1. Profitability Index
An Investment Appraisal
Technique

2. Definition
Profitability index is an investment appraisal
technique calculated by dividing the present
value of future cash flows of a project by the
initial investment required for the project.

3. Formula
Present value of Future Cash Flow
Profitability Index=
Initial Investment Required
Present Value
= 1+
initial Investment Required

4. Explanation
Profitability index is actually a modification of
the net present value method. While present
value is an absolute measure (i.e. it gives as
the total dollar figure for a project), the
profitability index is a relative measure (i.e. it
gives as the figure as a ratio).

5. Decision Rule
Accept a project if the profitability index is
greater than 1, stay indifferent if the
profitability index is one and don't accept a
project if the profitability index is below 1.

6. Example
Company C is undertaking a project at a cost
of $50 million which is expected to generate
future net cash flows with a present value of
$65 million. Calculate the profitability index.

7. Solution
Profitability Index = PV of Future Net Cash Flows /
Initial Investment Required
Profitability Index = $65M / $50M = 1.3
Net Present Value = PV of Net Future Cash Flows −
Initial Investment Required
Net Present Value = $65M-$50M = $15M.
The information about NPV and initial investment can
be used to calculate profitability index as follows:
Profitability Index = 1 + ( Net Present Value / Initial
Investment Required )
Profitability Index = 1 + $15M/$65 = 1.3

8. Advantages of PI
 It considers time value of money.
 It takes into account the cash inflows and outflows
throughout the economic life of the project.
 Though PI method is almost similar to NPV method
and has got the same advantages, the former is still a
better measure because PI measures the relative
profitability and NPV, being an absolute measure.
 PI ascertains the exact rate of return of the project.

9. Disadvantages of PI
It is difficult to understand interest rate or
discount rate.
It is difficult to calculate profitability index if
two projects having different useful life.

10. Thank you