Profitability Index

Profitability index (PI) is the ratio of investment to payoff of a suggested project. It is a useful capital budgeting technique for grading projects because it measures the value created by per unit of investment made by the investor.

This technique is also known as profit investment ratio (PIR), benefit-cost ratio and value investment ratio (VIR).

The ratio is calculated as follows:

Profitability Index = Present Value of Future Cash Flows / Initial Investment

If project has positive NPV, then the PV of future cash flows must be higher than the initial investment. Thus the Profitability Index for a project with positive NPV is greater than 1 and less than 1 for a project with negative NPV. This technique may be useful when available capital is limited and we can allocate funds to projects with the highest PIs.

Decision Rule:

Rules for the selection or rejection of a proposed project:

If Profit Index is greater than 1, then project should be accepted.

If Profit Index is less than 1, then reject the project.