NPV vs PI: How Investment Size Changes Things

Imagine you are deciding between two ice cream trucks to buy for your new business. Let’s say both trucks are fantastic and will last for years. To make the best choice, you need to figure out which one is the better investment. This is where tools like Net Present Value, or NPV, and the Profitability Index, or PI, come into play.

Think of NPV as the total profit you expect to make from an investment, but measured in today’s dollars. It considers not only the money you expect to earn in the future but also the fact that money today is worth more than the same amount of money in the future. This is because you could invest money today and earn interest, making it grow over time. So, when calculating NPV, we discount future cash flows back to their present value and then subtract the initial investment. A positive NPV means the investment is expected to increase your wealth, like buying an ice cream truck that will bring in more money than it costs over its lifespan. The larger the positive NPV, generally, the better the investment in terms of absolute dollar value creation.

Now, let’s consider the Profitability Index. Instead of focusing on the absolute profit, PI looks at the bang for your buck. It’s a ratio that compares the present value of all the benefits you expect to receive from an investment to the initial investment required. You can think of it as how many dollars of present value benefit you get for every dollar you invest. A PI greater than one indicates that the investment is profitable; a PI of exactly one means you break even, and a PI less than one suggests the investment will lose money. For example, a PI of 1.2 means for every dollar invested, you are expected to get back $1.20 in present value terms.

Here’s where the scale of the investment becomes really important. NPV is directly affected by the size of the investment. If you are considering two ice cream truck options, and one is a small, basic truck while the other is a large, deluxe model with all the bells and whistles, the deluxe truck will likely have a higher initial investment. If both are profitable, the deluxe truck, because it’s larger and potentially serves more customers, might generate a significantly higher NPV in absolute dollar terms. It could be like saying the deluxe truck is expected to make you a total profit of $100,000 in present value, while the basic truck might only generate $50,000 in present value profit. In this case, based solely on NPV, the deluxe truck seems like the better choice because it adds more to your wealth.

However, the Profitability Index tells a slightly different story, especially when resources are limited. Imagine you only have a certain amount of money to invest. While the deluxe truck might have a higher NPV, it also requires a much larger upfront investment. The Profitability Index helps you compare the efficiency of these investments. Let’s say the deluxe truck has a PI of 1.1, meaning for every dollar invested, you get $1.10 back in present value. The basic truck, even with a lower NPV, might have a higher PI, say 1.3, meaning for every dollar invested, you get $1.30 back in present value.

In this scenario, even though the deluxe truck provides a larger total profit in NPV terms, the basic truck is actually more efficient in generating profit relative to the investment amount. If you have limited capital, investing in the basic truck might be a wiser choice because it gives you a better return for each dollar you put in. It’s like choosing between planting a small garden that yields a high amount of produce per seed versus a large farm that yields more total produce but less produce per seed.

So, to directly answer the question of how scale affects these metrics, NPV is directly proportional to the scale of the investment. Larger projects, assuming they are still profitable, tend to have larger NPVs. Profitability Index, being a ratio, is less directly affected by scale in terms of absolute value. It’s more about the relative efficiency of the investment. When comparing projects of very different sizes, especially when capital is constrained, PI can be incredibly useful in prioritizing projects that offer the highest return per dollar invested, even if they might not have the absolute highest NPV. NPV tells you the total value created, while PI tells you how efficiently that value is created for each unit of investment. Both are valuable tools, but they provide different perspectives on an investment’s worth, particularly as the scale of the investment changes.