What is the Profitability Index?
The profitability index (PI) measures how much value a project creates per dollar invested, making it a key tool for ranking projects under capital rationing. It complements NPV by expressing profitability as a ratio rather than an absolute dollar amount.
The profitability index is the ratio of the present value of a project's future cash flows to its initial investment: PI = PV of future cash flows / Initial investment. A PI above 1 means the project creates value and should be accepted.
- •Measures value in absolute dollars
- •Best for single, independent projects
- •Larger NPV isn't always the better ratio
- •Directly maximizes shareholder wealth
- •Measures value per dollar invested
- •Best for ranking projects under capital rationing
- •Useful for comparing projects of different sizes
- •PI > 1 signals a value-creating project
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Step-by-step worked examples
A project requires an initial investment of $100,000 and its future cash flows have a present value of $120,000. Find the PI and decide.
PI = PV of future cash flows / Initial investment PI = 120,000 / 100,000 = 1.20 Since PI > 1, the project creates value — accept.
A machine costs $80,000. Its future cash flows have a present value of $95,000. Should the company invest, and what is PI?
PI = 95,000 / 80,000 = 1.19 Because PI > 1, the machine adds value — accept the investment.
Two mutually exclusive projects are being ranked under capital rationing: Project A has NPV of $20,000 and initial investment of $80,000. Find its PI.
PV of future cash flows = NPV + Initial investment = 20,000 + 80,000 = 100,000 PI = PV of future cash flows / Initial investment = 100,000 / 80,000 = 1.25
Flashcards
Quick quiz
Q1.A project has PV of future cash flows of $150,000 and an initial investment of $100,000. What is its PI?
Q2.What does a PI of 0.9 indicate?
Q3.PI is especially useful for...
Q4.If NPV = $30,000 and initial investment = $150,000, what is PI?
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Common mistakes
Believing a higher PI always means a bigger dollar gain. — Correct: PI measures value per dollar invested, not total value — a small project can have a higher PI than a large, more profitable one.
Using raw future cash flows instead of their present value. — Correct: PI must use the present value (discounted) of future cash flows, not their nominal totals.
Ranking mutually exclusive projects by PI alone. — Correct: For mutually exclusive projects of different scale, NPV is the better decision criterion; PI works best for ranking under capital rationing.
Thinking PI = 1 means reject the project. — Correct: PI = 1 means the project exactly breaks even (NPV = 0) — it's typically treated as indifferent, not a rejection.
FAQ
What is the profitability index formula?
PI = PV of future cash flows / Initial investment. It can also be written as PI = 1 + (NPV / Initial investment).
What is a good profitability index?
Any PI greater than 1 indicates the project creates value; the higher above 1, the more efficient the investment.
What are examples of using the profitability index?
Comparing two projects with different initial investments to decide which creates more value per dollar under a limited capital budget.
How do you calculate the profitability index from NPV?
Add 1 to the ratio of NPV to the initial investment: PI = 1 + (NPV / Initial investment).