Profitability Index (PI) answers one simple question: for every rupee you invest, how many rupees of present value do you get back? That makes it the go-to tool when a company has limited funds and must choose between multiple projects — this is called capital rationing.
The formula is straightforward: PI = PV of Future Cash Inflows ÷ Initial Cash Outflow. You can also compute it as PI = 1 + (NPV ÷ Initial Investment). A PI greater than 1 means accept the project (you're earning more than your cost of capital). A PI less than 1 means reject it. Exactly 1 means you're just breaking even on a present-value basis — the project earns exactly the discount rate, nothing more.
Where PI really shines is project ranking under capital rationing. Imagine Rajesh & Co. Pvt. Ltd. has ₹10 lakhs to invest and three projects on the table. NPV alone can mislead you here — a project with a high NPV might require a huge investment and crowd out two better smaller projects. PI normalises for size. You rank projects from highest PI to lowest, then keep picking until the budget runs out. Important nuance: this ranking works cleanly only when projects are independent and divisible (you can take a fraction of a project). If projects are indivisible (all-or-nothing), you must enumerate feasible combinations and pick the one with the highest total NPV — PI ranking alone isn't sufficient.
PI is closely related to NPV and IRR — all three are DCF (Discounted Cash Flow) methods and will almost always agree on accept/reject for a single project. The real exam edge of PI is in ranking and capital rationing scenarios. This topic is asked frequently as a 5-mark problem where you're given 3–4 projects with limited capital and must select the optimal mix. Always show your PI calculation clearly and state your accept/reject conclusion explicitly — examiners award marks for both.