7.19 : Calculating Profitability Index

The profitability index or PI  is calculated by dividing the present value of future expected cash flows by the project's initial investment amount.

A PI greater than one is considered a good investment, with higher values corresponding to more attractive projects.

Consider an automobile company, AutoTech Inc., with limited capital, considering choosing from two investment options.

Project A requires an eight hundred thousand dollar investment in a new robotic assembly line and is expected to generate cash flows with a present value of one million dollars.

Project B requires investing five hundred thousand dollars in a new electric vehicle battery, with expected cash flows having a present value of six hundred and fifty thousand dollars.

Using the formula, the PI for Project A is one point two five,  whereas the PI for Project B is one point three.

Given its limited resources, AutoTech Inc. might prioritize Project B over Project A, as it offers higher returns on investment relative to their cost.

Using the Profitability Index with other financial metrics, such as Net Present value or internal rate of return, can provide a more comprehensive view of each project's potential.