What is profitability index?
A profitability index (PI) is the relationship between the costs and benefits of a proposed project. It is calculated by dividing the present value of the project’s future cash flows by the initial amount invested.
PI, also known as benefit-cost ratio is calculated as follows:
In the equation above represents the annual free cash flow in time period t and can be either positive or negative, k is the required rate of return (cost of capital), IO is the initial investment and n is the expected life of the project. A PI greater than 1.0 indicates that profitability is positive, while a PI of less than 1.0 indicates that the project will lose money.
As values on the PI increase, the proposed project becomes more financially appealing. The PI rule is a variation of the net present value (NPV) rule. Usually, if NPV is positive, the PI would be greater than 1. If NPV is negative, the PI would be below 1. However, the PI differs from NPV in that it ignores the size of the investment and provides no indication of the amount of the actual cash flows. Basically the PI is a project’s NPV turned into a percentage rate. It may seem a little bit confusing but if you have problems our finance homework service can help.
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