Profitability Index
The Profitability Index (PI) is the ratio of the present value of an investment's future cash flows to its initial cost, measuring how much value is created per dollar of capital invested and providing a useful tool for ranking projects under capital rationing.
Also called the Benefit-Cost Ratio, the Profitability Index is computed as: PI = PV of future cash flows / Initial investment = 1 + NPV / Initial investment. A PI greater than 1.0 (equivalently, a positive NPV) indicates value creation; a PI below 1.0 indicates value destruction. A project with a $10 million investment and $12 million present value of cash flows has a PI of 1.2, meaning it generates $1.20 in present value for every $1.00 invested.
The key advantage of PI over NPV emerges under capital rationing — when a firm has more positive-NPV projects available than it has capital to fund. In this situation, simply maximizing total NPV is not feasible; the constraint is the limited capital budget. Ranking projects by PI and accepting the highest-PI projects first until the budget is exhausted maximizes the NPV generated per dollar of limited capital, which is the economically correct allocation rule.
Consider a US regional bank with a $100 million capital deployment budget evaluating five small business lending programs. Program A requires $60 million and has NPV of $18 million (PI = 1.30); Program B requires $50 million and NPV of $12.5 million (PI = 1.25); Program C requires $40 million and NPV of $9.2 million (PI = 1.23); and so on. Simply taking the highest NPV programs might use up the budget before the highest-PI programs are funded. Ranking by PI ensures capital goes to the most efficient opportunities first.
In private equity and venture capital, a related concept is the Multiple on Invested Capital (MOIC), which expresses total undiscounted proceeds divided by invested capital. A 2.0x MOIC means the investor got back two dollars for every dollar invested, ignoring the time value of when those proceeds were received. PI adjusts for timing through discounting, making it theoretically superior to raw MOIC. However, because MOIC is simple to communicate and widely understood, it remains the dominant metric for fund performance reporting in US private markets.
PI is most useful in corporate settings when divisions compete for a finite capital budget — a classic scenario at large US conglomerates like General Electric historically, or currently at diversified industrial companies like Honeywell or 3M, where multiple business units submit capital requests exceeding total available capital each budget cycle.