The profitability index (PI) is a ratio that shows the relationship between the costs and benefits of a project. It is calculated by dividing the present value of future cash flows by the initial investment. It is a tool for evaluating and ranking potential projects. A profitability index greater than 1 indicates that the project is worthwhile.
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What is the Formula for the Profitability Index?
The formula for calculating the profitability index is as follows:
Profitability Index=Present Value of Future Cash FlowsInitial InvestmentProfitability Index=Initial InvestmentPresent Value of Future Cash Flows
Another variation of the PI formula adds the initial investment to the net present value (NPV), which is then divided by the initial investment.
Profitability Index=Net Present Value + Initial InvestmentInitial InvestmentProfitability Index=Initial InvestmentNet Present Value + Initial Investment
How to Interpret the Profitability Index?
In corporate finance, the primary use case for the PI ratio is for ranking projects and capital investments. The higher the PI ratio, the more attractive the proposed project is and the more likely it will be pursued. For some general guidelines on interpreting the PI ratio:
- PI = 1: Neutral/Acceptable
- PI > 1: Approve Project
- PI < 1: Reject Project
What is the Relationship Between the Profitability Index and the Net Present Value?
The profitability index (PI) and net present value (NPV) are two closely related metrics. If PI Ratio is > 1, then NPV will be positive. If PI Ratio is < 1, then NPV will be negative2. The major distinction between the two is that the profitability index depicts a “relative” measure of value whereas the net present value (NPV) represents an “absolute” measure of value. With that said, for purposes of presenting a project or capital investment’s benefits on a per-dollar basis of the initial investment, the profitability index is more practical since it is standardized. The PI metric can thereby be used for comparisons among different projects. By contrast, comparisons of NPV between projects are not always functional (i.e. non-standardized metric).
Example of Calculating and Comparing the Profitability Index
Suppose we’re evaluating two proposed five-year projects with the following assumptions:
| Project A | Project B |
| Discount Rate: 10% | Discount Rate: 10% |
| Project CF Growth Rate: 25% | Project CF Growth Rate: 15% |
| Initial Investment: –$10,000,000 | Initial Investment: –$5,000,000 |
| Project Cash Flows (Year 1): $2,000,000 | Project Cash Flows (Year 1): $1,500,000 |
The present value of future cash flows for each project can be calculated using an annuity formula:
PV of Future Cash Flows=Cash Flow in Year 1×(1−1(1+Discount Rate)Number of Periods)Discount Rate−Growth RatePV of Future Cash Flows=Discount Rate−Growth RateCash Flow in Year 1×(1−(1+Discount Rate)Number of Periods1)
For Project A:
PV of Future Cash Flows= PV of Future Cash Flows=
