1. What is the Profitability Index?

The Profitability Index (PI) is a capital budgeting tool that measures the relationship between the costs and benefits of a proposed project. It compares the present value of future cash flows to the initial investment.

2. How Does the Calculator Work?

The calculator uses the Profitability Index formula:

Where:

• \( CF_t \) — Cash flow at time period t (USD)
• \( r \) — Discount rate (decimal)
• \( t \) — Time period (unitless)
• Initial Investment — Upfront project cost (USD)

Interpretation:

• PI > 1 indicates a profitable project
• PI = 1 means break-even
• PI < 1 suggests the project may not be worthwhile

3. Importance of PI Calculation

Details: The PI helps investors and managers rank projects when capital is rationed. It considers the time value of money and provides a relative measure of value created per dollar invested.

4. Using the Calculator

Tips:

• Enter initial investment as positive value
• Discount rate should be between 0 and 1 (e.g., 0.1 for 10%)
• Separate cash flows with commas (e.g., "100,200,300")
• Negative cash flows can represent costs

5. Frequently Asked Questions (FAQ)

Q1: How does PI differ from NPV?
A: While both use discounted cash flows, NPV gives absolute dollar value while PI provides a ratio, making it better for comparing projects of different sizes.

Q2: What are typical discount rates?
A: Rates vary but often use company's cost of capital (8-12% for many businesses) or a risk-adjusted rate.

Q3: When is PI most useful?
A: Particularly valuable when comparing projects with different investment requirements or when capital is limited.

Q4: What are limitations of PI?
A: Doesn't indicate project size, can conflict with NPV rankings for mutually exclusive projects, and requires accurate cash flow estimates.

Q5: How to interpret PI of 1.25?
A: Means the project creates $1.25 in present value for every $1 invested - generally considered a good investment.