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How It Works
The profitability index divides the present value of expected cash flows by the initial investment. A PI above 1.0 means the investment creates value; below 1.0 means it destroys value. It is especially useful for ranking projects when capital is limited.
Unlike NPV, which gives a dollar amount, PI expresses return as a ratio. This makes it easier to compare projects of different sizes.
Example Problem
A project requires $200,000 upfront and the present value of future cash flows is $260,000.
- PI = $260,000 / $200,000 = 1.30
A PI of 1.30 means every dollar invested generates $1.30 in present value, creating $0.30 of value per dollar. This project should be accepted.
Frequently Asked Questions
What profitability index should I look for?
Accept projects with PI above 1.0. The higher the PI, the better the return per dollar invested. A PI of 1.5 means $1.50 of value for every $1 invested. When choosing between projects, rank by PI.
How is PI different from NPV?
NPV gives the total dollar value created. PI gives the value per dollar invested. A $10 million project with $2 million NPV (PI = 1.2) may rank below a $1 million project with $500,000 NPV (PI = 1.5) if capital is scarce.
Can PI be used for real estate investments?
Yes. Discount expected rental income and resale proceeds to present value, then divide by your cash investment. A rental property with $150,000 in PV of cash flows on a $120,000 investment has a PI of 1.25.
Related Calculators
- Present Worth Calculator — discount future cash flows.
- Return on Equity Calculator — measure equity returns.
- Cash on Cash Rate Calculator — evaluate real estate cash returns.
- Compounding & Discount Factors Calculator — compute discount factors for cash flows.
- Rule of 72 Calculator — quickly estimate investment doubling time.
Reference: Brealey, Richard A., Myers, Stewart C. & Allen, Franklin. Principles of Corporate Finance. McGraw-Hill Education.