Profitability index

Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment.

The ratio is calculated as follows:

Profitability index = PV of future cash flows Initial investment

Assuming that the cash flow calculated does not include the investment made in the project, a profitability index of 1 indicates breakeven. Any value lower than one would indicate that the project's present value (PV) is less than the initial investment. As the value of the profitability index increases, so does the financial attractiveness of the proposed project.

Rules for selection or rejection of a project:

If PI > 1 then accept the project

If PI < 1 then reject the project

For example:

Investment = $40,000

Life of the Machine = 5 Years

CFAT Year CFAT 1 18000 2 12000 3 10000 4 9000 5 6000

Calculate Net present value at 10% and PI:

Year CFAT PV@10% PV 1 18000 0.909 16362 2 12000 0.827 9924 3 10000 0.752 7520 4 9000 0.683 6147 5 6000 0.621 3726 Total present value 43679 (-) Investment 40000 NPV 3679 PI = 43679/40000 = 1.091 > 1 ⇒ Accept the project