Question

Net Present Value, Internal Rate of Return, and Pay Back Period are decision rules used to evaluate the possibility of investments in capital projects. NPV>0, IRR>Hurdle Rate (or IRR>Cost of Capital), and acceptable Pay Back Period relative to capital constraints.

How are these rules challenged amid the pandemic and do you envision corporations relaxing or tightening the application of these rules in their corporate planning processes moving forward, as they navigate their response to unprecedented circumstances? What other "rules" / types of rules do you envision being implemented, and why?

Answer 1

Answer:

The pandemic has affected the economy badly. Every business has suffered downfall due to the lockdown during this pandemic scenario. As a result of it, businesses have remained shut down for a long period causing stoppage in production & running of business whereas the Fixed Cost have continued to occur. Thus causing shortage of cash reserves for the businesses. The labourers have moved from the cities causing shortage of labour supply leading to increased labour rates. All these factors have affected the investment in capital projects. I see the corporations tightening the application of rules such as NPV, IRR, Payback period as a method to evaluate the investment as the projects that take longer duration to payback the investment or the projects that require more investment than returns cannot be taken up because of already cash reserves shortages & increased costs especially fixed costs, otherwise it will hamper the going concerns of the businesses.

Other than these rules, following methods can be used:

(i) Accounting rate of return: this method can be used beacuse it is not concerned with cash flows but rather based upon profits which are reported in annual accounts and sent to shareholders. Unlike payback period method, this method does take into consideration total project period. In case there are various capital investment proposals being considered, a quick decision can be taken by use of ranking the investment proposals. If higher profits are required to be achieved, this is certainly a way of achieving them.

(ii) Profitability Index: It is the present value of an anticipated future cash inflows divided by the initial outlay. A project is acceptable if its profitability index value is greater than 1. This method is also called benefit-cost ratio. It can be useful to consider whether the benefit is greater than the cost involved or not.

(iii) Discounted Payback Period Method: In this method the cash flows involved in a project are discounted back to present value terms. The cash inflows are then compared to the original investment in order to identify the period taken to payback the original investment in present values terms. It can be used beacuse it ensures that altleast minimum required return is achieved. In addition to the recovery of cash investment, the cost of financing the investment during the time that part of the investment remains unrecovered is also provided for.