Profitability Index is another most important capital investment evaluation method. It is denoted by PI. It takes into account present value of future cash flows and compares it with the initial amount of investment. That is why; it makes this ratio popular among financial analyst because you can compare investments of two different sizes.
Formula
Profitability Index = Present value of future cash flows / Initial investment
Example
ABC is considering investing in a high class production plant which will smooth out its production process and will increase production up to 40 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c}. But, this production plant needs an initial investment of $ 20 million. The cash flows of $ 3 million, $ 5 million, $ 8 million, $ 9 million are expected to generate from year 1 to 4 respectively. Discount rate is 10 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c}. Calculate profitability index.
Required
| Year | Description | Amount | Discount Factor | Present Value |
| 1 | Cash inflow | 3,000,000 | 0.9091 | 2,727,300 |
| 2 | Cash inflow | 5,000,000 | 0.8264 | 4,132,000 |
| 3 | Cash inflow | 8,000,000 | 0.7513 | 6,010,400 |
| 4 | Cash inflow | 12,000,000 | 0.6830 | 8,196,000 |
| PV of future cash flows | 21,065,700 |
Profitability Index = Present value of future cash flows / Initial investment = 21,065,700 / 20,000,000 = 1.05