The profitability of an investment, also known as Profitability Index (PI) or Profit Investment Ration (PIR), is the ratio of payoff to investment of a proposed project. In other words, it is the comparison of a payoff to a proposed project in order to make it easy to quantify the amount of value created per unit of the business. There are different methods of evaluating the profitability of an investment project. The top four are
- Payback period PBP)
- Average annual rate of return (AARR)
- Net present value (NPV)
- Internal Rate of Return (IRR)
Any of these methods can be used in calculating the profitability of an investment. For the purpose of this post, let us explain just one of the methods; the payback period.
THE PAYBACK PERIOD:
At the start of a project, the investor is expected to have put in some resources that will cost him or her some amount of money, after this, the next point of concern will be to regain that cost back, and then start to enjoy whatever returns that may come after that. The payback period is concerned with the return of the original expenses made. To do this, calculation of the cash flow that will arise from the business per annum is made. This will give one an idea of when the capital cost will be recovered. How long it takes to recover the cash flow that is equal to the original cost is what determines the payback period of the business.
There are a lot of things that can be benefitted from calculating the profitability of an investment using the payback period method, or any other method for that matter, so long as it is an approved one. It shows how profitable a business is, how long it will take to recover the costs, and in making analysis or ranking a project.
CALCULATING THE PAYBACK PERIOD OF A PROJECT
Here is an example on how to calculate the PBP of a project.
If the capital cost of a project is $21,000, and it is expected to generate an annual cash inflow of $7,000 for ten years, what will be the payback period?
PBP = Initial investment / Annual cash inflow
P = C / A1
P = Payback period
C = initial investment = $21,000
A = annual cash inflow = $7,000
P = 21000 / 7000
P = 3 years
From this calculation, it can be seen that it will take about three years to get as much cash inflow that will equate the initial investment. It can serve as a criterion to either reject or accept a business proposal. Usually, investors prefer projects that bring back the initial cost in three years or less.
The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.