Financial Management: Core Concepts, Third Edition

9.5 Profitability Index

If people have a natural affinity for rate of return rather than current dollars for a project, is there a way to adjust the preferred NPV model and still have the ability to assign the appropriate level of risk for the project (the discount rate or hurdle rate)? The answer again is a qualified yes, and the decision model to achieve this goal is the profitability index.

The profitability index (PI) is a modification of the NPV to produce the ratio of the present value of the benefits (future cash inflow) to the present value of the costs (initial investment):

$$\text{profitability index}=\frac{\text{present value of benefits}}{\text{present value of costs}}$$ 9.4

When the benefits exceed the costs, the PI is greater than 1. Therefore, the ...