 The Profitability Index is a capital budgeting tool that allows us to rank projects based on the number of dollars returned for each dollar invested. It is useful because often projects with large initial investments tend to have larger net present values than projects with smaller investments. Yet the smaller project may be more profitable per dollar invested. I think an example is the best way to demonstrate this. REM is considering three capital projects, all with positive net present values. The Radio Free Europe project has net present value of $500,000. The Man on the Moon project has net present value of $1.6 million, and it's the end of the world as we know it project has net present value of $2 million. Since capital is limited, which should they choose? Well, based on the net present values, it appears that we should choose it's the end of the world as we know it project, which has net present value of $2 million. But perhaps we should apply the Profitability Index to these projects and see if that is true. This is a common template used for profitability index analysis. The calculation for profitability index is net present value divided by initial investment. So you can see I completed the table. Once we compare net present value to their initial investments of the project, it appears that the best project is Radio Free Europe, as it returns $2 for every dollar invested. When capital rationing limits the number of projects, ranking projects from highest to lowest profitability index shows the greatest dollar earned per dollar invested.