PI and Net Present Value (NPV) are two financial tools that are widely used as a profit estimation metric for businesses. PI and NPV are said to be directly proportional where positive NPV leads to PI that is greater than, while a negative NPV means a PI lower than 1. Profitability index helps businesses assess their ability to make money and this is what makes it one of the most important metrics for estimating profits over a period efficiently.

• What if the 3 year project has an NPV of $1,000 and the 5 year project has an NPV of $1,100.
• Hence, it enables companies to choose projects that are best value for money.
• Download CFI’s Excel template to advance your finance knowledge and perform better financial analysis.
• A profitability index of 1.0 is the lowest acceptable measure on the index.
• To best understand how to calculate and rank investment projects using the profitability index equation, consider the following examples.

And lastly, similar story for Catcher; we expect to earn $0.02 for every $1 invested. Alternatively, you could calculate it as the ratio of PV to I, so that the PV (Present Value) is divided by the investment. Fundamentally, the Profitability Index shows us the amount of money we earn for every $1 / £1 invested. In the case of the two examples, since Project B has a slightly lower PI, then Project A is the most profitable project. Unfortunately, when two different investments have the same PI, this does not tell you which ties up more money initially. Often though, it isn’t always this simple to see that everything is equal except for the term.

What Are Other Methods To Rank Investment Opportunities?

The project PI is 1.19 which is greater than 1, and the project should be accepted and ranked against the PI of other projects. If for whatever reason, Garch Ltd can’t find anything else to invest in, and the risk-free rate is lower than say inflation, then they should probably go ahead and invest in Catcher. If you’re not comfortable with it, please go back to the article on NPV where we look at how to calculate NPV in much more detail.

Example Calculation

This metric calculates the difference between the current or today’s value of cash inflows and cash outflows over a specific time. It can be helpful to calculate the net present value prior to calculating the profitability index. But, the profitability index can get calculated using the following profitability index formula(s). It doesn’t matter the type of business that you operate or the industry that you are in.

A less than 1 PI ratio means that the project’s present value would not recover its initial investment or cost. Theoretically, it reveals unprofitability of a proposed investment and suggests rejection of the same. In general terms, the higher the PI metric, the more attractive a proposed investment is. The new factory project is expected to cost $2 million and generate cash flows of $300,000 per year for the next 5 years, also with a discount rate of 10%. While the net present value gives us the absolute value that a project adds, it is wrong to compare the net present values of different investments directly. Let’s say there are two projects, A and B, each with initial investment outlay of $10 million and net present values of $2 million and $2.2 million respectively.

It represents the relationship that exists between the costs and the benefits of a potential project. The profitability index is the ratio between the initial amount invested in a project and the present value of future cash flows. The Profitability Index (PI) or profit investment ratio (PIR) is a widely used measure for evaluating viability and profitability of an investment project. It is calculated by dividing the present value of future cash flows by the initial amount invested.

For simplicity, with no further investment, the amount of 6,000 is returned in 3 years time at the end of year 3. The profitability index (PI) is used to assess how much profit may come from a particular investment. Although not that common among finance professionals, as opposed to NPV and IRR, it is still considered economically sound. Governments and NGOs normally use this index when performing capital analysis. A positive NPV indicates that the investment will generate value, while a negative NPV suggests the investment may not meet the required rate of return on investment. While the PI is an efficient method, there are other equally efficient valuation metrics for stocks that you can use to rank investment projects.

N Enterprise has decided to invest in a project for which the initial investment would be $100 million. As they are considering whether it’s a good deal to invest in, they have found out that the present value of the future cash flow of this project is 130 million. Firms follow the profitability index rule to obtain ratios that depict returns with respect to each investment dollars. Hence, it enables companies to choose projects that are best value for money. A ratio of 1 indicates that the present value of the underlying investment just equals its initial cash out outlay and is considered the lowest acceptable number for a proposal.

