Profitability Index (PI)

PI measures the ratio of present value of inflows to the initial investment. PI > 1 indicates value creation at the chosen discount rate.

Formula

PI = (\u2211 CF_t / (1 + r)^t) / Initial investment

Example

Initial outlay $100,000; inflows: $40,000, $45,000, $50,000; r = 10%.

• PV inflows = 36,364 + 37,190 + 37,565 = $111,119
• PI = 111,119 / 100,000 = 1.11

Since PI > 1, the project is acceptable at 10%.

Step-by-Step

1. List initial investment and future inflows by period.
2. Choose discount rate r.
3. Compute PV of inflows and divide by initial investment.
4. Interpret: PI > 1 accept; PI < 1 reject.

Considerations

• Useful for ranking projects when capital is rationed.
• NPV provides absolute value; PI provides relative efficiency.
• Assumptions (timing, r, cash flow certainty) affect results.

Related Metrics

• Net Present Value (NPV) — absolute value created, best for mutually exclusive choices.
• Internal Rate of Return (IRR) — percentage return accounting for timing.
• Return on Investment (ROI) — simple profitability ratio.