Complete Guide To Corporate Finance


Net Present Value And Internal Rate Of Return - Profitability Index

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
Initial Investment

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.

(Find some profitable ideas in 8 Ways To Make Money With Real Estate and Outside The Box Ways To Get Money.)

Capital Budgeting
Related Articles
  1. Professionals

    Career Advice: Accountant Vs. Financial Planner

    Identify the key differences between a career in accounting and financial planning, and learn how your personality dictates which is the better choice for you.
  2. Investing Basics

    What Does In Specie Mean?

    In specie describes the distribution of an asset in its physical form instead of cash.
  3. Economics

    Calculating Days Working Capital

    A company’s days working capital ratio shows how many days it takes to convert working capital into revenue.
  4. Economics

    Calculating Cross Elasticity of Demand

    Cross elasticity of demand measures the quantity demanded of one good in response to a change in price of another.
  5. Fundamental Analysis

    Emerging Markets: Analyzing Colombia's GDP

    With a backdrop of armed rebels and drug cartels, the journey for the Colombian economy has been anything but easy.
  6. Professionals

    Career Advice: Accountant Vs. Controller

    Learn about the differences between controllers and accountants, how the two are related and which is the best career choice for aspiring bookkeepers.
  7. Professionals

    What is Cash Basis Accounting?

    Cash basis accounting recognizes revenues and expenses at the time cash is paid or received.
  8. Entrepreneurship

    What's a Good Profit Margin for a Mature Business?

    How to determine if the amount you clear dovetails with the competition.
  9. Fundamental Analysis

    Emerging Markets: Analyzing Chile's GDP

    Chile has become one of the great economic success stories of Latin America.
  10. Investing

    Watch Your Duration When Rates Rise

    While recent market volatility is leading investors to look for the nearest exit, here are some suggestions for bond exposure in attractive sectors.
  1. Put-Call Parity

    A principle that defines the relationship between the price of ...
  2. Encumbrance

    A claim against a property by a party that is not the owner. ...
  3. Alpha

    Alpha is used in finance to represent two things: 1. a measure ...
  4. Capitalization Rate

    The rate of return on a real estate investment property based ...
  5. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and ...
  6. Linear Relationship

    A statistical term used to describe the directly proportional ...
  1. What should I study in school to prepare for a career in corporate finance?

    Depending on which area you want to specialize in, corporate finance can be one of the most competitive fields in business. ... Read Full Answer >>
  2. Why would a company issue preference shares instead of common shares?

    Preference shares, or preferred stock, act as a hybrid between common shares and bond issues. As with any produced good or ... Read Full Answer >>
  3. What is the difference between cost of debt capital and cost of equity?

    In corporate finance, capital – the money a business uses to fund operations – comes from two sources: debt and equity. While ... Read Full Answer >>
  4. What is the difference between gross profit, operating profit and net income?

    The terms profit and income are often used interchangeably in day-to-day life. In corporate finance, however, these terms ... Read Full Answer >>
  5. Does working capital include salaries?

    A company accrues unpaid salaries on its balance sheet as part of accounts payable, which is a current liability account, ... Read Full Answer >>
  6. Student loans, federal and private: what's the difference?

    The cost of a college education now rivals many home prices, making student loans a huge debt that many young people face ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  2. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  3. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  4. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  5. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  6. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!