Profitability Index: Discounted Cash Flows and Project Selection
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Calculate profitability index from discounted cash flows. Reconcile NPV, compare project scale and avoid ranking indivisible investments by a ratio alone.
Profitability index compares the present value of a project’s future net cash flows with its positive initial investment. Under the stated conventional setup, PI above 1 corresponds to positive NPV, but the ratio alone does not select the best combination of projects.
Every amount in the worked case is an original fictional USD planning assumption. It is not an industry benchmark, a customer result or a prediction.
State the cash-flow convention before calculating PI
PI = present value of future net project cash flows ÷ initial investment. Here the investment occurs at time zero, future amounts are net incremental project cash flows, and discounting uses end-of-year timing. NPV = present value of future net cash flows − initial investment. With these conventions and a positive initial outlay, PI = 1 + NPV ÷ initial investment.
Some sources use a different numerator or treat later investment outlays separately. Do not compare such ratios without reconciling the definitions. A zero initial investment makes this version undefined. Nonconventional cash flows and multiple later capital commitments need an explicitly rebuilt model.
Discount the same project year by year
| Time | Net project cash flow | Discount calculation | Present value |
|---|---|---|---|
| 0 | −$20,000 | Initial investment | −$20,000.00 |
| Year 1 | $9,000 | 9000 ÷ 1.10 | $8,181.82 |
| Year 2 | $9,000 | 9000 ÷ 1.10² | $7,438.02 |
| Year 3 | $9,000 | 9000 ÷ 1.10³ | $6,761.83 |
| Future PV total | $27,000 nominal | Sum of unrounded PV | $22,381.67 |
PI is $22,381.6679 ÷ $20,000 = 1.1191. NPV is $2,381.67. Retain unrounded discount factors until the final display. The 10% rate is an illustrative input, not a recommended return, borrowing quote or risk-adjusted rate for your business.
A ratio above one is not an annual return
A PI of 1.1191 means about $1.1191 of discounted future net cash flows for each $1 initially invested in this defined case. It is not an 11.91% annual ROI. Project timing, risk, taxes, replacement needs and a suitable discount rate affect the interpretation. Accounting profit and EBITDA are not substitutes for incremental project cash flow.
At the same 10% discount rate, reducing each future annual cash flow to $8,000 gives future PV of about $19,894.82, PI of 0.9947 and NPV of −$105.18. A modest assumption change crosses the acceptability threshold, so retain a sensitivity table rather than only the base-case label.
Use NPV and constraints when comparing alternatives
Consider project A requiring $10,000 with future PV $13,000: PI is 1.30 and NPV $3,000. Project B requires $30,000 with future PV $36,000: PI is 1.20 and NPV $6,000. If the projects are mutually exclusive and risk, timing and other constraints are comparable, choosing the higher ratio alone would miss B’s larger dollar NPV.
Under a fixed budget with indivisible projects, evaluate feasible combinations. Dividing a project into fractions is not automatically possible. Include dependencies, available funding, staff capacity, required assets and strategic obligations. A ratio ranking can assist analysis; it is not a universal capital-allocation rule.
Build a defensible project cash schedule
- Specify the decision and the alternative being compared.
- List incremental cash inflows, operating outflows, working-capital changes, later investment and terminal recoveries.
- Use consistent timing, currency, nominal/real treatment and tax assumptions.
- Document the chosen discount rate and review sensitivities.
- Reconcile PI to NPV and confirm feasibility before approval.
Use the present-value guide for discounting, the business investment calculator for its stated return/payback measures, and the cash forecast to check funding dates. A discounted value result does not ensure cash is available to buy the asset.
Use the worksheet with your own records
Download the printable, editable HTML worksheet. It contains the completed example and a blank table. Open it in a browser, edit the blank fields, calculate the outputs using the stated method and print to PDF or paper. It does not automatically calculate results or replace your accounting records.
Method references and source notes
The method references below support the definitions. The examples, assumptions and decision checks on this page are independently constructed.
Frequently asked questions
Is PI minus one an annual return?
No. It expresses discounted value relative to initial outlay under the selected horizon and rate, not a compound annual return.
Should I always choose the highest PI?
No. Mutually exclusive projects, different scale, indivisibility and funding constraints can change the best feasible choice. Reconcile NPV and the actual decision constraints.
What cash flows belong in PI?
Use the explicitly defined incremental project cash flows, timing and rate. Include later investment and terminal effects consistently with the chosen convention.
Why keep unrounded discount factors?
Rounding each year early can change the reported total. Sum unrounded present values, then round the displayed PI and NPV.
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Planning estimates only—not accounting, tax, legal or lending advice.