How is the profitability index (PI) calculated?

The profitability index (PI) is a financial metric used to evaluate the attractiveness of an investment or project. It is calculated by dividing the present value of future cash flows from the investment by the initial investment outlay. This means that the profitability index reflects the amount of value created per unit of investment, making it a useful tool for comparing projects with different scales of capital requirements.

When using the profitability index, a PI greater than 1 indicates that the present value of cash flows exceeds the initial investment, suggesting that the project is potentially profitable. Conversely, a PI less than 1 signals that the project may not generate sufficient returns to justify the investment.

This method of calculation highlights the time value of money, as the cash flows are usually discounted to their present value before the calculation. By focusing on the ratio of present value of cash flows to initial outlay, the profitability index provides a clear and straightforward measure for decision-makers when assessing different investment opportunities.