Profitability index PI explanation, formula, example, application

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 NPV @ 14% in last column of the above table has been obtained by subtracting the initial investment at C0 date from the present value @ 14% discount rate. The numerator is the present value of cash flow that occurs after the initial funds have been invested into the project. The denominator consists of the total funds the firm initially needs to undertake the opportunity.

The ranking can help project financiers to decide which project to implement and which to discard. In this case, the profitability index is measured before implementing a project. Capital Com Online Investments Ltd is a limited liability company with company number B. Capital Com Online Investments Ltd is a Company registered in the Commonwealth of The Bahamas and authorised by the Securities Commission of The Bahamas with license number SIA-F245. The Company’s registered office is at Bahamas Financial Centre, 3rd Floor, Shirley and Charlotte Street, P.O. Box N-4865, Nassau, Bahamas. CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage.

Investment

Calculating the profitability index is important before making any investment decisions. If two investments have the same initial investment cost, the profitability index helps decide which one to finance first. To make this work easier, Excel offers to calculate the profitability index accurately. In this article, I will show you how to calculate the profitability index in Excel and also give you an overview of it. The profitability index is considered somewhat limited, in that it would instruct us to accept all investments above 1.

• Financial indicators like gross profit margin, net profit margin, return on investment, profitability index, return on equity, etc. are great tools to measure financial performance.
• The initial investment is the investment or total cash outflow incurred by the company to start the project or company.
• It is sometimes known as value investment ratio (VIR) or profit investment ratio (PIR).

It helps companies and investors measure the expected return for each dollar invested into a project or venture. Other names used for profitability index are the value investment ratio (VIR) and the profit investment ratio (PIR). The profitability index is calculated by dividing the present value of future cash flows by the initial cost (or initial investment) of the project. The initial costs include the cash flow required to get the team and project off the ground.

Logistics Calculators

The denominator in the generalized formula contains the present value of all cash outflows instead of only the initial investment. The initial investment is the investment or total cash outflow incurred by the company to start the project or company. The initial investment includes the company’s expenditure, working capital, and other expenses to start the project. Calculating profitability index manually is very tedious and time consuming, as you have to discount multiple future cash flows.

A profitability index greater than 1.0 is often considered to be a good investment, as it means that the expected return is higher than the initial investment. When making comparisons, the project with the highest PI may be the best option. In this example, the factory expansion project has a higher profitability index, meaning it is 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.

Step 1. Project Assumptions

However the profitability index makes it easier to compare properties that have a different purchase price. This is because the profitability index is a ratio, showing us each investments proportion for the dollar that is returned vs. the dollar invested initially. We can also make the profitability index formula more general so that it applies to more than one cash outflow.

Generally, you should prefer the project with the highest PI and the highest IRR, as it means that it creates the most value per unit of capital invested and offers the highest return on investment. However, if you have a limited budget or a capacity constraint, you may have to choose among mutually exclusive projects, which means that you can only accept one of them. In such cases, you should use the incremental PI and the incremental IRR, which measure the additional value and return of one project over another.

What is the Profitability Index?

The profitability index (PI) is a measure of the attractiveness of a project or investment. It is calculated by dividing the present value of future expected cash flows by the initial investment amount in the project. A PI greater than 1.0 is considered to be a good investment, with higher values corresponding to more attractive projects.

Sensitivity analysis is a technique used to test the sensitivity of a project’s profitability to changes in key assumptions. To conduct sensitivity analysis for the profitability, change the discount rate and observe the effect on the profitability formula. The profitability index profitability index formula rule is a decision-making exercise that helps evaluate whether to proceed with a project. The index itself is a calculation of the potential profit of the proposed project. The rule is that a profitability index or ratio greater than 1 indicates that the project should proceed.

Capital Budgeting

If the profitability index is greater than 1, the project is accepted, and if it is less than 1, the project is rejected. My academic and professional aspects have led me to revere Microsoft Excel. So, I am here to create a community that respects and loves Microsoft Excel. The community will be fun, helpful, and respectful and will nurture individuals into great excel enthusiasts. If the PI is more than 1 the project should be accepted, if the PI is less than 1 the project shouldn’t be accepted as it will give a negative return.

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. The major distinction between the two is that the profitability index depicts a “relative” measure of value whereas the net present value (NPV) represents an “absolute” measure of value. If you don’t fancy calculating the present value manually, you can use the present value calculator here.