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How do you calculate project PI?

Published in Financial Analysis 3 mins read

The Project Profitability Index (PI) is calculated by dividing the present value of future cash flows by the initial cost of the project.

Here's a more detailed explanation:

What is the Project Profitability Index (PI)?

The Project Profitability Index (PI), also known as the Profit Investment Ratio (PIR) or Value Investment Ratio (VIR), is a capital budgeting technique used to rank projects based on their profitability, considering the time value of money. It essentially measures the value created per unit of investment.

Formula for Calculating PI:

PI = Present Value of Future Cash Flows / Initial Investment

Components of the Formula:

  • Present Value of Future Cash Flows: This represents the sum of all future cash inflows discounted back to their present value using an appropriate discount rate (typically the company's cost of capital).

    • To calculate the present value of a single future cash flow: PV = FV / (1 + r)^n

      • Where:
        • PV = Present Value
        • FV = Future Value
        • r = Discount Rate
        • n = Number of periods

  • Initial Investment: This is the initial cash outflow required to undertake the project (e.g., cost of equipment, initial working capital). It is often a negative cash flow.

Decision Rule:

The PI is used to decide whether to accept or reject a project:

  • PI > 1: Accept the project. The project is expected to generate more value than its cost.
  • PI < 1: Reject the project. The project is expected to lose value.
  • PI = 1: The project is expected to break even. This is a point of indifference and other factors should be considered.

Example:

Let's say a project requires an initial investment of $100,000 and is expected to generate the following cash flows over the next 3 years:

  • Year 1: $40,000
  • Year 2: $50,000
  • Year 3: $60,000

Assume the discount rate is 10%.

  1. Calculate the present value of each cash flow:

    • Year 1: $40,000 / (1 + 0.10)^1 = $36,363.64
    • Year 2: $50,000 / (1 + 0.10)^2 = $41,322.31
    • Year 3: $60,000 / (1 + 0.10)^3 = $45,078.92

  2. Sum the present values of the cash flows:

    • Total Present Value = $36,363.64 + $41,322.31 + $45,078.92 = $122,764.87

  3. Calculate the PI:

    • PI = $122,764.87 / $100,000 = 1.2276

Conclusion:

Since the PI is 1.2276, which is greater than 1, you should accept the project. It is expected to generate $1.2276 in present value for every $1 invested. The higher the PI, generally, the more attractive the project.

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