What is Profitability Index (PI)?
The profitability index is a capital budgeting ratio that measures the value created per unit of investment. It equals the present value of a project’s future cash flows divided by the initial investment. A PI greater than 1 means the project creates value; below 1 means it destroys value.
How It Works
- Formula: PI = PV of future cash flows / Initial investment
- PI > 1 → accept; PI < 1 → reject; PI = 1 → indifferent
- Useful when capital is rationed and projects must be ranked
- Closely related to NPV: NPV = PI × Initial investment − Initial investment
- Like NPV, sensitive to the discount rate assumption
Saudi Context
Saudi corporates evaluating Vision 2030-linked expansion projects often combine PI with NPV and IRR. PI is especially useful when picking between several capex projects of different sizes that compete for the same limited budget.
Example
A Saudi manufacturer has SAR 100 million to invest and three projects: A (PV 130M, cost 80M, PI 1.625), B (PV 90M, cost 60M, PI 1.50), C (PV 70M, cost 60M, PI 1.17). With limited capital the firm picks A and B (total cost 140M is too high, so A first; then C with the SAR 20M left, etc.) — the PI ranking guides the choice.