A regulation for evaluating whether to proceed with a project or investment. The profitability index rule states: If the profitability index or ratio is greater than 1, the project is profitable and may receive the green signal to proceed. Conversely, if the profitability ratio or index is below, the optimum course of action may be to reject or abandon the project.
The profitability index rule is a variation of the net present value (NPV) rule. In general, if NPV is positive, the profitability index would be greater than 1; if NPV is negative, the profitability index would be below 1. The profitability index differs from NPV in one important respect; Being a ratio, it ignores the scale of investment and provides no indication of the size of the actual cash flows.
For example, a project with an initial investment of $1 million, and present value of future cash flows of $1.2 million, would have a profitability index of 1.2. Based on the profitability index rule, the project would proceed.
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