Profitability Index Definition, Formula & Example

However, when comparing two positive projects, the NPV does not consider the amount tied up in the investment. To more easily illustrate this, use the extreme example of two projects with both having an NPV of $1,000. But, suppose that one has an initial investment of $1,000 and the other has an initial investment of $1,000,000. It is easy to see now with additional information that the lower upfront amount is far better. The profitability index formula runs into the same problems that the NPV does.

The net present value analysis favors project 1 because its NPV number is bigger than project 2. But the profitability index indicates otherwise and says that project 2 with its self-employment higher PI value is a better opportunity than project 1. Now that we have obtained the PI value for both the projects, let’s look into its application for appraising projects.

  1. That’s because the PI result simply ignores the projects’ scale and the absolute added shareholder value.
  2. Theoretically, it reveals unprofitability of a proposed investment and suggests rejection of the same.
  3. Because profitability index calculations cannot be negative, they consequently must be converted to positive figures before they are deemed useful.
  4. The higher the profitability index (PI) ratio, the more attractive the proposed project is, and the more likely it will be pursued.
  5. The rule is that a profitability index or ratio greater than 1 indicates that the project should proceed.

The basis of comparing projects with only the Net Present Value does not take into account what is the initial investment. Profitability Index compares the Net Present Value reached with the initial investment and shows the most accurate representation of the usage of company assets. For example, a project with an initial investment of $1 million and a present value of future cash flows of $1.2 million would have a profitability index of 1.2. Based on the profitability index rule, the project would proceed, even though the initial capital expenditure required are not identified.

And if you still are, well it’s almost certainly not as straightforward a decision/choice as you thought it was before. The problem is that this doesn’t factor in the magnitude of the investment requirement. Consider that we tell you there are two projects, which we’ll conveniently call Project A and Project B. However, if they are added together, the sum total is larger than project 1’s NPV. The common sense here dictates that the company should choose both project 2 and 3, and leave the first one.

To find more attractive investments, look for a profitability index that is the highest. This shows that the project will generate value for your business and it can be a good investment. It can be helpful to calculate the net present value prior to calculating the profitability index. But, the profitability index can get calculated using the following profitability index formula(s).

How Is the Profitability Index Computed?

The higher the profitability index (PI) ratio, the more attractive the proposed project is, and the more likely it will be pursued. Another variation of the PI formula adds the initial investment to the net present value (NPV), which is then divided by the initial investment. By contrast, there are also a few limitations or disadvantages to the profitability index formula. Unfortunately, when two different investments have the same PI, this does not tell you which ties up more money initially. We give you a realistic view on exactly where you’re at financially so when you retire you know how much money you’ll get each month.

Profitability index (PI)

The index itself is a calculation of the potential profit of the proposed project. The rule is that a profitability index or ratio greater than 1 indicates that the project should proceed. A profitability index or ratio below 1 indicates that the project should be abandoned. The cost of funding the project is $10 million, and the amount of cash flows generated in Year 1 is $2 million, which will grow by a growth rate of 25% each year.

Calculations less than 1.0 indicate the deficit of the outflows is greater than the discounted inflows, and the project should not be accepted. Calculations that equal 1.0 bring about situations of indifference where any gains or losses from a project are minimal. The main difference between NPV and profitability index is that the PI is represented as a ratio, so it won’t indicate the cash flow size. A profitability index number might be 1.5, but you wouldn’t necessarily know the capital expenditure required. You will then have to make a decision on what’s going to be best for your business moving forward. The result can be a higher return on investment and an increase in potential profitability.

However, since both PIs are less than 1.0, the company may end up forgoing either project in favor of a better opportunity elsewhere. The profitability index rule is a variation of the net present value (NPV) rule. In general, a positive NPV will correspond with a profitability index that is greater than one. A negative NPV will correspond with a profitability index that is below one. Suppose we’re evaluating a proposed five-year project with the following assumptions.

What is a Good Profitability Index (PI)?

The ratio could be used to develop a ranking of projects, to determine the order in which available funds will be allocated to them. The discounted projected cash outflows represent the initial capital outlay of a project. The initial investment required is only the cash flow required at the start of the project. All other outlays may occur at any point in the project’s life, and these are factored into the calculation through the use of discounting in the numerator. These additional capital outlays may factor in benefits relating to taxation or depreciation.

Despite its relevance, this index uses just an estimate of the cost of capital in its calculation, so it should not be reviewed on a stand-alone basis. Combined with the Payback Period, Discounted Payback Period, and the Accounting Rate of Return, this ratio provides meaningful data to work with. A Profitability Index of 1 indicates a break-even situation, implying the present value of the project’s cash inflows is equivalent to the initial investment. A PI value greater than 1 indicates a profitable project, whereas a value less than 1 suggests the project may not be profitable. The profitability index is calculated as the ratio between the present value of future expected cash flows and the initial amount invested in the project.

The profitability index (PI) is used to assess how much profit may come from a particular investment. Although not that common among finance professionals, as opposed to NPV and IRR, it is still considered economically sound. Governments and NGOs normally use this index when performing capital analysis. Even though some projects have higher net present values, they might not have the highest profitability index.

Project Assumptions

Often though, it isn’t always this simple to see that everything is equal except for the term. What if the 3 year project has an NPV of $1,000 and the 5 year project has an NPV of $1,100. One could annualize these net returns using the equivalent annual annuity formula, for the sake of like comparison.

However, actual decision should attempt to maximize the total net present value of the project keeping in view the available funds for initial investment using capital rationing. The first thing you notice is that Project I has a larger scale compared to Project II — it requires larger initial investment and returns higher cash flows. The first project will return cash flows for a period of 10 years, while the second one is expected to deliver for 8 years only. It assumes cash flows are consistent, and disregards factors like financing and risk which can affect a project’s feasibility. It also requires an accurate estimation of future cash flows, which can be difficult. A ratio of 1 indicates that the present value of the underlying investment just equals its initial cash out outlay and is considered the lowest acceptable number for a proposal.

Anything lower than 1 indicates that the project’s present value is far less than the initial investment. So, the higher the profitability index, the more benefit and value you will get from it. It works as a way for you to appraise a project to make a more informed decision.