What Is the Profitability Index (PI) Rule?
The profitability index 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. A profitability index or ratio below 1 indicates that the project should be abandoned.
Key Takeaways
- The formula for PI is the present value of future cash flows divided by the initial cost of the project.
- The PI rule is that a result above 1 indicates a go, while a result under 1 is a loser.
- The PI rule is a variation of the NPV rule.
Understanding the Profitability Index Rule
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. A profitability index of 1 indicates that the project will break even. If it is less than 1, the costs outweigh the benefits. If it is above 1, the venture should be profitable.
For example, if a project costs $1,000 and will return $1,200, it's a "go."
PI vs. NPV
The profitability index rule is a variation of the net present value (NPV) rule. In general, a positive NPV will correspond with a profitability index that is greater than one. A negative NPV will correspond with a profitability index that is below one.
For example, a project that costs $1 million and has a present value of future cash flows of $1.2 million has a PI of 1.2.
PI differs from NPV in one important respect: Since it is a ratio, it provides no indication of the size of the actual cash flow.
For example, a project with an initial investment of $1 million and a present value of future cash flows of $1.2 million would have a profitability index of 1.2. Based on the profitability index rule, the project would proceed, even though the initial capital expenditure required are not identified.
PI vs. IRR
Internal rate of return (IRR) is also used to determine if a new project or initiative should be undertaken. Broken down further,the net present value discounts after-tax cash flows of a potential project by the weighted average cost of capital (WACC).
To calculate NPV:
- First identify all cash inflows and cash outflows.
- Next, determine an appropriate discount rate (r).
- Use the discount rate to find the present value of all cash inflows and outflows.
- Take the sum of all present values.
The NPV method reveals exactly how profitable a project will be in comparison to alternatives. When a project has a positive net present value, it should be accepted. If negative, it should be rejected. When weighing several positive NPV options, the ones with the higher discounted values should be accepted.
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. If the IRR is lower than the cost of capital, the project should be killed.
FAQs
The profitability index 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.
What is the formula of profitability index rule? ›
The formula for Profitability Index is simple and it is calculated by dividing the present value of all the future cash flows of the project by the initial investment in the project. It can be further expanded as below, Profitability Index = (Net Present value + Initial investment) / Initial investment.
What does a profitability index PI of 0.85 for a project mean? ›
A profitability index of . 85 for a project means that: the present value of benefits is 85% greater than the project's costs.
How do you calculate profitability index quizlet? ›
Profitability index = Present value of net cash flows ÷ Initial investment.
What is the profitability index PI rule for an independent project quizlet? ›
T/F: The profitability index rule for an independent project states that, if a project has a positive NPV, then the present value of the future cash flows must be smaller than the initial investment.
What is the difference between NPV and PI? ›
The PI allows you to compare the profitability of two properties without regard to the amount of money invested in each. NPV, on the other hand, suggests exactly how profitable an investment will be in comparison to alternatives and provides an actual cash flow estimation in dollars.
What is the formula for profit profitability? ›
There are a few formulas for measuring profitability: Profit Margin = (Revenue – Expenses) / Revenue. Gross Margin Ratio = (Revenue – Cost of Goods Sold) / Total Revenue. Return on Investment = (Gain from Investment – Cost of Investment) / Cost of Investment.
What is the formula for each of the profitability ratios? ›
These are some common profitability ratios: Return on assets = net income ÷ average total assets. The return-on-assets ratio indicates how much profit companies make compared to their assets. Return on equity = net income ÷ average stockholder equity.
What is pi calculation used for? ›
Succinctly, pi—which is written as the Greek letter for p, or π—is the ratio of the circumference of any circle to the diameter of that circle. Regardless of the circle's size, this ratio will always equal pi. In decimal form, the value of pi is approximately 3.14.
How accurate is pi on calculator? ›
For some numbers (such as Pi) a calculator's accuracy is based on how many decimal places are shown. In the case of Pi, 3.14 is more accurate than just 3, and 3.14159265 is far more accurate than 3.14.
