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Profitability Index - Investment Ranking Tool

The profitability index is also known as benefit/cost ratio. It is Present Value of Future Values (NPV) + the Initial Investment, divided by the Initial Investment. To put in mathematical terms, the formula is: Profitability Index = (Net Present Value + Initial Investment) / Initial Investment Just like using the Net Present Value (NPV) rule, if an investment has a Positive (+) Profitability Index (>1), then we should take up the project and invest in it. However if an investment has a Negative (-) Profitability Index (<1), we should NOT take up the project. For example, suppose a project costs you $200 and the NPV of that project is $20. Therefore, Profitability Index would be: (20 + 200) / 200 = $1.10 - Since $1.10 is greater than 1, we should go ahead and perform the investment project.

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Rules of Profitability Index

- If PI > 1, Good Investment - If PI < 1, Bad Investment How do you explain the results of Profitability Index? It measures the value created per dollar of an investment. Consider the question below:

Fun Money Fact More people in USA think about money (37%) than sex (24%). Investment Poll What percentage of your investment portfolio is invested in Cyclical Stocks?
1-20% 21-50% 51-100%
0.9b 1002934

Profitability Index Sample Question

Given the following cash flows for an investment, calculate the profitability index. The required rate of return is 8% Year 0 1 2 3 Cash Flows -$10,000 $1500 $2500 $4000 $3000 5 6 $3000 $3000

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More Capital Budgeting Tutorials

Comparison between Internal Rate of Return (IRR) and Net Present Value The Payback Rule - Recovering Initial Investment Costs Profitability Index - Investment Ranking Tool Cost Minimization with Net Present Value (NPV) Discounted Payback Period Rule -

Here's a graphical representation of the Cash Flows