What is the profitability index (PI)?
The profitability index (PI), also called investment value ratio (VIR) or profit investment ratio (PIR), describes an index that represents the relationship between the costs and benefits of a proposed project, using the following ratio:
The PI is useful for classifying various projects because it allows investors to quantify the value created for each investment unit. A profitability index of 1.0 is logically the lowest acceptable measure of the index, since any value lower than this number would indicate that the current value (PV) of the project is lower than the initial investment. As the value of the profitability index increases, so does the financial attractiveness of the proposed project.
Understanding the profitability index
The profitability index is a valuation technique applied to potential investment expenses. The method divides the projected capital inflows by the projected capital outflows to determine the profitability of a project. As indicated in the above formula, the profitability index uses the present value of future cash flows and the initial investment to represent the above variables.
When using the profitability index to compare the advisability of projects, it is essential to consider how the technique does not take into account the size of the project. Therefore, projects with larger cash inflows can result in lower profitability index calculations because their profit margins are not as high.
Components of the profitability index
PV 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 by the appropriate number of periods to equalize future cash flows to current monetary levels. The update explains the idea that the value of $ 1 today is not equal to the value of $ 1 received in one year, because current money offers more earning potential via savings accounts carrying interest that money still unavailable. Cash flows received later in the future are therefore considered to have a lower present value than the money received closer to the present.
Investment required (denominator): The discounted projected cash outflows represent the initial capital expenditures of a project. The initial investment required is only the cash flow required at the start of the project. All other expenses can occur at any time during the life of the project, and these are taken into account in the calculation using discounting in the numerator. These additional capital expenditures may take into account tax and amortization benefits.
Calculation and interpretation of the profitability index
Since profitability index calculations cannot be negative, they must therefore be converted into positive figures before being deemed useful. Calculations greater than 1.0 indicate that the expected future discounted cash inflows from the project are greater than the expected discounted cash outflows. Calculations below 1.0 indicate that the output deficit is greater than the discounted inputs and the project should not be accepted. Calculations equal to 1.0 cause situations of indifference where the gains or losses of a project are minimal.
When using the profitability index exclusively, calculations greater than 1.0 are ranked according to the higher calculation. When limited capital is available and projects are mutually exclusive, the project with the highest profitability index should be accepted as it indicates the project with the most productive use of limited capital. The profitability index is also called the benefit-cost ratio for this reason. Although some projects result in higher net present values, these projects can be ignored as they do not have the highest profitability index and do not represent the most advantageous use of business assets.