Profitability Index vs NPV: Key Differences

Remember, a PI greater than 1 is not just a number—it’s a signal that an investment could lead to prosperity and success. Businesses across various industries use the Profitability Index to guide their investment decisions. For instance, a real estate development firm might use PI to decide between several potential property developments.

Like we said at the start of this article, it’s helpful to know how to calculate the NPV, and we’re going to assume that you’re fairly comfortable with that. The projects are divisible, meaning Garch Ltd can invest in parts of a project instead of having to invest fully in a given project. Put differently, you earn a 10th (1/10) of what Project A is offering you on a per pound invested basis.

• The profitability index can also get referred to as a profit investment ratio (PIR) or a value investment ratio (VIR).
• The best thing about this index is that it allows businesses to compare between different projects whenever they require choosing one out of the other.
• But the profitability index indicates otherwise and says that project 2 with its higher PI value is a better opportunity than project 1.
• Discounted cash flows may unexpectedly differ in the future, which immediately makes us question the predictive accuracy of both PI and NPV figures as stand-alone metrics.
• PI is a ratio of the advantage of a project to its expense, thus helpful in prioritizing projects.

Hence, it is also known as the profit investment ratio (PIR), value investment ratio (VIR), or benefit-cost ratio (BCR). Where “PV of future cash flows” is the present value of cash flows, starting from period 1 until the end of the project, and NPV denotes the Net Present Value. Note that PI results are based on estimates rather than precise numbers taken from a firm’s major financial statements.

Sales & Investments Calculators

Keep in mind that if the profitability index is less than 1, this does not necessarily mean that the cash flows will add up to less than the initial outflow. It may only mean that the rate of return is less than the discount rate used when calculating the present value of the cash flows. formula for profitability index When the future cash flows of five years from the poultry sales are discounted at a rate of 10%, the total sum of the present value (PV) is $800,000.

This is the present value of the future cash flow that you’re earning, for every pound you’ve invested. As mentioned above, having a profitability index higher than 1 is ideal. You will then have to make a decision on what’s going to be best for your business moving forward.

And between NPV and the Profitability Index, you’re probably better off applying the rule or investment appraisal criteria using profitability index rather than NPV. In other words, in this particular example, the interpretations/results from the PI are consistent with the results from the NPV capital budgeting tool. Investing in Archer will allow Garch Ltd to earn $80,000 in annual cash flow for the next 5 years. The projects require investments of $300,000; $200,000; and $600,000 for Archer, Brochure, and Catcher respectively. We’d say that for every £1 pound that you invest in A, you earn £1.50 in cash flow, in present value terms.

Examining and ranking multiple ventures, however, require you to treat the results with caution. That’s because the PI result simply ignores the projects’ scale and the absolute added shareholder value. Consider a project that costs $10 and has a $20 present value (Investment 1), and another one (Investment 2) that costs $1,000 with a $1,500 present value. Furthermore, you learned that there are 2 ways to calculate the PI, including one where we take the ratio of NPV to I, and another, where we take it as the ratio of PV to I. And depending on the risk-free rate (typically the yield on U.S. Government Bonds), Garch Ltd should either deposit the remaining $50,000 and earn the risk-free rate. If we think about Brochure, for instance, the 18 cents means that for every $1 we invest in brochure, we expect to earn 18 cents.

The cost of funding the project is $10 million, and the amount of cash flows generated in Year 1 is $2 million, which will grow by a growth rate of 25% each year. In the case of limited funds, we should rank projects according to profitability index (PI) ratios and not on the basis of their net present values (NPVs). Since project 2 and 3 both have higher PI values than project 1, they should be ranked ahead of project 1 while rationing the available capital. The factory expansion project has a higher profitability index and a more attractive investment. The company might decide to pursue this project instead of the new factory project because it is expected to generate more value per unit of investment. The discount rate (value the business places on its money) is very important in the calculation.

What Are the Advantages of the PI?

This article describes how to determine the profitability index, its formula, and why it differs from net present value (NPV). We will also provide examples to give you an understanding of the concept. At the end of this guide, you will learn how to calculate the profit index and how it is used in financial decision-making.