Profitability Index
PI = PV of Future Cash Flows / Initial Investment
Measures the bang for the buck. A PI above 1.0 means the project creates value per dollar invested.
Variables
Sum of discounted future cash flows
Upfront capital outlay
Example Calculation
Scenario
Project costs $200,000 and the PV of future cash flows is $240,000.
Given Data
Calculation
PI = 240,000 / 200,000 = 1.20
Result
1.20
Interpretation
Every dollar invested returns $1.20 in present value. Accept since PI > 1.
When to Use This Formula
- ✓Ranking projects under capital rationing
- ✓Comparing projects of different sizes
- ✓Supplement to NPV when budget is limited
Common Mistakes
- ✗Choosing the project with the highest PI when projects are mutually exclusive (use NPV instead)
- ✗Confusing PI with ROI
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Common questions about this formula
NPV gives total value added in dollars. PI gives value per dollar invested, which is useful for ranking under capital constraints.
Yes, when projects differ in size. A smaller project might have a higher PI (more bang per buck) but lower total NPV. Use PI for ranking under capital rationing; use NPV for choosing among mutually exclusive projects with no budget constraint.