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PREFERENCE DECISIONSTHE RANKING OF INVESTMENT PROJECTS

LEARNING OBJECTIVE 2
1. Rank investment projects in order of preference.
Chapter 11 LO 2 Interactive Presentation
Recall that when considering investment opportunities, managers must make two types of decisions
screening decisions and preference decisions. Screening decisions, which come first, pertain to whether or
not a proposed investment is acceptable. Preference decisions come after screening decisions and attempt to
answer the following question: How do the remaining investment proposals, all of which have been
screened and provide an acceptable rate of return, rank in terms of preference? That is, which one(s) would
be best for the company to accept?
Sometimes preference decisions are called rationing decisions, or ranking decisions. Limited investment
funds must be rationed among many competing alternatives. Hence, the alternatives must be ranked.
The net present value of one project cannot be directly compared to the net present value of another project
unless the initial investments are equal. For example, assume that a company is considering two competing
investments, as shown below:

Investment

Investment required.....

$(10,000)$(5,000)

Present value of cash inflows..... 11,000 6,000

Net present value.....

$1,000 $1,000

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Although each project has a net present value of $1,000, the projects are not equally desirable if the funds
available for investment are limited. The project requiring an investment of only $5,000 is much more
desirable than the project requiring an investment of $10,000. This fact can be highlighted by dividing the net
present value of the project by the investment required. The result, shown below in equation form, is called
the project profitability index.

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The project profitability indexes for the two investments on the previous page would be computed as follows:

Investment

Net present value (a).....

Investment required (b).....

$1,000$1,000
$10,000$5,000

Project profitability index, (a) (b).....

0.10

0.20

When using the project profitability index to rank competing investments projects, the preference rule is: The
higher the project profitability index, the more desirable the project.6 Applying this rule to the two
investments above, investment B should be chosen over investment A.
The project profitability index is an application of the techniques for utilizing constrained resources discussed
in an earlier chapter. In this case, the constrained resource is the limited funds available for investment, and
the project profitability index is similar to the contribution margin per unit of the constrained resource.
A few details should be clarified with respect to the computation of the project 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.
IN BUSINESS Fedex Goes GreenWell, Not Exactly!
IN BUSINESS
Fedex Goes GreenWell, Not Exactly!
In 2003, FedEx announced a 10-year plan to replace 3,000 delivery trucks per year with environmentally
friendly hybrid vehicles, thereby eliminating 250,000 tons of greenhouse gases per year. The hybrid vehicles
cost 75% more than conventional trucks, but over 10 years they generate fuel savings that offset the higher
cost. By 2007, FedEx had purchased less than 100 hybrid vehicles because management decided that the
eco-friendly investment was not the most profitable use of the company's resources. FedEx's environmental

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director justified the company's actions by saying we do have a fiduciary responsibility to our shareholders
we can't subsidize the development of this technology for our competitors.

This example illustrates the challenges that companies face when attempting to satisfy the expectations of
various stakeholders. Perhaps FedEx shareholders would applaud the company's decision to retreat from its
10-year plan, whereas environmentally conscious customers may criticize the company's actions. What do
you think?
Source: Ben Elgin, Little Green Lies, BusinessWeek, October 29, 2007, pp. 4552.

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