
These two calculations are crucial to determine whether the project would succeed or fail. They are often referred to as being similar because of their close relationship. However, there is a slight difference between these two terms: that is, the profitability index does not suggest the amount of the actual cash flows.
You should be careful when using both methods together, as it has been detected that they can rate projects differently. A certain project could be classified first with one method whereas last with the other method. For an investor making one or a few property investments, NPV may provide a better insight by giving the total expected return. For an investor making multiple investments in multiple properties, profitability index may provide for better decision-making in that it delivers, in essence, a percentage of return on the investment per property. These two measures, when used in harmony, may help with diversification decisions as well.
Calculation
Present Value of Future Cash Flows / Initial Investment Required
This is the same as 1 + net present value/initial investment required.
A profitability index of 1.0 means that the property’s net present value is greater than its initial investment; 1.0 is, therefore the minimum ratio acceptable for the PI. A profitability index greater than 1.0 means that the initial investment goals have been exceeded, and thus the property may be a good investment.
Keep in mind that while using the PI is an efficient way of ranking investment projects in terms of desirability, it does not take into account the interest rate, and it may not provide an accurate number for mutually exclusive projects.
Profitability Index Method
Profitability index serves as a tool to classify projects. If the value of the index is bigger, then the project would be more attractive.
The acceptable measure of profitability index for a single project is 1.0 or more. This suggests that the business will move forward. But if it is lower than 1.0, the project would be dismissed. The index can serve as a substitute for NPV when determining the profits per dollar of investment.
Net Present Value Method
NPV or Net Present Value is one of the primary methods or techniques for evaluating an investment.
NPV Discount Rate
When using this method, it is essential to choose a proper discount rate. Usually, the weighted average cost of capital or the return rate on unconventional investments is used.
If the NPV is lower, the discount rate would be higher. Investments with higher risk, have a higher discount rate than risk-free investments.
Formulas
NPV Single investment formula is as it follows :
- Net Present Value = Present Value less Investment
Whereas for multiple investments :
- CF (Cash flow)/ (1 + r)t
Here, r indicates the discount rate, while t is the time of the cash flow.
Let’s take an example to explain this calculation.
- Single investment : $150,000 – $10,000 = $140,000
- Multiple investments: $150,000 / 1.1 = 136,363
The downside of these methods is their relativity. The project may hold corresponding profitability index with separate investments and different dollar return, which contributes to dominant NPV.
Conclusion
Net Present Value is considered as one of the most desirable types of evaluation, analysis, and selection of great investments. However, we should note that we have to be very careful when estimating cash flows, since an incorrect cash flow estimation may lead to deceptive NPV.
Another thing you should take into account is that the discount rate is the same for both cash inflows and outflows, and the thing here is that the rates are different when lending or borrowing.
Still, NPV is the first and foremost measure of investment evaluation, compared to other methods such as determining the rate of return, payback period, internal rate of return (and Profitability Index). In fact, profitability index is related toNet Present Value, where the value presents an absolute measure, and the index presents a relative measure.
Proprietors raise investors’ wealth by welcoming projects that have a higher value than they actually cost, that has a positive expected Net Present Value. Sometimes the investment can be postponed and choose a time that is the most suitable for investment, and thus improve the cash flow.
