How to Use the Profitability Index (PI) Rule

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What Is the Profitability Index (PI) Rule?
The profitability index rule is a decision-making
exercise that helps evaluate whether to proceed
with a project. The index itself is a calculation of
the potential profit of the proposed project. The
rule is that a profitability index or ratio greater than
1 indicates that the project should proceed. A
profitability index or ratio below 1 indicates that the
project should be abandoned.

Key Takeaways
The formula for PI is the present value of future
cash flows divided by the initial cost of the project.
The PI rule is that a result above 1 indicates a go,
while a result under 1 is a loser.
The PI rule is a variation of the NPV rule.
Understanding the Profitability Index Rule
The profitability index is calculated by dividing the
present value of future cash flows that will be
generated by the project by the initial cost of the
project. A profitability index of 1 indicates that the
project will break even. If it is less than 1, the costs
outweigh the benefits. If it is above 1, the venture
should be profitable.
For example, if a project costs $1,000 and will
return $1,200, it's a "go."

PI vs. NPV
The profitability index rule is a variation of the net
present value (NPV) rule. In general, a positive
NPV will correspond with a profitability index that
is greater than one. A negative NPV will
correspond with a profitability index that is below
one.

For example, a project that costs $1 million and

has a present value of future cash flows of $1.2
million has a PI of 1.2.

PI differs from NPV in one important respect:

Since it is a ratio, it provides no indication of the
size of the actual cash flow.

For example, a project with an initial investment of

$1 million and a present value of future cash flows
of $1.2 million would have a profitability index of
1.2. Based on the profitability index rule, the
project would proceed, even though the initial
capital expenditure required are not identified.

PI vs. IRR
Internal rate of return (IRR) is also used to
determine if a new project or initiative should be
undertaken. Broken down further, the net present
value discounts after-tax cash flows of a potential
project by the weighted average cost of capital
(WACC).

To calculate NPV:

First identify all cash inflows and cash outflows.

Next, determine an appropriate discount rate (r).
Use the discount rate to find the present value of
all cash inflows and outflows.
Take the sum of all present values.
The NPV method reveals exactly how profitable a
project will be in comparison to alternatives. When
a project has a positive net present value, it should
be accepted. If negative, it should be rejected.
When weighing several positive NPV options, the
ones with the higher discounted values should be
accepted.

In contrast, the IRR rule states that if the internal

rate of return on a project is greater than the
minimum required rate of return or the cost of
capital, then the project or investment should
proceed. If the IRR is lower than the cost of
capital, the project should be killed.