Profitability Index PI Formula + Calculator

The profitability index, in fact, is another way of representing the net present value model. The only difference between two is that the NPV shows an absolute value whereas the PI measures the relative value in ratio format. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. In the subsequent step, we can now calculate the project’s PI given the NPV from the prior step. 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.

  1. The PI is calculated by dividing the present value of future cash inflows by the initial investment.
  2. 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.
  3. The profitability index is also called the benefit-cost ratio for this reason.
  4. A financial analyst is reviewing a proposed investment that requires a $100,000 initial investment.
  5. The initial investment is the amount of capital required to start the project.
  6. In the subsequent step, we can now calculate the project’s PI given the NPV from the prior step.

A less than 1 PI ratio means that the project’s present value would not recover its initial investment or cost. Theoretically, it reveals unprofitability of a proposed investment and suggests rejection of the same. In general terms, the higher the PI metric, the more attractive a proposed investment is. The profitability index is helpful in ranking various projects because it lets investors quantify the value created per each investment unit. As the value of the profitability index increases, so does the financial attractiveness of the proposed project.

A profitability index greater than 1.0 is often considered to be a good investment, as it means that the expected return is higher than the initial investment. When making comparisons, the project with the highest PI may be the best option. When using the profitability index to compare the desirability of projects, it’s essential to consider how the technique disregards project size.

Regardless of the type of business you operate or your industry, generating a profit is critical to growing and expanding. And when it comes to projects or possible investments, understanding the benefits you can receive is important. There are a number of other considerations besides the profitability index to examine when deciding whether to invest in a project.

Cash flows are discounted the appropriate number of periods to equate future cash flows to current monetary levels. Cash flows received further in the future are therefore considered to have a lower present value than money received closer to the present. For example, a project that costs $1 million and has a present value hotel invoice template of future cash flows of $1.2 million has a PI of 1.2. In corporate finance, the primary use case for the PI ratio is for ranking projects and capital investments. While the net present value gives us the absolute value that a project adds, it is wrong to compare the net present values of different investments directly.

What Is the Profitability Index? Definition & Calculation

Firms use the profitability index to determine the relationship between costs and benefits for a proposed project. They utilize this measure to rank projects based on the value created per investment unit. More specifically, the PI ratio compares the present value (PV) of future cash flows received from a project to the initial cash outflow (investment) to fund the project. You can use a profitability index template or table like the one below to plug in your values. A PI template helps give a visual representation of the present value of future cash flows in order to calculate your project’s PI. It is considered that when NPV is $0+ and the profitability index is 1+, the project is a healthy venture.

How Is the Profitability Index Computed?

The profitability index is a calculation determined by dividing the present value of futures cash flows by the initial investment in the project. The initial investment is the amount of capital required to start the project. The profitability index formula is used calculate the profitability of a project based on its future discounted returns relative to the initial investment. You need to consider initial investment, the rate of return and future cash flows.

Profitability index (PI)

The main advantages of PI include consideration of all cash flows throughout the project, time value of money and relative profitability. It can be used to compare and prioritize different projects based on their profitability. A Profitability Index greater than 1 indicates a potentially profitable investment, while a value less than 1 suggests a potential loss or lower return. In this example, the PI of 1.25 indicates that the investment is expected to generate positive returns. The profitability index is used for comparison and contrast when a company has several investments and projects it is considering undertaking. The PI is especially useful when a company has limited resources and can’t pursue all potential projects, as it can be used to prioritize which projects to pursue first.

We can see that the PI number obtained through our incremental analysis is greater than 1. We would discuss and exemplify the above three applications of profitability index later in this article, but let’s first look into how it is computed. Download CFI’s Excel template to advance your finance knowledge and perform better financial analysis.

Alternatively, you could calculate it as the ratio of PV to I, so that the PV (Present Value) is divided by the investment. Fundamentally, the Profitability Index shows us the amount of money we earn for every $1 / £1 invested. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.

Profitability Index vs. NPV: What is the Difference?

The index can be used alongside other metrics to determine which is the best investment. Because profitability index calculations cannot be negative, they consequently must be converted to positive figures before they are deemed useful. Calculations greater than 1.0 indicate the future anticipated discounted cash inflows of the project are greater than the anticipated discounted cash outflows.

The higher a profitability index means a project has benefits and would be considered more attractive. It can be very helpful in ranking potential projects in order to let investors quantify their value. A final issue is that the index cannot be used to rank projects that are mutually exclusive; that is, only one investment or the other would be chosen, which is a binary solution. In this situation, a project with a large total net present value might be rejected if its profitability index were lower than that of a competing but much smaller project. For example, Garch Ltd could invest in Catcher even though the initial investment required is $600,000 while the company only has $550,000 available to invest.

The Profitability Index (PI) is a crucial business and finance term that signifies the relationship between the costs and benefits of an investment project. It plays a fundamental role in capital budgeting decisions by providing a quantitative measure of the expected return per dollar invested. This index is computed by dividing the present value of expected future cash flows by the initial investment cost. Its components mainly include expected future cash flows and the discount rate reflecting opportunity cost of capital. The importance of the PI lies in its ability to guide management in selecting investment projects. Therefore, the PI serves as a vital decision-making tool in helping businesses maximize their profitability and utilize their resources efficiently.