Ranking Investment Projects – The Preference Decisions:

Learning Objectives:

1. Define and explain screening and preference decisions.
2. Rank investment projects in order of preference.

When considering investment opportunities, managers must make two types of decisions―screening decisions and preference decisions.

Screening and Preference Decisions:

Screening decisions:

Relate to whether a proposed project meets some preset standard of acceptance. For example, a firm may have a policy of accepting projects only if they promise a retune of, say, 20% on the investment. The required rate of return is the minimum rate of return a project must yield to be acceptable.

Preference decisions:

Relate to selecting from among several competing courses of action. To illustrate, a firm may be considering several different machines to replace an existing machine on the assembly line. The choice of which machine to purchase is a preference decisions. Preference decisions are more difficult to make than screening decisions because investment funds are usually limited. This often requires that some (perhaps many) otherwise very profitable investment opportunities must be passed up. Sometime preference decisions are called rationing decisions, or ranking decisions. Limited investment funds must be rationed among many competing alternatives, or the alternatives must be ranked. Either the internal rate of return method or the net present value method can be used in making preference decisions. However, if the two methods are in conflict, it is best to use the net present value method, which is more reliable.

Internal Rate of Return Method:

When using the internal rate of return method to rank competing investment projects, the preference rule is: The higher the internal rate of return, the more desirable the project. An investment project with an internal rate of return of 18% is usually considered preferable to another project that promises a return only 15%. Internal rate of return is widely used in ranking investment projects.

Net Present Value Method:

Unfortunately, the net present value of one project cannot be directly compared to the net present value of another project unless the investments are of equal size.

Example:

Assume that a company is considering two competing investments, as shown below.

 Investment required Present value of cash inflows Net present value Investments A \$(80,000) \$81,000 ——— \$1,000 ======= B \$(5,000) \$6,000 ——– \$1,000 ======

Each project has a net present value of \$1,000, but the projects are not equally desirable. When funds are limited, the project requiring an investment of only \$5,000 is much more desirable than the project requiring an investment of \$80,000. To compare the two projects on a valid basis, the present value of the cash inflows should be divided by the investment required, The result is called the profitability index.

The formula for the profitability index:

[Profitability index = Present value of cash inflows / Investment required]

The profitability index for the two investments above would be computed as follows:

 Present value of cash inflows (a)Investment required (b) Profitability index, (a) ÷ (b) Investments A \$81,000 ======= \$80,000 ======= 1.01 ======= B \$6,000 ======= \$5,000 ======= 1.20 =======

When using the profitability index to rank competing investments projects, the preference rule is: The higher the profitability index, the more desirable the project. Applying this rule to the two investments above, investment B should be chosen over investment A.

The profitability index is an application of the techniques for utilizing scarce resources. In this case, the scarce resource is the limited funds available for investment, and the profitability index is similar to the contribution margin per unit of the scarce resource.

A few details should be clarified with respect to the computation of the profitability index. The “investment required” refers to any cash outflows that occur at the beginning of the project, reduced by any salvage value recovered from the sale of old equipment. The “investment required” also includes any investment in working capital that the project may need. Finally, we should note that the “Present value of cash inflows” is net of all outflows that occur after the project starts.

The net present value and internal rate of return methods have gained widespread acceptance as decision-making tools. Other methods of making capital budgeting decisions are also used and are preferred by some managers. Two of these methods are payback method and simple rate of return. Both methods have been in use for many years, but have been declining in popularity as primary tools for project evaluation.