World Library  
Flag as Inappropriate
Email this Article

Profitability index

Article Id: WHEBN0009579767
Reproduction Date:

Title: Profitability index  
Author: World Heritage Encyclopedia
Language: English
Subject: PI, Profit (accounting), Net present value, Profit (economics), Financial ratio
Publisher: World Heritage Encyclopedia

Profitability index

Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment.

The ratio is calculated as follows:

  • \text{Profitability index} = \frac{\text{PV of future cash flows}}{\text{Initial investment}}

Assuming that the cash flow calculated does not include the investment made in the project, a profitability index of 1 indicates breakeven. Any value lower than one would indicate that the project's present value (PV) is less than the initial investment. As the value of the profitability index increases, so does the financial attractiveness of the proposed project.

Rules for selection or rejection of a project:

  • If PI > 1 then accept the project
  • If PI < 1 then reject the project

For example:

  • Investment = $40,000
  • Life of the Machine = 5 Years
CFAT Year      CFAT

      1        18000
      2        12000
      3        10000
      4         9000
      5         6000

Calculate Net present value at 10% and PI:

     Year      CFAT      PV@10%       PV

      1        18000      0.909      16362 
      2        12000      0.827       9924   
      3        10000      0.752       7520
      4         9000      0.683       6147     
      5         6000      0.621       3726
              Total present value    43679
              (-) Investment         40000
                         NPV           3679

     PI = 43679/40000 = 1.091 > 1 ⇒ Accept the project


External links

Use explained in the business book: Pursuing the Competitive Edge, Hayes, Pisano, Upton and Wheelwright. Wiley, 2005. pg. 264

This article was sourced from Creative Commons Attribution-ShareAlike License; additional terms may apply. World Heritage Encyclopedia content is assembled from numerous content providers, Open Access Publishing, and in compliance with The Fair Access to Science and Technology Research Act (FASTR), Wikimedia Foundation, Inc., Public Library of Science, The Encyclopedia of Life, Open Book Publishers (OBP), PubMed, U.S. National Library of Medicine, National Center for Biotechnology Information, U.S. National Library of Medicine, National Institutes of Health (NIH), U.S. Department of Health & Human Services, and, which sources content from all federal, state, local, tribal, and territorial government publication portals (.gov, .mil, .edu). Funding for and content contributors is made possible from the U.S. Congress, E-Government Act of 2002.
Crowd sourced content that is contributed to World Heritage Encyclopedia is peer reviewed and edited by our editorial staff to ensure quality scholarly research articles.
By using this site, you agree to the Terms of Use and Privacy Policy. World Heritage Encyclopedia™ is a registered trademark of the World Public Library Association, a non-profit organization.

Copyright © World Library Foundation. All rights reserved. eBooks from Project Gutenberg are sponsored by the World Library Foundation,
a 501c(4) Member's Support Non-Profit Organization, and is NOT affiliated with any governmental agency or department.