The problem is that this doesn’t factor in the magnitude of the investment requirement. Consider that we tell you there are two projects, which we’ll conveniently call Project A and Project B. In the subsequent step, we can now calculate the project’s PI given the NPV from the prior step. Suppose we’re evaluating a proposed five-year project with the following assumptions. By contrast, comparisons of NPV between projects are not always functional (i.e. non-standardized metric).

You learned that the Profitability Index formula overcomes the magnitude problem of the Net Present Value (NPV) by showing us how much we are in for every $1 invested (or £1 invested). In other words, in this particular example, the interpretations/results from the PI are consistent https://www.wave-accounting.net/ 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. Alternatively, you could calculate it as the ratio of PV to I, so that the PV (Present Value) is divided by the investment.

If the profitability index is greater than or equal to 1, it is termed a good and acceptable investment. The profitability index (PI) offers a way to measure the balance between an initial investment and its present value of future cash flows. It’s a simple ratio that indicates whether or not an investment project is likely to be profitable by showing the value created per investment quickbooks online accountant free unit. A general rule of thumb is that a PI greater than one indicates the project should go forward, while a PI below one indicates it will not be worth the investment. Ideally the PI ratio of more than 1 is expected from the project, which means the value of future cash flows will be greater than the initial investments and it reflects the profitability of a proposed project.

Secondly, as a relative metric, it becomes beneficial in contrasting projects of varying magnitudes. 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. Because the NPV / I approach shows us exactly how much money we make for every pound we invest. Well, it just means that for every £1 pound you invest in Project A, you earn 50p. This shows you how much money you make for every one dollar or one pound you invest.

- In general, a positive NPV will correspond with a profitability index that is greater than one.
- A PI greater than 1.0 is considered to be a good investment, with higher values corresponding to more attractive projects.
- However, since both PIs are less than 1.0, the company may end up forgoing either project in favor of a better opportunity elsewhere.
- Thus, the initial investment is the amount you have invested in the business for the profitability of the business.

A PI exceeding 1 signifies that the present value of future cash inflows overruns the initial investment, suggesting that the project may be a lucrative venture. Running a profitable business demands a lot of investments and assessing them for profitability is essential. The profitability index (PI), also known as profit investment ratio (PIR) is a method to describe the relationship between cost and benefits of a project. In contrast, the IRR rule states that if the internal rate of return on a project is greater than the minimum required rate of return or the cost of capital, then the project or investment should proceed. More specifically, the PI ratio compares the present value (PV) of future cash flows received from a project to the initial cash outflow (investment) to fund the project. The profitability index is helpful in ranking various projects because it lets investors quantify the value created per each investment unit.

## Core Benefit of the Profitability Index

If I now told you that the investment required for Project A is £20,000 and the investment requirement for Project B is £2,000,000, you’re probably not thinking about choosing Project B anymore. Fundamentally, the Profitability Index shows us the amount of money we earn for every $1 / £1 invested. The PI ratio uses the time value of money, which means that if you receive a payment today, you can reinvest it today, and start making profits immediately, rather than receiving the same amount on a later date.

## Example of the Profitability Index

Prior to accepting a position as the Director of Operations Strategy at DJO Global, Manu was a management consultant with McKinsey & Company in Houston. He served clients, including presenting directly to C-level executives, in digital, strategy, M&A, and operations projects. If any part of the profitability index formula isn’t quite clear, please re-read this article.

## Advantages of profitability index

The basis of comparing projects with only the Net Present Value does not take into account what is the initial investment. Profitability Index compares the Net Present Value reached with the initial investment and shows the most accurate representation of the usage of company assets. The profitability index is calculated by dividing the present value of future cash flows that will be generated by the project by the initial cost of the project. 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.

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. Thus, the initial investment is the amount you have invested in the business for the profitability of the business. The main difference between NPV and profitability index is that the PI is represented as a ratio, so it won’t indicate the cash flow size. A profitability index number might be 1.5, but you wouldn’t necessarily know the capital expenditure required. The PI is most effective when a project’s cash flow pattern is conventional, meaning that a series of inflows follow an initial outlay.

In short, the profitability index (PI) measures the attractiveness of a potential project or investment to guide decision-making. Profitability Index helps us to know whether to invest in the business or not, thus acting as a worthy tool for finance. So, you can consider calculating PI for taking some decisions related to finance for your company. As, the higher the PI denotes the favorable the business option is, or the positive the Pi the higher it is to be considered. The main usage of this tool is to rank down the investment projects as well as to show the value which is formed for each unit of the investment. Some of the other names for Profitability index are the Profit Investment Ratio (PIR) and the Value Investment Ratio (VIR).

Should these be mutually exclusive investments, the second project will be preferable, even though it has a lower PI. This is how, if examined in isolation, PI ignores the size and added shareholder value of a given project. Suppose further that the company has only $40,000 available to invest and all the projects are independent, not mutually exclusive. Because of cash constraint, It can’t undertake both project 1 and another from project 2 and 3. The PI is more than a simple binary indicator; it also aids in comparing multiple projects. The project boasting the highest PI could be deemed the most appealing investment as it offers the highest return relative to its cost.

As indicated by the aforementioned formula, the profitability index uses the present value of future cash flows and the initial investment to represent the aforementioned variables. If there are multiple projects, the project with the highest profitability index should be chosen. This is called a benefit-cost ratio when limited capital and projects are mutually exclusive.

However, if they are added together, the sum total is larger than project 1’s NPV. The common sense here dictates that the company should choose both project 2 and 3, and leave the first one. We can see that the PI number obtained through our incremental analysis is greater than 1. Now that we have obtained the PI value for both the projects, let’s look into its application for appraising projects. In essence, the PI should serve as a component of a broader, comprehensive approach to investment analysis.

However, the profitability index ratio can be very helpful in assessing the profitability of the projects when used along with other measures of profitability assessment. With that said, for purposes of presenting a project or capital investment’s benefits on a per-dollar basis of the initial investment, the profitability index is more practical since it is standardized. 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.

When assessing a possible investment’s viability, the profitability index is particularly beneficial for two main reasons. 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. And lastly, investing in Catcher will earn Garch Ltd $155,000 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.