Capital Budgeting - Profitability Index

[Michelle]

I am trying to work out several Capital Budgeting measures using Excel and am stumped by this one:
Profitability index (PI) = (Present Value of Future Cash Flows / Initial Investment)

The problem is with incremental investments:
For example, if I have an analysis period of, say 5 years, with both investments each year AND
revenue from the investment how do I calculate the Initial Investment value? The initial
investment, that being in year 1 does not completely state the total cost of the project.

Do I need to do a PV of all the investments, and use this as the value for the divisor (Initial
Investment)?

Any help on this would be greatly appreciated,

Thank you,

Michelle

 

[Norman Harker]

Hi Michelle!

I think that you've hit on one of the problems of the profitability
index.

Perhaps the best approach might be to separate out the positive and
negative flows and then use

NPV Positive Flows / NPV Negative Flows

But profitability index is a very crude measure as are a lot of the
common tools (including NPV and IRR).
--
Regards
Norman Harker MVP (Excel)
Sydney, Australia
(e-mail address removed)
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