The Profitability Index is simply the profitability of an investment (dividend yield plus the expected growth rate of the investment’s market value) expressed as a percentage of the total return of the investment.
The profitability index assists in assessing investments and determining the optimal investment to make.
PI larger than one shows that the present value of future cash flows from the investment exceeds the initial investment, indicating that the venture will generate a profit.
Is Profitability Index Same as ROI?
As the profitability index improves in value, so does the financial appeal of the proposed enterprise. PI is comparable to ROI, except that the nett profit is discounted.
Difference between NPV and profitability index
In general, a positive NPV corresponds with a PI greater than one, and a negative NPV corresponds with a PI less than one. The primary distinction between NPV and profitability index is that the PI is expressed as a ratio and hence does not reveal the magnitude of cash flows.
Why Use Profitability Index (PI)?
In a perfect world, the corporation would accept all projects with positive NPV, but in reality, there are things known as restrictions. For instance, you may have a budget, and your boss may tell you that you cannot exceed this budget of one million or two million dollars while investing in initiatives.
Therefore, despite the fact that you may have a number of positive NPV projects that would be best for the company to engage in, you lack the funds to pursue them, and the resource limitation may be something else. It might be the quantity of engineers or scientists at your company, etc., thus these limits can make it such that you cannot accept all positive NPV projects, and you must choose which ones to accept and which to reject. In such cases, the profitability index emerges as the best tool to evaluate the proposals and arrive at a decision.