What it means
Companies often have more good ideas than money, and they need a way to decide which ones to fund. The profitability index (PI) answers a simple question: for every dollar I put in today, how many dollars of present value do I get back?
A PI of 1.20 means each dollar invested creates $1.20 of value in today's terms. Present value is the key idea.
Money received in the future is worth less than money today, so future cash flows are reduced using a discount rate (the annual return the business requires, reflecting the risk of the project). Only after this adjustment can you fairly compare the future inflows with the cost today.
The decision rule is straightforward. If the PI is greater than 1, accept the project; if it is exactly 1, the project just earns the required return; if it is below 1, reject it.
This always gives the same accept or reject decision as net present value (NPV), because PI above 1 is the same as NPV above zero. Where the rule shines is capital rationing, which occurs when a firm has a fixed budget and cannot fund every positive project.
Ranking projects by PI shows which ones create the most value per dollar invested, and funding the highest ones first usually makes the best use of limited money. There are limits to the approach.
When projects are of very different sizes, or cannot be split into smaller pieces, the highest PI does not always give the highest total NPV, so a careful analyst checks the combination of projects as well as the ranking.
In practice
Real-world examples.
Example
A logistics company has a $500,000 equipment budget and three requests. Their profitability indices are 1.30, 1.18 and 0.95, so the finance team funds the first two and rejects the third because it destroys value.
Example
A hospital group compares a new scanner with a refurbished ward. The scanner costs $800,000 and has a present value of $920,000, a PI of 1.15, while the ward costs $400,000 and has a present value of $500,000, a PI of 1.25, so the ward ranks first per dollar spent.
Example
A software firm considers a $60,000 marketing automation project with cash flows worth $54,000 in present value. The PI of 0.90 tells the team the project would return only 90 cents of value for each dollar spent, so they drop it.
Formula
Calculation
The formula is:
Profitability index = Present value of future cash flows / Initial investment
Suppose Project A requires an investment of $100,000 and is expected to return a single cash flow of $145,200 at the end of year 2. The required rate of return is 10%.
Present value = $145,200 / (1.10 x 1.10) = $145,200 / 1.21 = $120,000.
Profitability index = $120,000 / $100,000 = 1.20.
The project's NPV is $120,000 - $100,000 = $20,000, which agrees with the PI being above 1.
Now suppose Project B costs $300,000 and has a present value of $345,000, giving PI = $345,000 / $300,000 = 1.15 and NPV = $45,000. Project A has the higher PI, but Project B adds more total value, which shows why both measures should be reviewed together.Case study
Seen in the real world.
Lakeshore Manufacturing is an illustrative, fictional company with a $1,000,000 capital budget and five proposals. Each department head argued that their own project was the most important.
The finance manager calculated the profitability index for each, discounting at the company's required return of 10%. Two projects came out below 1 and were removed immediately, which settled two arguments without debate.
Of the remaining three, the project with the highest PI was small, so the manager combined it with the second-highest and checked that the total NPV was higher than the alternatives. The illustrative lesson is that a single ranking number helps focus the discussion, but the final choice should still test the total value created by the combination.
Watch out
Common mistakes.
- Calculating the index using undiscounted cash flows, which overstates the ratio and makes weak projects look attractive.
- Ranking projects by PI alone when the projects are mutually exclusive or very different in size, which can lead to a smaller value-creating choice.
- Forgetting to include all of the initial costs, such as installation and working capital, in the investment figure.
Questions
People also ask.
Is the profitability index the same as NPV?
No, NPV is a dollar amount of value created while PI is a ratio, although both give the same accept or reject answer for a single project.
What discount rate should I use?
Use the return the business requires for projects of similar risk, which is often based on the cost of capital with an adjustment for risk.
When is PI better than NPV?
It is most helpful when capital is limited, because it shows value created per dollar invested and so helps rank competing projects.
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