What Is the Profitability Index (PI) Rule?
The profitability index rule is a decision-making exercise that helps evaluate whether to proceed with a project. The index itself is a calculation of the potential profit of the proposed project. The rule is that a profitability index or ratio greater than 1 indicates that the project should proceed. A profitability index or ratio below 1 indicates that the project should be abandoned.
- The formula for PI is the present value of future cash flows divided by the initial cost of the project.
- The PI rule is that a result above 1 indicates a go, while a result under 1 is a loser.
- The PI rule is a variation of the NPV rule.
Understanding the Profitability Index Rule
The profitability index is calculated by dividing the present value of future cash flows that will be generated by the project by the initial cost of the project. A profitability index of 1 indicates that the project will break even. If it is less than 1, the costs outweigh the benefits. If it is above 1, the venture should be profitable.
For example, if a project costs $1,000 and will return $1,200, it's a "go."
PI vs. NPV
The profitability index rule is a variation of the net present value (NPV) rule. In general, a positive NPV will correspond with a profitability index that is greater than one. A negative NPV will correspond with a profitability index that is below one.
For example, a project that costs $1 million and has a present value of future cash flows of $1.2 million has a PI of 1.2.
PI differs from NPV in one important respect: Since it is a ratio, it provides no indication of the size of the actual cash flow.
For example, a project with an initial investment of $1 million and a 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, even though the initial capital expenditure required are not identified.
PI vs. IRR
Internal rate of return (IRR) is also used to determine if a new project or initiative should be undertaken. Broken down further, the net present value discounts after-tax cash flows of a potential project by the weighted average cost of capital (WACC).
To calculate NPV:
- First identify all cash inflows and cash outflows.
- Next, determine an appropriate discount rate (r).
- Use the discount rate to find the present value of all cash inflows and outflows.
- Take the sum of all present values.
The NPV method reveals exactly how profitable a project will be in comparison to alternatives. When a project has a positive net present value, it should be accepted. If negative, it should be rejected. When weighing several positive NPV options, the ones with the higher discounted values should be accepted.
In contrast, the IRR rule states that if the internal rate of return on a project is greater than the minimum required rate of return or the cost of capital, then the project or investment should proceed. If the IRR is lower than the cost of capital, the project should be killed.