Knowing how to determine profitability index is crucial in finance management. The profitability index, or PI, is a method used to make businesses determine whether an investment in a project is worthwhile. PI is a measure of the benefit of an investment compared to the cost. The greater the PI, the more desirable the investment. This article describes how to determine the profitability index, its formula, and why it differs from net present value (NPV). We will also provide examples to give you an understanding of the concept. At the end of this guide, you will learn how to calculate the profit index and how it is used in financial decision-making.
What Is the Profitability Index?
The profitability index (PI) is a capital budgeting ratio. It indicates the value an investment will yield per unit of cost. PI assists companies in selecting the optimal projects when funds are scarce. It is also called the “profit investment ratio” or “value investment ratio.”
A PI of more than 1 indicates that the project is profitable. A PI of less than 1 indicates the project is not a good investment. Companies utilize PI to compare several projects and choose the one with the greatest returns.
Why Is PI Important?
- Helps in deciding whether to accept or reject a project.
- Compares different projects easily.
- Useful when funds are limited.
- Measures the value created per unit of investment.
How to Calculate Profitability Index?
To understand how to calculate profitability index, we use a simple formula. PI is the ratio of the present value of future cash flows to the initial investment cost.
Steps to Calculate Profitability Index
- Calculate PV of All Future Cash Flows: The sum of the present value of the cash flows expected to be received in the future discounted through a discount rate.
- Initial Investment Cost: This is how much you will need to invest to get started on the project.
- Calculate the Profitability Index: PV of cash inflows / Initial investment
- Analyze the Result: If PI exceeds 1, the project is profitable. If PI is less than 1, do not invest.
Profitability Index Formula
The profitability index formula is:
Where:
- PV of Future Cash Flows is the present value of all expected income.
- Initial Investment is the total cost required to start the project.
Example Calculation
Let’s assume a company wants to invest in a project with:
- Future cash flows worth $100,000 (discounted to present value)
- An initial investment of $80,000
Using the formula: PI=100,00080,000=1.25PI = \frac{100,000}{80,000} = 1.25
Since PI is greater than 1, the project is profitable.
What is a Good Profitability Index (PI)?
A good profitability index (PI) depends on business goals. However, general guidelines include:
- PI > 1.0: Acceptable. The project will generate more value than it costs.
- PI < 1.0: Unacceptable. The project will not recover its cost.
- PI = 1.0: Break-even. The project will recover its cost but will not generate extra value.
How to Use PI for Decision-Making?
- Compare Several Projects: More PI projects are worth the investment.
- Prioritize Scarce Funds: Select projects that yield maximum return per dollar spent.
- Measure Risk and Uncertainty: Lower PI projects are riskier.
Profitability Index vs. NPV: Key Differences
The net present value (NPV) and profitability index (PI) are critical capital budgeting tools. Although related to each other, they are used for different purposes. PI is a ratio of the advantage of a project to its expense, thus helpful in prioritizing projects. NPV, however, is an absolute dollar amount a project will earn after it pays for itself.
- Decision Making: PI assists in ranking projects with limited capital, whereas NPV quantifies overall profit in dollars.
- Interpretation: PI above 1 is a good investment, while positive NPV signifies that the project creates value.
- Usability: PI is more useful when comparing projects of varying sizes, while NPV is most useful for determining overall profitability.
| Feature | Profitability Index (PI) | Net Present Value (NPV) |
| Measures | Ratio of benefits to costs | Total value in dollars |
| Decision Rule | PI > 1 (profitable) | NPV > 0 (profitable) |
| Best for | Comparing projects | Understanding absolute returns |
| Focus | Efficiency | Total profitability |
Which One to Use?
- Apply PI when money is scarce and you have to select among several projects.
- Use NPV if you wish to know the absolute profitability of a project.
- The two approaches can complement each other when making decisions.
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Profitability Index Calculation Example
Let’s take a real-world example to understand how to calculate profitability index in financial management.
Example Scenario
A company wants to invest in a new product line. Here are the details:
- Initial investment: $200,000
- Yearly cash inflows: $50,000 for 5 years
- Discount rate: 10%
Step 1: Calculate Present Value of Cash Inflows
We use the formula for the present value of an annuity:
Where:
- C = $50,000 (cash inflow per year)
- r = 10% (discount rate)
- n = 5 years
Using the formula, the PV of cash inflows = $189,540
Step 2: Calculate PI
PI=189,540/200,000=0.95
Since PI is less than 1, the project is not profitable.
Relevance to ACCA Syllabus
The profitability index (PI) is a useful concept in finance, and it forms part of the ACCA study material under Financial Management (FM) and Advanced Financial Management (AFM) papers. The PI assists with capital budgeting choices, an integral element of investment appraisal. The ACCA students must recognise PI’s role in determining a project’s profitability and how resources are allocated so it applies to everyday financial decision-making.
Profitability Index ACCA Questions
Q1: What is the formula for calculating the profitability index (PI)?
A) Initial Investment / Present Value of Future Cash Flows
B) Present Value of Future Cash Flows / Initial Investment
C) Net Present Value / Discount Rate
D) Initial Investment – Present Value of Future Cash Flows
Answer: B) Present Value of Future Cash Flows / Initial Investment
Q2: If the profitability index of a project is 0.85, what should a company do?
