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Finance · level 2

Profitability index

When capital, engineers or factory hours are scarce, rank projects on NPV per unit of the scarce resource, not on raw NPV.

Theory: Corporate Finance 

Worked example: A project costs $7M and has NPV $2.7M. The firm can only spend $14M this year. What is the project's profitability index (NPV per dollar of investment)?

NPV$2.7M
investment$7M
PI0.39
budget$14M

Step by step

  1. 1

    PI = NPV ÷ resource used

    $2.7M / $7M = 0.39

  2. 2

    Read it

    Every dollar tied up in this project creates 39¢ of value.

  3. 3

    Rationing rule

    Rank all projects by PI and take them in order until the $14M runs out. Works only if the budget is the single binding constraint and projects are divisible or fit exactly.

A project costs $7M and has NPV $2.7M. The firm can only spend $14M this year. What is the project's profitability index (NPV per dollar of investment)? = 0.39

The theory behind it

Intuition

Finance is time and risk applied to cash: move every cash flow to the same date at a rate that reflects its risk, then compare.

Common pitfalls

  • ×Discounting a nominal flow at a real rate (or vice versa).
  • ×Mixing enterprise-value and equity-value numbers in the same ratio.

In the interview

Valuation, WACC, LBO and accretion rounds — where a wrong bridge is a wrong answer.