What is the Profitability Index (PI)?
The Profitability Index (PI), also known as the Value Investment Ratio (VIR) or Profit Investment Ratio (PIR), is a financial metric that gauges the relationship between the costs and benefits of a prospective project. It is calculated as the ratio of the present value of future expected cash flows to the initial investment in the project. A higher PI indicates a more attractive project or investment.
Key Takeaways
- The PI measures the attractiveness of an investment.
- It’s calculated by dividing the present value of future cash flows by the initial investment.
- A PI greater than 1.0 signifies a good investment.
- In conditions of limited capital, only projects with the highest PIs should be considered.
Understanding the Profitability Index (PI)
The profitability index helps to rank various projects by quantifying the value generated per unit of investment. A PI of 1.0 is the lowest acceptable measure, as any number below that indicates the project’s present value is less than the initial investment. Higher PI values correspond to more financially attractive projects.
When comparing projects, consider that larger cash inflows might lower PI calculations due to potentially smaller profit margins.
What Is PI for an Investment?
The PI measures the costs and benefits of a proposed project. It is essentially the present value of the expected cash flows divided by the initial cost of the investment.
Formula for the Profitability Index
The PI is computed using the following ratio:
PV of Future Cash Flows (Numerator)
Discounting future cash flows to the present value involves applying the time value of money principles. A dollar today is worth more than a dollar in the future, because of its potential earnings. Therefore, cash received in the future is less valuable than cash in hand.
Investment Required (Denominator)
The denominator represents the initial investment or the immediate cash outlay required. Other future costs are factored through discounting in the numerator, considering taxation and depreciation benefits.
Interpreting the Profitability Index
The PI is always a positive figure and evaluated as follows:
- PI > 1.0: Future discounted cash inflows exceed outflows, indicating a good investment.
- PI < 1.0: Outflows exceed inflows, the project should be rejected.
- PI = 1.0: Gains and losses are minimal, indicating indifference.
The highest PI value is preferred when capital is limited, as it signifies the most productive use of resources.
Example of the Profitability Index
Consider a company debating between building a new factory or expanding an existing one:
- Expansion Project: Costs $1 million, generates cash flows of $200,000/year for 5 years at a 10% discount rate. The present value (PV) is $750,319, making the PI = 0.75
- New Factory: Costs $2 million, $300,000/year cash flows for 5 years at 10% discount rate. PV is $1,125,479, making the PI = 0.56.
With both PIs being less than 1.0, it might be advisable to seek alternative, more profitable opportunities.
Advantages and Disadvantages of the Profitability Index
Here are some pros and cons of using the PI:
Advantages
- Considers the Time Value of Money: Reflects true potential earnings.
- Cross-Project Comparison: Useful for varied project lifespans.
- Capital Constraint Decision-Making: Maximizes resource utility.
Disadvantages
- Ignores Ongoing Investments: Future costs not factored in.
- Project Size Not Considered: Larger projects might show lower PIs.
- Forecast Reliant: Inaccurate estimates could mislead.
Profitability Index Pros and Cons
Pros
- Considers time value of money
- Compatible with projects of different durations
Cons
- Ignores future costs and project size
- Dependent on accurate forecasts
How Is the Profitability Index Computed?
PI is calculated by dividing the present value of future cash flows by the initial investment, using time value of money principles to discount these future flows.
What Is the Profitability Index Used For?
Companies use PI for comparison and evaluation of several investment opportunities, particularly under capital constraints to rank projects.
What Is a Good Profitability Index?
Higher PI values reflect better investments, with PIs above 1.0 typically considered favorable. Projects with the highest PIs are most ideal.
Alternate Names for PI
The PI is also known as the Profit Investment Ratio (PIR), Value Investment Ratio (VIR), or the benefit-cost ratio.
The Bottom Line
The Profitability Index (PI) is a vital measure for assessing project attractiveness by comparing the present value of future cash flows against the initial investment. While a PI above 1.0 is desirable, high PI values mark the optimum use of limited capital. However, the technique doesn’t consider project size and assumes precise future cash flow forecasts.
Related Terms: Present Value, Net Present Value, Capital Budgeting, Time Value of Money.
References
- GoodCalculators.com. “Profitability Index”.
