The profitability index, also known as the profit investment ratio, is calculated as the ratio of the present value of the future cash flows and the initial investment in the project.
Since NPV is the difference between the present value of future cash flows and initial investment, the profitability index can also be expressed in terms of NPV as follows:
The firms use PI to decide whether to accept or reject a project.
PI > 1, Accept the project
PI < 1, Reject the project
Let’s taken an example to understand how profitability index is calculated. Assume that a company invests $5,000 in a project, which generates the following cash flow in the next 5 years. The firm has a cost of capital of 10%. Column 3 presents the discounted cash flows.
|Year||Cash Flow||Discounted Cash Flows|
The total PV of future cash flows = 6277.64
Initial Investment = $5000
PI = 6277.64/5000 = 1.25
Since PI > 1, the project can be accepted.
The profitability index is a useful tool for capital rationing, as the projects can be ranked based on their PI.