Investment decisions
Payback and profitability index
How long until you get your money back, how much value per unit invested — and what each measure hides.
Learning objectives
- Calculate the payback period with interpolation
- Calculate discounted payback and the profitability index
- Explain what payback ignores and when PI is the right ranking tool
NPV tells you how much value a project adds, but managers also ask two other questions. How quickly do we get our money back? That's the payback period, popular because it is simple and speaks to liquidity and risk. How much value do we get per unit invested? That's the profitability index (PI), the right tool when capital is limited and you must choose which projects to fund.
Both are useful supplements to NPV. Neither replaces it.
Payback = years before recovery + (unrecovered amount ÷ cash flow in the recovery year) PI = PV of future cash flows ÷ initial investment
- Payback
- years until cumulative cash flow turns positive (interpolating within the year)
- Discounted payback
- the same, using discounted cash flows
- PI
- above 1 exactly when NPV is above 0
Included with a Formula Quest membership
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