Ranking Investment Projects - The Preference Decisions:
Learning Objectives:
- Define and explain screening and
preference decisions.
- 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. |
