A profitability index attempts to identify the relationship between the costs and benefits of a proposed project. The profitability index is calculated by dividing the present value of the project's future cash flows by the initial investment. A PI greater than 1.0 indicates that profitability is positive, while a PI of less than 1.0 indicates that the project will lose money. As values on the profitability index increase, so does the financial attractiveness of the proposed project.
The PI ratio is calculated as follows:
PV of Future Cash Flows
A ratio of 1.0 is logically the lowest acceptable measure for the index. Any value lower than 1.0 would indicate that the project's PV is less than the initial investment, and the project should be rejected or abandoned. The profitability index rule states that the ratio must be greater than 1.0 for the project to proceed.
For example, a project with an initial investment of $1 million and present value of future cash flows of $1.2 million would have a profitability index of 1.2. Based on the profitability index rule, the project would proceed. Essentially, the PI tells us how much value we receive per dollar invested. In this example, each dollar invested yields $1.20.
The profitability index rule is a variation of the net present value (NPV) rule. In general, if NPV is positive, the profitability index would be greater than 1; if NPV is negative, the profitability index would be below 1. Thus, calculations of PI and NPV would both lead to the same decision regarding whether to proceed with or abandon a project.
However, the profitability index differs from NPV in one important respect: being a ratio, it ignores the scale of investment and provides no indication of the size of the actual cash flows.
The PI can also be thought of as turning a project's NPV into a percentage rate.
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