A Guide to the Profitability Index
A Capital Budgeting Method to Evaluate a Proposed Investment Project
The profitability index (PI), also known as the profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of payoff to an investment of a proposed project. In layman's terms, it is an indication of the costs and benefits to a business firm if they invest in a particular capital project. The PI is a cost/benefit ratio used in the capital budgeting financial analysis.
The profitability index is an appraisal technique applied to potential capital outlays and is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment.
The Profitability Index Formula
The profitability index can be calculated by dividing the present value of future cash flows expected to be generated by a capital project by the initial cost, or initial investment, in the project. The future cash flow cannot include the investment.
The present value of future cash flows requires the implementation of the time value of money calculations to equate future cash flows to current monetary levels. This discounting occurs because the value of $1 does not equate to the value of $1 received in one year. Money received closer to the present time is considered to have more value than money received further in the future.
The initial investment is the cash flow required at the start of the project.
A profitability index of 1 indicates breakeven, which is seen as an indifferent result. If the result is less than 1.0, you do not invest in the project. If the result is greater than 1.0, you do invest in the project. If the profitability index of a project is 1.2, for example, you can expect a return of $1.20 for every $1.00 you invest in the project.
How the Profitability Index formula Is Calculated
You can calculate the PI as follows:
Profitability Index = Present Value of Future Cash Flows Generated by the Project/Initial Investment in the Project.
In other words, if the result is greater than 1.0, and the owner invests in the project, then the company will benefit financially and make a profit if the business owner invests in the project.
How the Profitability Index is Used
The profitability index is often used to rank a firm's possible investment projects. Because companies usually have limited financial resources, they invest in only the most profitable projects. If there are a number of possible investment projects available, the company can use the profitability index to rank those projects from the highest profitability index to the lowest to decide which to invest in. Although some projects result in a higher net present value, those projects may be passed over because they do not represent the most beneficial usage of company assets.
It's important to note that one problem with using the profitability index is that it does not allow a business owner to consider the size of the project when evaluating projects. Using the net present value method of evaluating investment projects solves this problem. Obviously, the time the project will require and the time to profitability are also concerns.