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 a capital budgeting tool that measures the profitability of an investment or 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 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 is calculated by dividing the present value of future cash flows to be generated by a capital project by the initial cost, or initial investment, of the project. The initial investment is the cash flow required at the start of the project. The future cash flows do not include the initial investment amount.
Profitability Index = Present Value of Future Cash Flows Generated by the Project/Initial Investment in the Project.
The present value of future cash flows is a method of discounting future cash to its current value, and it requires the implementation of the time value of money calculation. This discounting occurs because the current value of $1 is not equivalent to the value of $1 received in the future. Money received closer to the present time is considered to have more value than money received further in the future.
A profitability index of 1 indicates breakeven, which is seen as an indifferent result. If the result is less than 1.0, you should not invest in the project as the costs outweigh the benefits. If the result is greater than 1.0, you should consider investing 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.
The profitability index is often used to rank a firm's investments and/or projects. Because companies usually have limited financial resources or must maximize profits for shareholders, they often 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 high to low and decide which offers the greatest benefit. Although some projects result in a higher net present value, those projects may be passed over because they do not represent the most beneficial use 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. 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.