A) Accept the project
B) Reject the project
C) Increase the discount rate
D) Decrease the initial investment
Answer: B) Reject the project
Q3: Which of the following capital budgeting techniques is closely related to the profitability index?
A) Net Present Value (NPV)
B) Payback Period
C) Internal Rate of Return (IRR)
D) Accounting Rate of Return (ARR)
Answer: A) Net Present Value (NPV)
Q4: What is the profitability index if a project has an NPV of $50,000 and an initial investment of $200,000?
A) 1.25
B) 0.75
C) 1.50
D) 0.50
Answer: A) 1.25
Q5: What does a profitability index of 1.2 mean?
A) The project is not profitable
B) The project generates $1.20 for every $1 invested
C) The project has an IRR of 12%
D) The payback period is 1.2 years
Answer: B) The project generates $1.20 for every $1 invested
Relevance to US CMA Syllabus
The US CMA course syllabus emphasizes financial decision-making and investment appraisal, so the profitability index (PI) is vital in Part 2: Financial Decision Making. Capital budgeting methods are examined in the CMA exam, and PI assists professionals in analysing project viability and maximising shareholders’ value.
Profitability Index US CMA Questions
Q1: Which of the following best describes the profitability index?
A) A measure of project liquidity
B) A ratio comparing the present value of future cash flows to the initial investment
C) A method of tax savings for corporations
D) A ratio comparing the net income of a project to its initial cost
Answer: B) A ratio comparing the present value of future cash flows to the initial investment
Q2: The profitability index is useful for capital budgeting because it:
A) Measures the break-even point of a project
B) Helps prioritize projects when capital is limited
C) Calculates total profit from an investment
D) Determines the tax liability of a project
Answer: B) Helps prioritize projects when capital is limited
Q3: A project with a PI of 1.3 indicates what?
A) The project is likely unprofitable
B) The project returns $1.30 per dollar invested
C) The NPV of the project is negative
D) The project has a payback period of 1.3 years
Answer: B) The project returns $1.30 per dollar invested
Q4: How does an increase in the discount rate affect the profitability index?
A) Increases the PI
B) Decreases the PI
C) Does not affect PI
D) Increases the project’s payback period
Answer: B) Decreases the PI
Q5: If two projects have different profitability indexes, which one should be chosen?
A) The one with the lower PI
B) The one with the higher PI
C) The one with the shorter payback period
D) The one with the lower IRR
Answer: B) The one with the higher PI
Relevance to US CPA Syllabus
Capital budgeting is covered by the US CPA exam in Financial Accounting and Reporting (FAR) and Business Environment and Concepts (BEC). PI is a significant measure financial professionals utilize to determine whether a long-term investment is profitable. Knowledge of how to compute profitability index assists CPAs in making critical decisions regarding investments.
Profitability Index US CPA Questions
Q1: What does a profitability index of exactly 1 indicate?
A) The project is profitable
B) The project is at break-even
C) The project should be rejected
D) The project’s cash flows are uncertain
Answer: B) The project is at break-even
Q2: When comparing two projects, why might a company use the profitability index instead of NPV?
A) PI considers sunk costs, while NPV does not
B) PI is useful when capital is limited and projects need ranking
C) PI provides a more accurate dollar value than NPV
D) PI always results in the same project selection as NPV
Answer: B) PI is useful when capital is limited and projects need ranking
Q3: Which of the following statements about profitability index is TRUE?
A) A PI of less than 1 suggests that the project is profitable
B) A higher PI means a lower NPV
C) PI is calculated using the future value of cash flows
D) PI helps measure the efficiency of an investment
Answer: D) PI helps measure the efficiency of an investment
Q4: The profitability index is most useful when:
A) Comparing projects of different sizes
B) Evaluating projects with the same initial cost
C) Assessing a company’s liquidity
D) Determining depreciation expense
Answer: A) Comparing projects of different sizes
Q5: If a project’s initial cost is $500,000 and its present value of future cash flows is $625,000, what is the profitability index?
A) 1.25
B) 0.80
C) 1.50
D) 0.95
Answer: A) 1.25
Relevance to CFA Syllabus
Capital budgeting, specifically Level 1 and Level 2 of the CFA program, encompasses it. Profitability index, or PI, is a valuable investment analysis tool that allows finance professionals to assess projects in terms of their present value compared to cost. CFA candidates need to recognise PI’s contribution to investment decision-making.
Profitability Index CFA Questions
Q1: The profitability index is useful when:
A) Evaluating mutually exclusive projects
B) Capital is limited and projects need ranking
C) Determining a company’s total assets
D) Estimating tax deductions
Answer: B) Capital is limited and projects need ranking
Q2: Which project should be chosen if two projects have the same NPV but different profitability indexes?
A) The project with the higher PI
B) The project with the lower PI
C) The project with the longest payback period
D) The project with the lowest discount rate
Answer: A) The project with the higher PI
Q3: A company is evaluating a project with an initial investment of $300,000 and a profitability index of 1.4. What is the present value of future cash flows?
A) $120,000
B) $420,000
C) $300,000
D) $210,000
Answer: B) $420,000
Q4: Which capital budgeting technique closely relates to the profitability index?
A) Payback period
B) Net present value (NPV)
C) Internal rate of return (IRR)
D) Cost of capital
Answer: B) Net present value (NPV)
Q5: What happens to the profitability index if the discount rate increases?
A) It increases
B) It decreases
C) It remains the same
D) It turns negative
Answer: B) It decreases
