About Profitability Index

What is Profitability Index?

The Profitability Index (PI), also known as the Profit Investment Ratio (PIR) or Value Investment Ratio (VIR), is a financial metric used to evaluate the desirability of a project or investment. It is calculated as the ratio of the present value of future cash flows to the initial investment required for the project.

Formula for Profitability Index

The formula to calculate Profitability Index is:

\[\\text{Profitability Index (PI)} = \\frac{\\text{Present Value of Future Cash Flows}}{\\text{Initial Investment}}\]

Or, more specifically:

\[\\text{PI} = \\frac{\\text{NPV} + \\text{Initial Investment}}{\\text{Initial Investment}}\]

Where:

• NPV = Net Present Value
• Initial Investment = Total upfront cost of the project

Calculation Steps

1. Calculate the Net Present Value (NPV) of the project.
2. Add the Initial Investment to the NPV.
3. Divide the result by the Initial Investment.

Example

Let's calculate the Profitability Index for a project with the following financial data:

• Initial Investment: $100,000
• NPV: $20,000

1. PI = ($20,000 + $100,000) / $100,000 = 1.2

Visual representation:

Therefore, the Profitability Index for this project is 1.2, meaning that for every dollar invested, the project is expected to generate $1.20 in present value. Since the PI is greater than 1, this project would be considered profitable.