What Is the Profitability Index (PI)?

The profitability index (PI) is a capital budgeting metric that compares the present value of a project’s expected future cash inflows to its initial investment. It shows how much value is created per dollar invested and helps prioritize projects when resources are limited.

Key formula

PI = Present Value of Future Cash Flows / Initial Investment

If PI > 1 → project creates value (NPV > 0)
If PI = 1 → project breaks even (NPV = 0)
If PI < 1 → project destroys value (NPV < 0)

How to calculate PI

1. Project the expected cash inflows for each period.
2. Choose an appropriate discount rate (cost of capital).
3. Discount each future cash inflow to its present value and sum them:
   PV = Σ (CFt / (1 + r)^t) for t = 1..n
4. Divide the total PV by the initial investment.

Interpretation and relationship to NPV

• PI measures value created per dollar invested and is useful for ranking projects, especially under capital constraints.
• PI and NPV are closely related: PI > 1 if and only if NPV > 0. However, PI is a ratio and does not show absolute dollar value created (NPV does).
• Because PI is scale‑insensitive, a small project with a high PI may be favored over a much larger project that yields a higher NPV but lower PI.

Worked example

Two projects, both with five annual cash inflows and a 10% discount rate:

• Expansion: initial cost = $1,000,000; annual CF = $200,000 for 5 years.
  PV factor for an annuity at 10% for 5 years ≈ 3.79079.
  PV = $200,000 × 3.79079 ≈ $758,158.
  PI = 758,158 / 1,000,000 ≈ 0.76.

• New factory: initial cost = $2,000,000; annual CF = $300,000 for 5 years.
  PV = $300,000 × 3.79079 ≈ $1,137,237.
  PI = 1,137,237 / 2,000,000 ≈ 0.57.

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Both projects have PI < 1 (NPV < 0), so neither is financially attractive on these assumptions. Between the two, the expansion has the higher PI and would be preferred if choosing one project, but the company might still reject both.

Explain like I’m five

PI tells you how many dollars of value you get back for every dollar you put in today. A number above 1 means you get more back than you paid (good); below 1 means you get less back (bad).

Advantages

• Incorporates the time value of money.
• Useful for ranking projects when capital is limited.
• Simple to compute and interpret.

Limitations

• Ignores absolute dollar value (NPV) and project scale.
• Can be misleading for mutually exclusive projects: a project with the highest PI may produce less total value than one with a lower PI but much larger scale.
• Assumes reinvestment of interim cash flows at the discount rate.

When to use PI

• When you must rank projects under a capital constraint.
• As a complementary metric alongside NPV and IRR to get a fuller picture of project attractiveness.

What is a “good” PI?

Generally, PI > 1 is considered acceptable because it indicates positive NPV. Higher PI values indicate more attractive returns per dollar invested. Always consider PI together with NPV, project scale, and strategic factors.

Bottom line

The profitability index is a useful ratio for assessing and ranking investments by value created per unit of investment. Use it alongside NPV and other metrics to make well-rounded capital allocation decisions.