What is the 'Profitability Index'
The profitability index is an index that attempts to identify the relationship between the costs and benefits of a proposed project through the use of a ratio calculated as:
PV of future cash flows/Investment
A ratio of 1.0 is logically the lowest acceptable measure on the index, as any value lower than 1.0 would indicate that the project's PV is less than the initial investment. As values on the profitability index increase, so does the financial attractiveness of the proposed project.
BREAKING DOWN 'Profitability Index'
Profitability index is an appraisal technique applied to potential capital outlays. The technique divides the projected capital inflow by the projected capital outflow to determine the profitability of a project. The main feature of using profitability index is the technique disregards project size. Therefore, projects with larger cash inflows may result in lower profitability index calculations because their profit margin is not as high.
Present Value of Future Cash Flows (Numerator)
The present value of future cash flows requires the implementation of time value of money calculations. Cash flows are discounted the appropriate number of periods to equate future cash flows to current monetary levels. This discounting occurs because the value of $1 does not equate the value of $1 received in one year. Because the $1 received now may be invested and gain value, money received closer to the present is considered to have more value than money received further in the future.
Investment Required (Denominator)
The discounted projected cash outflows represent the initial capital outlay of a project. The initial investment required is only the cash flow required at the start of the project; all other outlays may occur at any point in the project's life, and these are factored into the calculation through the use of discounting in the numerator. These additional capital outlays may factor in benefits relating to taxation or depreciation.
Decision Process
Profitability index calculations cannot be negative and must be converted to a positive figure before they are useful. Calculations greater than one indicate the future anticipated discounted cash inflows of the project are greater than the anticipated discounted cash outflows. Calculations less than one indicate the deficit of the outflows is greater than the discounted inflows and the project should not be accepted. Calculations that equal one bring about situations of indifference where any gains or losses from a project are minimal.
When using the profitability index exclusively, calculations greater than one are ranked based on highest calculation. When limit capital is available and projects are mutually exclusive, the project with the highest profitability index is to be accepted as it indicates the project with the most productive use of limited capital. Profitability index is also called the benefitcost ratio for this reason. Although some projects result in a higher net present value, those projects may be passed over because they do not the highest profitability index and do not represent the most beneficial usage of company assets.

Initial Cash Flow
Initial cash flow is the amount of money paid out or received ... 
Present Value  PV
The current worth of a future sum of money or stream of cash ... 
Discounted Payback Period
A capital budgeting procedure used to determine the profitability ... 
Incremental Cash Flow
The additional operating cash flow that an organization receives ... 
Accounting Rate of Return  ARR
The amount of profit, or return, that an individual can expect ... 
Unconventional Cash Flow
An unconventional cash flow is a series of inward and outward ...

Financial Advisor
A Guide on the RiskAdjusted Discount Rate
When a project or investment faces higher amounts of risk or uncertainty, it may be appropriate to utilize the riskadjusted discount rate. 
Investing
An Introduction To Capital Budgeting
We look at three widely used valuation methods and figure out how companies justify spending. 
Small Business
Calculating Net Present Value at Different Points Using Excel
Calculating the net present value (NPV) of your investment projects using Excel. 
Personal Finance
10 Ways to Improve Cash Flow in Construction
Improving cash flow in construction requires some sectorspecific strategies. 
Investing
The Essentials Of Corporate Cash Flow
Tune out the accounting noise and see whether a company is generating the stuff it needs to sustain itself. 
Investing
Value Investing: Why Investors Care About Free Cash Flow Over EBITDA
Examine value investing philosophy and methodology to see why free cash flow is more important than EBITDA in pure intrinsic value calculation. 
Investing
Analyze Cash Flow The Easy Way
Find out how to analyze the way a company spends its money to determine whether there will be any money left for investors.

How do you use the profitability index rule when scoping out a project?
Understand the parameters of the profitability index rule and how this rule is used in corporate capital allocation to determine ... Read Answer >> 
How do you use discounted cash flow to calculate a capital budget?
Learn how discounted cash flows are used in creating capital budgets as a part of the net present value and internal rate ... Read Answer >> 
How much debt is too much when calculating capital budgeting?
Learn how companies determine how much debt is acceptable when funding a new project by using the net present value to estimate ... Read Answer >> 
How do you use net present value to calculate a capital budget?
Learn about the net present value calculation (NPV) and how the NPV rule is used in capital budgeting to compare the expected ... Read Answer >> 
How do you use DCF for real estate valuation?
Learn how discounted cash flow analysis is used for real estate valuation and the various factors that go into calculating ... Read Answer >> 
How do you use a financial calculator to determine present value?
Learn how to utilize a financial calculator to calculate present value. Understand the necessary data, why it is important ... Read Answer >>