1.23 Profitability Index
Another helpful Capital Budgeting technique compares the present value of the project’s inflows to its cost or outflows. This is referred to as the “profitability index” (“PI”). It is the ratio of inflows to outflows, calculated on a present value basis. If the PI exceeds one, we may conclude that the expected yield exceeds the discount rate and, accordingly, we would accept any independent project.
PI = (PV inflows ÷ PV outflows)
Again, if PI > 1.0, we accept the project and necessarily its NPV > 0. Among mutually exclusive projects, we would choose that which has the highest PI. This is a kind of cost-benefit analysis. The PI tells us what we get back relative to each dollar invested, in present value terms.
In cases where there may be negative interim cash flows, we may either add the present value of the negative cash flows to the denominator or subtract them from the numerator.
While the PI is useful in ranking projects, it does not address the problem of scale where competing projects may be concerned. Further, a project may have the highest NPV among its competition, but not the highest PI per dollar invested. The PI does not provide us with a Rate of Return.
The Profitability Index may be used in a “Capital Rationing” context, as seen in the next section.