The profitability index (PI) is the present value of a project’s future cash flows divided by the initial investment. It can be expressed as
You can see that the PI is closely related to the NPV. The PI is the ratio of the PV of future cash flows to the initial investment, while an NPV is the difference between the PV of future cash flows and the initial investment. Whenever the NPV is positive, the PI will be greater than 1.0, and conversely, whenever the NPV is negative, the PI will be less than 1.0. The investment decision rule for the PI is as follows:
Invest if PI > 1.0
Do not invest if PI < 1.0
Because the PV of future cash flows equals the initial investment plus the NPV, the PI can also be expressed as 1.0 plus the ratio of the NPV to the initial investment, as shown in Equation above. Attached Excel illustrates the PI calculation.
The PI indicates the value you are receiving in exchange for one unit of currency invested. Although the PI is used less frequently than the NPV and IRR, it is sometimes used as a guide in capital rationing, which we will discuss later. The PI is usually called the profitability index in corporations, but it is commonly referred to as a “benefit-cost ratio” in governmental and not-for-profit organizations.