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Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment. Under capital rationing, PI method is suitable because PI method indicates relative figure i.e. ratio instead of absolute figure. The ratio is calculated as follows: *\text = \frac = 1 + \frac Assuming that the
cash flow A cash flow is a real or virtual movement of money Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic contex ...
calculated does not include the investment made in the project, a profitability index of 1 indicates break-even. Any value lower than one would indicate that the project's present value ( PV) is less than the initial investment. As the value of the profitability index increases, so does the financial attractiveness of the proposed project. The PI is similar to the Return on Investment (ROI), except that the net profit is
discounted Discounting is a financial mechanism in which a debtor A debtor or debitor is a legal entity (legal person) that owes a debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another p ...
.


Example

We assume an investment opportunity with the following characteristics: *Investment = $40,000 *Life of the Machine = 5 Years CFAT Year CFAT 1 18000 2 12000 3 10000 4 9000 5 6000 Calculate
Net present value The net present value (NPV) or net present worth (NPW) applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the discount ra ...
at 6% and PI: Year CFAT PV@10% PV 1 18000 0.909 16362 2 12000 0.827 9924 3 10000 0.752 7520 4 9000 0.683 6147 5 6000 0.621 3726 Total present value 43679 (-) Investment 40000 NPV 3679 PI = 43679/40000 = 1.092 > 1 ⇒ Accept the project


See also

*
Net present value The net present value (NPV) or net present worth (NPW) applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the discount ra ...


References

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External links

Use explained in the business book: Pursuing the Competitive Edge, Hayes, Pisano, Upton and Wheelwright. Wiley, 2005. pg. 264 Profit Capital budgeting {{economics-stub