What does the profitability index measure?

• A. Time to recover initial investment
• B. Internal rate of return
• C. Payback period
• D. Ratio of present value of inflows to initial investment

Answer: (D)

The profitability index measures value created per unit of investment after accounting for the time value of money. It discounts the expected cash inflows to their present value using the project’s discount rate and then divides that amount by the initial investment. If the index is greater than 1, the project adds value because the present value of inflows exceeds the outlay; if it’s less than 1, it would destroy value; exactly 1 means it just breaks even.

You can see how this relates to overall project value: PI equals (NPV + initial investment) divided by the initial investment, so a higher PI corresponds to a higher net present value for the same initial cost. This differs from the payback period, which only tells you how long it takes to recover the initial investment without considering money received after recovery or the time value of money, and it’s not the internal rate of return, which is the discount rate that makes NPV zero. The defining feature is that ratio of present value of inflows to initial investment.