PI greater than 1 will be profitable and accepted and PI less than one will be rejected as it will create a loss. PI helps and takes into consideration the time value of money and future cash flow of money in the project. PI helps to indicate whether the investment made in the project will be accepted or rejected. 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.
Profitability Index (PI) Rule: Definition, Uses, and Calculation
The profitability index is the ratio between the initial amount invested in a project and the present value of future cash flows. 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.
Profitability Index Formula & Example
In this article, we will delve into the definition of the Profitability Index, explore its key components, and break down the formula used to calculate it. By understanding PI, businesses can make more informed decisions that align what is a three-way match in accounts payable gep glossary with their financial goals. If the IRR is lower than the cost of capital, the project should be killed. The profitability index (PI) refers to the present value of a project’s future cash flows divided by the initial investment.
- Put differently, you earn a 10th (1/10) of what Project A is offering you on a per pound invested basis.
- Although not that common among finance professionals, as opposed to NPV and IRR, it is still considered economically sound.
- Whether you’re a business owner, investor, or policymaker, understanding the PI can empower you to make informed choices about resource allocation and project selection.
- The advantage to using the NPV method over IRR using the example above is that NPV can handle multiple discount rates or varying cash flow directions.
- However, even if the PI is widely used for doing cost-benefit analyses, it is not free of demerits.
Example: Discounted Payback Period
If any part of the profitability index formula isn’t quite clear, please re-read this article. Furthermore, you learned that there are 2 ways to calculate the PI, including one where we take the ratio of NPV to I, and another, where we take it as the ratio of PV to I. Archer requires an investment of $300,000 and Brochure requires $200,000.
The Formula for Profitability Index
The profitability index can help you determine the costs and benefits of a potential project or investment. It’s calculated based on the ratio between the present value of future cash flows and the initial investment. The profitability index can also get referred to as a profit investment ratio (PIR) or a value investment ratio (VIR). It represents the relationship that exists between the costs and the benefits of a potential project.
Imagine a company is considering an investment project that requires an initial investment of $100,000. The expected future cash flows over the next five years are projected to be $25,000, $30,000, $35,000, $40,000, and $45,000, respectively. If the company’s discount rate is 10%, the present value of these cash flows can be calculated using the formula for the present value of an annuity. Once the present value is determined, it is divided by the initial investment to find the PI.
That’s because the PI result simply ignores the projects’ scale and the absolute added shareholder value. Consider a project that costs $10 and has a $20 present value (Investment 1), and another one (Investment 2) that costs $1,000 with a $1,500 present value. Join over 2 million professionals who advanced their finance careers with 365. Learn from instructors who have worked at Morgan Stanley, HSBC, PwC, and Coca-Cola and master accounting, financial analysis, investment banking, financial modeling, and more. Get new tipps on retirement savings, investment decisions and antifraud tipps.
A profitability index of 1 indicates that the project will break even. The internal rate of return (IRR) is the discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. For a project with one initial outlay, the IRR is the discount rate that makes the present value of the future after-tax cash flows equal to the investment outlay. To calculate NPV all, we need to do is to add up all discounted cash flows and then deduct the initial investment required. The profitability index allows investors to quantify the amount of value created per unit of investment.
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. The NPV method reveals exactly how profitable a project will be in comparison to alternatives.