Profitability Index - Investment Ranking Tool

The profitability index is also known as benefit/cost ratio. It is Present Value of Future Values (NPV) + the Initial Investment, divided by the Initial Investment. To put in mathematical terms, the formula is:

Profitability Index = (Net Present Value + Initial Investment) / Initial Investment

Just like using the Net Present Value (NPV) rule, if an investment has a Positive (+) Profitability Index (>1), then we should take up the project and invest in it. However if an investment has a Negative (-) Profitability Index (<1), we should NOT take up the project.

For example, suppose a project costs you $200 and the NPV of that project is $20. Therefore, Profitability Index would be: (20 + 200) / 200 = $1.10

- Since $1.10 is greater than 1, we should go ahead and perform the investment project.

Rules of Profitability Index

- If PI > 1, Good Investment
- If PI < 1, Bad Investment

How do you explain the results of Profitability Index? It measures the value created per dollar of an investment. Consider the question below:

Profitability Index Sample Question

Given the following cash flows for an investment, calculate the profitability index. The required rate of return is 8%

Year	Cash Flows
0	-$10,000
1	$1500
2	$2500
3	$4000
4	$3000
5	$3000
6	$3000

Here's a graphical representation of the Cash Flows

profitability index cash flows

Notes:

CFO = Initial Investment and is always entered as a negative (since the company is paying out the money). E.g an initial investment of $-10,000 means the company paid out that amount.

CO1 = Cash flow (in) for Year 1
CO2 = Cash flow (in) for Year 2
CO3 = Cash flow (in) for Year 3... etc

In your calculator, type in 2nd -> CF

CFO = -10,000
CO1 = 1500
FO1 = 1 (means cash flow for 1 year)
CO2 = 2500
FO2 = 1
CO3 = 4000
FO3 = 1
CO4 = 3000
FO4 = 3

CPT -> NPV

I = 8% (this is the company's required rate of return)

NPV -> CPT = $2845

Profitability Index = (Net Present Value + Initial Investment) / Initial Investment

(2845 + 10,000) / 10,000 = 1.285

Reasoning: For every $1 invested in this project, the total value created is $1.285. Therefore, we have a net profit of 1.285 - 1 = $0.285 per every dollar invested.

Relationship between Profitability Index & Net Present Value

You might have guessed already that there is a linear relationship between NPV and PI. Here it is:

- If Profitability Index > 1, NPV is Positive (+)
- If Profitability Index < 1, NPV is Negative (-)