Super PI is a computer program that calculates pi to a specified number of digits after the decimal point—up to a maximum of 32 million.
When the profitability index PI is greater than 1 the benefits exceed the costs? ›
The profitability index (PI) decision criterion states: if PI < 1.0, reject the project. If the PI is greater than one, the benefits exceed the costs. The profitability index (PI) method multiplies the Present Value of Benefits by Present Value of Costs.
Should a firm accept a project that has a PI of 0.8 Why? ›
Should a firm accept a project that has a PI of 0.8? Why? No, because the project would be generating cash inflows that are 20% short of the initial investment. Correct!
Why is the profitability index important? ›
Description: Profitability index helps in ranking investments and deciding the best investment that should be made. PI greater than one indicates that present value of future cash inflows from the investment is more than the initial investment, thereby indicating that it will earn profits.
How do you calculate profitability index PI for each project? ›
The PI 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 deemed as a good investment, with higher values corresponding to more attractive projects.
What are the two methods of project analysis? ›
The methods of project analysis can be classified into discounting criteria and non-discounting criteria.
When the project is accepted or rejected for investment according to the PI function? ›
PI greater than 1 will be profitable and accepted and PI less than one will be rejected as it will create a loss. PI helps and takes into consideration the time value of money and future cash flow of money in the project. PI helps to indicate whether the investment made in the project will be accepted or rejected.
Is the profitability index of a project is equal to 1 then NPV? ›
Answer: If a project's profitability index is equal to 1 then Net present value is positive.
What is the difference between PI and ROI? ›
As the value of the profitability index increases, so does the financial attractiveness of the proposed project. The PI is similar to the Return on Investment (ROI), except that the net profit is discounted.
Why does PI mean profit? ›
Answer and Explanation: There is no concrete reason available as to why the sign of Pi, Greek letter π , is used to denote economic profit.
NPV calculates the present value of future cash flows. IRR ignores the present value of future cash flows. PB method also ignores the present value of future cash flows. The PI method calculates the present value of future cash flows.
Is PI or NPV more important? ›
Conclusion. NPV is the most successful and reliable method of investment evaluation, compared to other methods such as the payback period, the rate of return, internal rate of return (and Profitability Index).
Do NPV and PI always lead to same investment decision? ›
When a firm can undertake all independent and profitable projects, using the PI will lead to the same decision as the NPV. However, if the projects are mutually exclusive and have different scales, the decision maker should not use the PI.
What are the advantages of the PI method of capital budgeting? ›
Profitability Index Advantages
- Evaluates all cash flows.
- Shows whether an investment increases firm value.
- Evaluates multiple projects.
- Compares time values of cash flows.
- Uses cost of capital as a comparison to projects.
π = Expected Inflation Rate. r = Real Interest Rate.
What does PI mean in pricing? ›
A price index (PI) is a measure of how prices change over a period of time, or in other words, it is a way to measure inflation.
What is PI theory of investment? ›
Personal Investment Theory
PI theory is concerned with how persons choose to invest their energy, talent, and time. PI theory is particularly relevant for investigations into how individuals of various cultural backgrounds relate to different achievement situations.
Why should we use pi? ›
Since it is defined mathematically as the ratio of circumference of circle by diameter,it is used in the every equation of circle. also circle has no sides so that no other equation can be used.
Why is higher pi better? ›
Generally, the higher the PI the better. 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.
Do investors prefer NPV or IRR? ›
The advantage to using the NPV method over IRR using the example above is that NPV can handle multiple discount rates or varying cash flow directions. Each year's cash flow can be discounted separately from the others, so the NPV method is more flexible when evaluating individual periods.
IRR is the full form of the Internal rate of return. It is the return where the PV of cash inflows gets equal to the cash outflows. PI is the full form of the Profitability index. It is the ratio that determines the relation between the present value of cash inflows and cash outflows.
What is a good IRR rate? ›
The internal rate of return (IRR) is a metric used to measure the return on a real estate investment considering the time value of money. It factors in cash inflows and outflows, and it is important when comparing real estate investment opportunities. A good IRR in real estate is around 18-20%.
