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Wize University Introduction to Finance Textbook > Capital Budgeting

Profitability Index

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Profitability Index

Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of payoff to the investment of a proposed project. It is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment.


If PI > 1, then NPV > 0 (investment is profitable)
If PI < 1, then NPV < 0 (investment is not profitable)
If PI = 1, then NPV = 0 (investment breaks-even)


Wize Tip
To quickly calculate PV(Inflows) you can use your financial calculator's CF and NPV functions. Just exclude any outflows when calculating NPV and your answer will the the PV(Inflows)

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Example: Profitability Ratio

You are considering 5-year investment that will require in initial cash outlay of $40,000. The expected inflows in years 1 through 3 are $10,000; then $12,000 in year 4 and $20,000 in year 5. Your cost of capital is 12% per year.

What is the profitability index of this investment and is this investment profitable?

Practice: Profitability Ratio

An investment requires an initial after-tax cash outflow of $100,000. The investment is expected to return $20,000 in each of the first 4 years and $60,000 in the fifth year. Assume your cost of capital is 8%. Answer the following:

What is the payback period?
(Round your answer to 4 decimal places)
Extra Practice
Question 2
A project requires an initial investment of $100,000 and will return $30,000 per year indefinitely. The firm's average cost of capital is 8% and this project is slightly riskier than their usual operations.
Risk premiums:
Question 1
A firm is considering a project with an initial after-tax cash outflow of $5,000 and inflows of $1,000 in year 1, $6,000 in year 2 and $3,000 in year 3. The firm's cost of capital is 6% .
Compute the profitability index for this project.
ABC Company is considering a new project that will require an initial investment of $100,000. The project is expected to generate the following cash flows over the next five years:
Year 1: $30,000 Year 2: $40,000 Year 3: $50,000 Year 4: $40,000 Year 5: $30,000
The required rate of return for this project is 10%.