Profitability Index (PI) is a measure of investment efficiency. It is a good tool for ranking projects because it allows you to clearly identify the amount of value created per unit of investment, thus if you are capital constrained you wish to invest in those projects which create value most efficiently first.
In simple terms, a PI of 1 means for every dollar invested you receive a dollar back in savings (over the system life). If PI is greater than 1, you receive more than your dollar invested back in savings. For example, a PI of 2 means for every dollar invested you receive 2 dollars back.
Profitability Index = (Net Present Value + Initial Investment) / Initial Investment ... where the Initial Investment is the Net Cost at installation (year 0).
Just like using the Net Present Value (NPV) rule, if an investment has a Positive (+) Profitability Index (>1), then we should take up the project and invest in it. However if an investment has a Negative (-) Profitability Index (<1), we should not take up the project.
For more information, please see http://en.wikipedia.org/wiki/Profitability_index
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