What Is an Index Method?

Osmand Vitez

The index method is an alternate formula by which a company can measure the rate of return for specific projects. Many companies use measurement techniques such as net present value or the internal rate of return for financial project analysis. The index method can use the terminal value — the value of a project at a period end — for measuring a return rate. A common formula here is the principal multiplied by one plus the interest rate, with the latter formula portion affected by the number of years for the project. This formula is akin to the compound interest rate formula applied by banks.

Man climbing a rope
Man climbing a rope

An example of the index method would be measuring the potential financial returns for a special product. The entire project would typically have an assessment based on the financial returns from capital spent on the project. For example, the entire project cost is $150,000 US Dollars (USD) with a potential interest rate — or cost of capital — of nine percent and total project length of five years. The terminal value or cost for this project is $230,794 USD at the project’s end. The company would then need to cover this cost through revenues in order to reach a profit.

Using an index method for project assessment is typically a simple process. It also allows a company to assess multiple projects in a short time period. This allows a company to quickly place assessments on multiple projects and select the most profitable based on the computed figures. Another option for this formula is to alter the cost of capital from external funds. Changing this figure comes from the different types of external funds available from lenders and other sources.

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The index method is not without its flaws. For example, inflation is not taken into account with the initial formula. This can lead to a project costing more than initially computed. Another problem may be projects lasting more years than initially estimated. The cost will increase due to length or cost overruns from the additional time.

An alternate index method is the profitability index. This latter formula divides the present value of cash flows by the cost of a project. Essentially, the profitability index is a hybrid between the index method and net present value method for project evaluation. The formula takes the present value of cash flows from income by the project cost from the index method. This additional step takes a deeper look into the potential financial returns for a project.

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