Corporate finance
What is profitability index?
Profitability index divides PV of future inflows by initial investment, expressing discounted inflows per unit invested.
Definition
Profitability index divides PV of future inflows by initial investment, expressing discounted inflows per unit invested.
Intuition
NPV measures an absolute surplus; PI measures a relative ratio. Each answers a different comparison question.
Formula
PI is the present value of future nonnegative inflows divided by the initial outlay.
Formula and assumptions
CFₜ is a nonnegative year-end inflow, r is a constant annual discount rate, and the initial outlay must be positive. Later outlays require NPV or a revised denominator.
Example
- Enter an outlay of 1,000, a 10% discount rate, and two inflows of 600.
- PV of inflows = 600/1.1 + 600/1.1² ≈ 1,041.32.
- PI ≈ 1.041 and NPV ≈ 41.32.
Common mistakes
Do not make an investment decision from PI alone, especially when project scale or capital constraints differ.
Frequently asked questions
What does PI = 1 mean?
At the selected discount rate, inflow PV equals the initial outlay and NPV is zero.
Why use PI under capital rationing?
PI shows discounted inflows per unit of initial capital, useful for comparing capital efficiency alongside scale, dependencies, and constraints.
Can I enter later additional outlays?
This version treats the initial outlay as the only cost; future rows must be nonnegative inflows. Use NPV for later outlays.