What Is the Profitability Index (PI)?

What Is the Profitability Index?

The profitability index measures the present value of future expected cash flows and the initial amount invested in a project. The PI, known as the value investment ratio (VIR) or profit investment ratio (PIR), represents the relationship between the costs and benefits of a proposed project.

Calculating PI

The profitability index is the ratio between the present value of future expected cash flows and the initial amount invested in the project. A higher PI means that a project will be considered more attractive.

• PV of Future Cash Flows: The numerator, or the present value of future cash flows, employs the time value of money. Cash flows are discounted to equate future cash flows to current monetary levels. The value of $1 today does not equal the value of $1 received in one year because money in the present offers earning potential via interest-bearing accounts. Cash flows received in the future have a lower present value.
• Initial Investment: The denominator represents the initial investment or the only 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 discounting in the numerator. These additional capital outlays may include taxation or depreciation benefits.

Interpreting the Profitability Index

The profitability index helps rank projects because it lets investors quantify the value created per each investment unit. A profitability index of 1.0 is the lowest acceptable measure on the index. Mathematically, a value lower than one means the project's present value (PV) is less than the initial investment.

Because profitability index calculations cannot be negative, they must be converted to positive figures. Calculations greater than 1.0 indicate the future anticipated discounted cash inflows are greater than the anticipated discounted cash outflows. Calculations less than 1.0 indicate the deficit of the outflows is greater than the discounted inflows, and the project should not be accepted.

The profitability index is used as an appraisal technique for potential capital outlays. However, the PI disregards project size when comparing project attractiveness. Therefore, projects with larger cash inflows may result in lower profitability index calculations because their profit margins are not as high. The PI is also called the benefit-cost ratio. Although some projects result in higher net present values, projects may be passed over because they do not have the highest profitability index and do not represent the most beneficial usage of company assets.

Example

A company is considering two potential projects: building a new factory or expanding an existing one. The factory expansion project is expected to cost $1 million and generate cash flows of $200,000 per year for the next 5 years, with a discount rate of 10%.

The new factory project is expected to cost $2 million and generate cash flows of $300,000 per year for the next 5 years, also with a discount rate of 10%.

To calculate the profitability index for the factory expansion project, the present value of the future cash flows is calculated using the formula:

PV = CF1 / (1 + r)^1 + CF2 / (1 + r)^2 + ... + CFn / (1 + r)^n

Where: PV is the present value, CF is the cash flow in a given year, r is the discount rate, and n is the number of years.

• PV = $200,000 / (1 + 0.10)^1 + $200,000 / (1 + 0.10)^2 + ... + $200,000 / (1 + 0.10)^5
• PV = $750,319

The profitability index for the factory expansion project is then calculated as:

• PI = PV / Initial Investment
• PI = $750,319 / $1,000,000
• PI = 0.75

To calculate the profitability index for the new factory project, the present value of the future cash flows is calculated using the same formula:

• PV = $300,000 / (1 + 0.10)^1 + $300,000 / (1 + 0.10)^2 + ... + $300,000 / (1 + 0.10)^5
• PV = $1,125,479

The profitability index for the new factory project is then calculated as:

• PI = PV / Initial Investment
• PI = $1,125,479/ $2,000,000
• PI = 0.56

The factory expansion project has a higher profitability index and a more attractive investment. The company might decide to pursue this project instead of the new factory project because it is expected to generate more value per unit of investment.

However, both PIs are less than 1.0, so the company may forgo either project.

The Bottom Line

The profitability index (PI) helps measure the attractiveness of a project or investment. It is calculated by dividing the present value of future expected cash flows by the initial investment amount in the project. A PI greater than 1.0 is considered a good investment, with higher values corresponding to more attractive projects.