Net Present Value (NPV) vs Profitability Index (PI) - YouTube

Net Present Value versus Profitability Index. What's the difference?

What are these? These are two of many different ways to evaluate an investment

opportunity. Let's say you can invest so much money and you can get back this

much in year 1, this much in year 2, and so on.

Is it worth it? Are you gonna make profit or are you gonna lose your money? So,

Net Present Value and Profitability Index are two different methods among

many different methods that help you figure out whether it's worth investing

your money or not. But they do it in a slightly different way. And the reason I

will be explaining them together is because they have a lot in common. Okay.

So, how would we figure that out? Let's say, we are given the following: the

interest rate - or you can say it's the return that's typical for this kind of

investments - is 10% per year. So, typically, when you invest your money

your money will be growing by 10% every single year. That's what this means. Is

the following investment opportunity worth it? And what we know is: you can

invest $1,500 today to get $400 back in one year, $700

in two years, another $300 in three years, another

$500 in four years, and another $200 in five years, and that's it. So, it's a

five-year investment opportunity. Okay. So, we want to calculate it, the

profitability, two different ways. First, "Net Present Value" which we call NPV, and,

second, "Profitability Index" which we can abbreviate as PI. Okay. So,

we are gonna do the math two different ways, but you'll see how much the two

methods have in common! What we want to do is basically find how profitable it

is, so you can make your decision today. So it might make sense to discount all

the future cash flows back to today. Because today is when we want to make

the decision, the investment decision, right? To discount multiple different

future cash flows the best technique is the cash flow approach, the cash flow

keys in the financial calculator. For that we need to enter cash flow 0, then we

have cash flow in year 1, which the display will call C01, C02, 03, 04, and

05. And that will be our 5 future cash flows we want for today. You are gonna

be using the cash flow keys for both investment valuation methods, both the

Net Present Value approach and the Profitability Index approach. What's the

difference? For Net Present Value you're gonna enter the numbers that are given:

negative $1500 for cash flow 0, then 400 for cash flow 1... 700 for cash flow 2... 300

cash flow 3... 500 cash flow 4... 200 cash flow 5. For the Profitability

Index though... actually let's calculate this first! Let's bring up the

financial calculator. Turn it on. To start the what we call the cash flow keys we

press the button "CF", cash flow. We want to enter $1,500, and then we change the sign

to negative by pressing the "plus minus" key, "enter", "down arrow" key. Cash flow 01:

that's 400. I keep the sign as positive because this

is the money we get back, cash inflow. "Enter", "down". Frequency, how many times in a

row do we have 100? Only once. And that will be the case with the rest of the

cash flows too. I keep the frequency at 1, and I press the "down arrow" key again. Cash

flow 2... 700 two years from today. "700", "enter", "down", and "down" again. "300", "enter", "down",

and "down". Then we have "500", "enter", "down", and "down" again. And last one is

"200" in year 5, "enter", "down", and "down" again. Then we press the "NPV" button, Net

Present Value, which is exactly what we are calculating now, Net Present Value. It

asks for the interest rate which is 10%, it's given. I press "10", "enter", "down", and

"compute". $133.23. Let's write it down. So my NPV equals 133 dollars and 23

cents. Okay. What does it mean? How do you... how do we interpret this number?

It's more than zero dollars, right? It means: the amount of money you get back

in all future years is higher than $1,500 that you would need to invest

today by $133.23. So you

will make a profit! So the investment is worth it!

Right? Worth it because NPV is greater than $0. Okay. That's how the

math works with the NPV approach. With the Profitability Index it's actually

very similar. Here's what we do. One thing we do differently is: for cash

flow 0 the enter "0". And why? Because the first step is... we're

gonna do it in two steps. The first step is: we discount back just all the future

cash flows as if there is nothing for year 0, no $1,500. And so in the cash

flow keys I will need to save my cash flow 0 as $0. And then 400,

700, 300, 500, and 200, just like with the Net

Present Value technique. And once again I will be computing NPV at 10%.

Let's do that. Okay. Let's reset and start all over again.

"Cash flow" button. Cash flow 0 - we want to keep it at 0. I press "enter", "down". And

then just like before I press all my future cash flows one by one leaving

their frequencies at 1. "400", "enter", "down", "down", "700", "enter", "down", "down", "300", "enter", "down",

"down" "500", "enter", "down", "down", and "200", "enter", "down", "down".

"NPV", the interest rate is "10", "enter", "down", "compute". 1633 dollars and 23 cents. Okay.

Let's write it down. So what we have is the Present Value of all future cash

flows,

and we found it to be $1,633.23.

So at this point we have not considered the initial investment of $1,500,

right? And so what we do next,

the way we calculate the profitability index, is we take $1,633.23,

the Present Value of all

future cash flows and divide it by the initial investment, $1,500. And when we do

that we get 1.09. This is how we find the Profitability Index. What does it tell

us? Because it's greater than 1 it means for every one dollar you invest

today you get one dollar and nine cents back in the future. For every one dollar

you invest today. Is it a good investment? Of course it's a good

investment! You want the Profitability Index to be greater than 1. If it's

greater than one the investment is worth it.

Right? So it's worth it because the Profitability Index is greater than 1.

So let me put that in the parentheses, greater than 1. And that's... and

typically the NPV and the Profitability Index will tell you exactly the same

thing. And that's why I wanted to show kind of how the calculations would be

similar but a little bit different at the same time.