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The Profitability Index (PI) shows a parallel between the expenses and profits of a certain project. It is obtained by dividing the net present value of the property’s future cash flows by the initial investment.
In other words, the profitability index is the ratio between the net present value of future cash flows and the initial investment.
A profitability index number of 1.0 is likely the lowest desired number for investors. If PI is less than 1.0, it shows that the net present value is lower than the initial investment. Therefore, the project should probably be discarded.
NPV and PI are often referred to as being similar.However, there is a difference between these two terms. The difference is that the profitability index does not suggest the amount of the actual cash flows.
While calculating NPV, a proper discount rate must be used. Generally, the return rate on unconventional investments or the weighted average cost of capital (WACC) is used.
When the NPV is lower, the discount rate will be higher. Investments with higher risk have a higher discount rate.
Where, indicates the discount rate and is the time of the cash flow.
NPV is the most successful and reliable method of investment evaluation, compared to other methods such as the payback period, the rate of return, internal rate of return (and Profitability Index). In fact, the profitability index is related to NPV, where the NPV presents an absolute measure, and the PI presents a relative measure.
