The Profitability Index (PI) is a metric that property investors can use to evaluate whether the property under consideration meets their return objectives, thus providing a basis for rejecting or further considering an opportunity
The PI shows how many times the present value (PV) of the property’s cash flow stream over the holding period is higher (or lower) than acquisition or investment cost.
A PI greater than 1 indicates that the expected return over the holding period is higher than the investor’s required rate of return, which is used as the discount rate in estimating the present value of the cash flows expected to be produced by the property over the holding period. A PI smaller than 1 indicates that the property’s expected cash flows will not be high enough to provide the minimum return required by the investor. The formula for calculating the PI is the following:
Profitability Index = PV of Cash Flows / Investment Cost
PI = PV / CF0
Investment Cost = 200,000
PV = 574,355
For the estimation of Present Value of cash flows see discussion of PV formula and example with its application.
PI = 574,355 /200,000 = 2.87
Thus, the PI in our example is 2.87, suggesting that the return of the particular investment is considerably higher than the investor’s required rate of return