Profitability Index Calculator
Evaluate investment projects and determine their viability using profitability index analysis
Calculate Profitability Index
The upfront cost required to start the project
The discounted value of all expected future cash flows
Example Calculation
Poultry Farm Expansion
Initial Investment: $500,000
Present Value of Future Cash Flows: $800,000
Project Duration: 5 years
Discount Rate: 10%
Calculation
PI = Present Value ÷ Initial Investment
PI = $800,000 ÷ $500,000
PI = 1.60
NPV = $800,000 - $500,000 = $300,000
Interpretation
PI = 1.60 > 1, indicating the project should be accepted. For every $1 invested, the project returns $1.60 in present value terms, creating $0.60 of value per dollar invested.
PI Decision Rules
PI > 1
Accept project - benefits exceed costs. Value is created.
PI = 1
Break-even - no gain or loss. Consider adjustments.
PI < 1
Reject project - costs exceed benefits. Value is destroyed.
PI Benefits
Provides comparable ratio for ranking projects
Shows value created per unit of investment
Considers time value of money
Ideal for capital rationing decisions
Accounts for project risk through discount rate
Understanding Profitability Index
What is Profitability Index?
The Profitability Index (PI) is a capital budgeting tool that measures the relationship between the costs and benefits of a proposed project. It calculates the value created per unit of investment, helping investors and companies make informed decisions about project viability.
Why Use Profitability Index?
- •Ranks projects when capital is limited
- •Shows efficiency of capital utilization
- •Considers time value of money
- •Helps in resource allocation decisions
PI Formula Components
PI = Present Value ÷ Initial Investment
- Present Value: Discounted future cash flows
- Initial Investment: Upfront capital required
- Discount Rate: Required rate of return
- NPV Relationship: PI = 1 + (NPV ÷ Initial Investment)
Key Insight: PI normalizes NPV by investment size, making it ideal for comparing projects of different scales and ranking investment opportunities.
PI vs NPV: When to Use Each
Use PI When:
- • Capital is limited (capital rationing)
- • Comparing projects of different sizes
- • Ranking multiple investment opportunities
- • Measuring efficiency of capital use
Use NPV When:
- • Measuring absolute value creation
- • Capital is unlimited
- • Evaluating mutually exclusive projects
- • Considering project scale matters
Limitations of PI
Project Size
Doesn't consider absolute project size. Small projects may have high PI but low absolute returns.
Mutually Exclusive
May not select the best alternative when projects are mutually exclusive.
Estimation Difficulty
Requires accurate estimation of future cash flows and discount rates.