Profitability index definition
A method used in the process of deciding whether a project should be accepted or rejected
What is profitability index?
The profitability index (PI) is sometimes referred to as Profit Investment Ratio. It is a ratio used for analysing the costs and benefits of investing in a specific project. The calculations are based on the present value of all future cash flows, which will occur during the lifespan of a project. The following equation is used for the calculation of the profitability index.
Profitability Index (PI) = PV of expected cash flows / Initial investment
Before calculating the PI, the present value of future cash flows should be estimated. Finding today's value allows comparing the value of money in different periods more accurately – it is easier to compare the value of investment made today and cash received in the future.
A value of PI below 1 would mean that the present value of future cash flows is lower than the value of the investment. The former would mean that the project should be rejected. Any value above 1 would indicate that today's value of expected cash flows is greater than the value of the initial investment, and the project can be accepted. When PI equals 1 realising the project will neither bring benefit nor loss. When making a financing decision between multiple projects with PI above 1, the project with the highest value of profitability index should be selected.
For example, project A has an initial investment of €100,000.00 and a present value of all future cash flow in the amount of €120,000.00. Project B has an initial investment of €50,000.00 and the present value of future cash flows of €65,000.00. The first impression would be to accept project A because it will bring a higher benefit in terms of monetary value. After calculating the PI, the following values are obtained:
PI for project A = 120,000.00 / 100,000.00 = 1.2
PI for project B = 65,000.00 / 50,000.00 = 1.3
After considering the results from the PI, it is obvious that project B will provide more value to the investor. Both projects have PI above 1, which means that they will bring benefits to the company.
Profitability index rule
A project with a PI lower than 1 – the project should be rejected
A project with a PI greater than 1 – the project should be accepted.
A project with PI equal to 1 – the acceptance or rejection depends on the decisionmaker's attitude since the company or investor will neither have a gain nor a loss.