Profitability Index Calculator
Calculate the profitability index (PI) to evaluate and rank investment opportunities. This calculator helps businesses make informed capital budgeting decisions by measuring the relationship between present value of future cash flows and initial investment.
Investment Details
Expected Cash Flows
Profitability Results
Profitability Index:
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Investment Decision:
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Ranking Priority:
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Financial Analysis
NPV:
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PV of Cash Flows:
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Return per Dollar:
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Risk Assessment
Profitability Margin:
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Investment Risk:
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Recommendation:
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Understanding Profitability Index
The Profitability Index (PI), also known as the Value Investment Ratio or Profit Investment Ratio, is a capital budgeting technique used to evaluate the attractiveness of an investment or project. It measures the relationship between the present value of future cash flows and the initial investment required.
What is Profitability Index?
Definition
- Ratio of present value of future cash flows to initial investment
- Measures value created per dollar invested
- Used for ranking and selecting investment projects
- Complements NPV in capital budgeting decisions
Formula
- PI = PV of Future Cash Flows ÷ Initial Investment
- PV = Present Value of cash flows
- Accept if PI > 1
- Rank by PI when capital is limited
Decision Rules
Investment Criteria
When to accept or reject projects
Accept (PI > 1):
- Project creates value
- PV of benefits > PV of costs
- Expected return > required return
- Positive NPV project
Reject (PI < 1):
- Project destroys value
- PV of benefits < PV of costs
- Expected return < required return
- Negative NPV project
Indifferent (PI = 1):
- Break-even project
- PV of benefits = PV of costs
- Expected return = required return
- Zero NPV project
Ranking (Multiple Projects):
- Higher PI = Better project
- Rank from highest to lowest PI
- Select until budget exhausted
- Maximizes total NPV
Advantages of Profitability Index
Relative Measure:
- Shows efficiency per dollar invested
- Easy comparison of different-sized projects
- Useful for capital rationing
- Scales with project size
Time Value of Money:
- Incorporates discount rate
- Accounts for risk and opportunity cost
- Future cash flows properly valued
- More accurate than simple ROI
PI vs Other Methods
| Method | Formula | Decision Rule | Best For |
|---|---|---|---|
| NPV | NPV = PV Benefits - PV Costs | Accept if NPV > 0 | Absolute profitability |
| PI | PI = PV Benefits ÷ Initial Investment | Accept if PI > 1 | Relative efficiency |
| IRR | Find r where NPV = 0 | Accept if IRR > Required Return | Rate of return |
| Payback Period | Time to recover investment | Accept if < Target Period | Liquidity assessment |
Applications in Capital Budgeting
Capital Rationing:
- Limited investment budget
- Rank projects by PI
- Select highest PI first
- Maximizes value creation
Project Selection:
- Mutually exclusive projects
- Compare PI values
- Choose highest PI
- Considers scale differences
Limitations of PI
Assumption Dependent:
- Cash flow estimates
- Discount rate selection
- Timing of cash flows
- Terminal value assumptions
Practical Issues:
- Mutually exclusive projects
- Project interdependencies
- Capital budgeting complexity
- Real option value
Industry Applications
Manufacturing:
- Equipment purchases
- Factory expansions
- Process improvements
- Capacity investments
Technology:
- Software development
- R&D projects
- Infrastructure upgrades
- Product development
PI and Risk Assessment
Risk-Adjusted PI:
- Higher discount rates for risky projects
- Risk-adjusted cash flows
- Certainty equivalents
- Scenario analysis
Sensitivity Analysis:
- Test different assumptions
- Identify key risk factors
- Probability-weighted scenarios
- Break-even analysis
Key Takeaways for Profitability Index
- Profitability Index measures the value created per dollar invested in a project
- PI greater than 1 indicates a profitable investment opportunity
- PI is useful for ranking projects when capital is limited
- The index accounts for the time value of money through discounting
- PI complements NPV analysis in capital budgeting decisions
- Higher PI values indicate more efficient use of capital
- PI is particularly useful for comparing projects of different sizes
- The method assumes accurate cash flow estimates and discount rate selection