The profitability index tells you how much value you get for every dollar invested. Formula: PI = Present Value of Future Cash Flows ÷ Initial Investment. A PI of 1.5 means every dollar invested generates $1.50 in present value — a 50-cent value creation. Any PI above 1.0 means the project creates value.
Example: A project costs $100,000 and its future cash flows have a present value of $130,000. PI = 1.30 — for every dollar invested, you get $1.30 back in present value terms. Compare it with another project costing $200,000 with PV of $240,000 (PI = 1.20). The first project creates more value per dollar, even though the second project has a higher absolute NPV.
PI is especially useful when a company has limited capital and must choose between competing projects (capital rationing). While NPV tells you the total value created, PI tells you the efficiency of value creation. Companies rank projects by PI to maximize total value when they cannot fund every positive-NPV project.