© 2000 John Petroff

5)- Profitability index

The profitability index PI is calculated as a ratio of the sum of present values of cash flows, divided by the initial outlay.

PI = Sum(PV(C_t) )/ I₀

where C_t = cash flows in period t

I₀ = initial outlay in period 0

t = time

PV() = present value operator

Example of calculation: In the previous example of printing press purchase the PI is PI = (42,727 + 44,627 + 56,348) / (120,000 - 20,000) = 143,702 / 140,000 = 1.02644

The decision rule is to choose all the projects that have a profitability index greater than one. Or when there are conflicting projects choose the project with the highest profitability index. Conceptually, PI is very similar to NPV, and in practice, it is much easier to calculate than IRR. Most notably, it allows to reach quickly an optimal combination of projects when a capital constraint exists as in the case discussed in the previous section. However, as will be observed in Chapter 10 Section 10E-4, PI can occasionally not give the correct solution, and NPV is therefore recommended.

See review questions Q-3G5.1 and Q-3G5.2.

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Last modified: Jun/01/01

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