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How do you update and monitor Profitability Index over the project life cycle?

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Profitability index (PI) is a ratio that compares the present value of future cash flows from a project to its initial investment. It is a useful tool for capital budgeting, as it helps you evaluate and rank different projects based on their profitability and efficiency. However, PI is not a static measure. It can change over the project life cycle due to various factors, such as changes in cash flow estimates, discount rates, or opportunity costs. Therefore, it is important to update and monitor PI regularly to ensure that your project is still worth pursuing and that you are not missing out on better alternatives. In this article, you will learn how to do that in four steps.

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Meng Hock Tan ????

External Audit | Financial Reporting | Know Your Client Compliance | Big Four | Associate Member of the Institute of…

1 Step 1: Estimate the cash flows

The first step is to estimate the cash flows from your project for each period of its life cycle. You can use various methods, such as net present value (NPV), internal rate of return (IRR), or payback period, to project the cash inflows and outflows. You should also consider the risk and uncertainty of the cash flows and adjust them accordingly. For example, you can use sensitivity analysis, scenario analysis, or Monte Carlo simulation to account for different possible outcomes and probabilities.

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Meng Hock Tan ????

External Audit | Financial Reporting | Know Your Client Compliance | Big Four | Associate Member of the Institute of Singapore Chartered Accountants (ISCA)
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I do agree that the first step is to estimate the incremental cash flow of a project. To do this, you take the revenue of the project and subtract the initial investment and expenses of the project. If the result is a positive figure, it shows that this project is profitable, and it can be considered. However, we are not done yet as we will need to use the five (5) types of capital budgeting techniques to evaluate the incremental cash flows of a project. They are classified into discounted cash flow method and non-discounted cash flow method. The five (5) types of capital budgeting techniques, I have already covered them in other articles within the capital budgeting topic, and you may keep a lookout to have a read up on them.

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2 Step 2: Calculate the initial PI

The second step is to calculate the initial PI by dividing the present value of the cash flows by the initial investment. The present value of the cash flows is the sum of the discounted cash flows for each period, using a discount rate that reflects the cost of capital and the risk of the project. The initial investment is the amount of money that you need to spend upfront to start the project. The initial PI tells you how much value you can expect to create for each dollar invested. Generally, a PI greater than one indicates that the project is profitable and acceptable, while a PI less than one indicates that the project is unprofitable and unacceptable.

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Meng Hock Tan ????

External Audit | Financial Reporting | Know Your Client Compliance | Big Four | Associate Member of the Institute of Singapore Chartered Accountants (ISCA)
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Profitability Index (PI) is one of the discounted cash flow methods that consider the time value of money and the timing of cash flows. The initial PI is equal to the present value of after-tax cash flows divided by initial cash outlay of a project (i.e., initial investment). The project with the highest PI will be chosen.

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3 Step 3: Update the PI periodically

The third step is to update the PI periodically throughout the project life cycle. This means that you need to revise your cash flow estimates and discount rates based on new information, data, or events that affect your project. For example, you may need to update your PI if there are changes in market conditions, customer demand, competitor actions, regulatory requirements, or technological innovations. Updating your PI allows you to track the performance of your project and compare it with your initial expectations. It also helps you identify any potential problems or opportunities that may arise and take corrective or preventive actions accordingly.

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Meng Hock Tan ????

External Audit | Financial Reporting | Know Your Client Compliance | Big Four | Associate Member of the Institute of Singapore Chartered Accountants (ISCA)
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Sometimes due to unforeseen circumstances, the cash flows of a project will have to be re-estimated or revised, as well as the discount rate, hence it affects the calculated Profitability Index (PI). The unforeseen circumstances may be due to market conditions, new regulatory requirements imposed, or an outbreak of a disease. The COVID-19 pandemic crisis is one very good example. Regularly updating the PI due to unforeseen situations will help the financial manager or accountant to take any corrective actions and gauge whether it is still feasible in continuing the project which might even incur further losses as it continues.

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4 Step 4: Monitor the PI against alternatives

The fourth step is to monitor the PI against alternatives. This means that you need to compare your PI with the PI of other projects that you could invest in instead of or in addition to your current project. This is especially important if you face capital rationing, which is a situation where you have limited funds available and cannot accept all profitable projects. By comparing your PI with the PI of other projects, you can rank them based on their profitability and efficiency and select the best combination of projects that maximizes your overall value. You should also monitor the PI against the opportunity cost of capital, which is the return that you could earn by investing your funds in another asset with similar risk and liquidity. If your PI is lower than the opportunity cost of capital, you are better off rejecting your project and investing elsewhere.

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How do you update and monitor Profitability Index over the project life cycle?

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1 Step 1: Estimate the cash flows

2 Step 2: Calculate the initial PI

3 Step 3: Update the PI periodically

4 Step 4: Monitor the PI against alternatives

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