What is Profitability Index?
The Profitability Index (PI) is the ratio between the present value of cash inflows and the present value of cash outflows.
Table of Contents
- How to Calculate Profitability Index (Step-by-Step)
- Profitability Index Formula
- How to Interpret Profitability Index (PI)
- Profitability Index vs. Net Present Value (NPV)
- Profitability Index Calculator – Excel Model Template
- Step 1. Project Assumptions
- Step 2. NPV Calculation
- Step 3. Profitability Index Calculation Analysis
How to Calculate Profitability Index (Step-by-Step)
The profitability index ratio measures the monetary benefits (i.e. cash inflows) received for each dollar invested (i.e. cash outflow), with the cash flows discounted back to the present date.
More specifically, the PI ratio compares the present value (PV) of future cash flows received from a project to the initial cash outflow (investment) to fund the project.
Profitability Index Formula
The formula for calculating the profitability index is as follows.
Another variation of the PI formula adds the initial investment to the net present value (NPV), which is then divided by the initial investment.
How to Interpret Profitability Index (PI)
In corporate finance, the primary use case for the PI ratio is for ranking projects and capital investments.
The higher the PI ratio, the more attractive the proposed project is and the more likely it will be pursued.
For some general guidelines on interpreting the PI ratio:
- PI =1: Neutral/Acceptable
- PI >1: Approve Project
- PI <1: Reject Project
Profitability Index vs. Net Present Value (NPV)
The profitability index (PI) and net present value (NPV) are two closely related metrics.
- If PI Ratio is >1, then NPV will be positive
- If PI Ratio is <1, then NPV will be negative
The major distinction between the two is that the profitability index depicts a “relative” measure of value whereas the net present value (NPV) represents an “absolute” measure of value.
With that said, for purposes of presenting a project or capital investment’s benefits on a per-dollar basis of the initial investment, the profitability index is more practical since it is standardized.
The PI metric can thereby be used for comparisons among different projects. By contrast, comparisons of NPV between projects are not always functional (i.e. non-standardized metric).
Profitability Index Calculator – Excel Model Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Step 1. Project Assumptions
Suppose we’re evaluating a proposed five-year project with the following assumptions.
- Discount Rate: 10%
- Project CF Growth Rate: 25%
- Initial Investment: –$10,000,000
- Project Cash Flows (Year 1): $2,000,000
The cost of funding the project is $10 million, and the amount of cash flows generated in Year 1 is $2 million, which will grow by a growth rate of 25% each year.
Step 2. NPV Calculation
We can now calculate the net present value (NPV) of the project using the NPV function in Excel:
- NPV: “=NPV (10% Discount Rate, Range of Net Cash Inflows/Outflows)”
- NPV = $1,756,382
In the subsequent step, we can now calculate the project’s PI given the NPV from the prior step.
Step 3. Profitability Index Calculation Analysis
The PI formula will consist of two parts:
- In the numerator, we’ll take the NPV and add back the initial investment.
- In the denominator, we’ll link to the initial investment cell with a negative sign in front (so both the numerator and denominator are positive figures).
Therefore, the formula divides the present value (PV) of the project’s future cash flows by the initial investment.
- Profitability Index = ($1,756,382 + $10,000,000) / ($10,000,000) = 1.2
In conclusion, the profitability index of our five-year project is 1.2, so the project seems likely to be accepted unless there are other projects with higher NPVs and profitability indices that are also under consideration.