Profitability Index (PI) Calculator

Understanding the profitability index calculator — concept and principle

The profitability index (PI), also called the benefit-cost ratio, tells you how much present value a project returns for each unit of money invested today. It is used in capital budgeting to screen projects, and it is especially helpful when capital is limited and you must rank several projects that all look worthwhile.

How it is calculated

• PV of future cash flows = CF1 ÷ (1 + r) + CF2 ÷ (1 + r)² + … + CF5 ÷ (1 + r)⁵
• Profitability index = PV of future cash flows ÷ initial investment

CF1 to CF5 are the net cash flows expected at the end of years 1 to 5, r is the discount rate (your required return or cost of capital) as a decimal, and the initial investment is paid at time 0. The calculator shows USD by default but works with any currency.

The principle

Money received later is worth less than money today, because today's money could be invested to earn r. Discounting converts each future cash flow into its value today. Dividing the total by what you pay now gives value created per unit invested. PI is closely linked to net present value: NPV = PV − investment, so PI > 1 exactly when NPV > 0, PI = 1 when NPV = 0, and PI < 1 when NPV is negative.

Worked example

1. Inputs: investment $100,000, cash flows $30,000, $35,000, $40,000, $30,000, $20,000, discount rate 8%.
2. Year 1: 30,000 ÷ 1.08 = $27,777.78.
3. Year 2: 35,000 ÷ 1.08² = $30,006.86.
4. Year 3: 40,000 ÷ 1.08³ = $31,753.29.
5. Year 4: 30,000 ÷ 1.08⁴ = $22,050.90; year 5: 20,000 ÷ 1.08⁵ = $13,611.66.
6. Sum of present values: $125,200.49.
7. PI = 125,200.49 ÷ 100,000 = 1.25. The NPV is about $25,200.

How to read the result

• PI above 1: the project earns more than the required return; here each dollar invested returns about $1.25 in present value.
• PI equal to 1: the project just earns the required return.
• PI below 1: the project destroys value at this discount rate.

When the budget is fixed, ranking projects by PI and funding the highest first tends to maximise total NPV. For mutually exclusive projects of different sizes, prefer the one with the higher NPV, because a small project can have a high PI but add little value in total.

Common mistakes

• Adding up undiscounted cash flows (here $155,000) and dividing by the investment.
• Using a discount rate that does not match the project's risk.
• Entering the initial investment as a negative number; enter it as a positive amount.

Frequently asked questions

What is the difference between PI and NPV?

NPV is an amount of money (PV minus investment); PI is a ratio (PV divided by investment). They agree on accept or reject but can rank projects differently when sizes differ.

What discount rate should I use?

Usually the company's cost of capital or the return you could earn on an investment of similar risk.

Sources: R. A. Brealey, S. C. Myers and F. Allen, Principles of Corporate Finance, McGraw-Hill · CFA Institute, Corporate Issuers curriculum: capital investments and capital budgeting