A:

While net present value (NPV) calculations are useful when you are valuing investment opportunities, the process is by no means perfect.

The biggest disadvantage to the calculation of NPV is its sensitivity to discount rates. After all, NPV computations are really just a summation of multiple discounted cash flows - both positive and negative - converted into present value terms for the same point in time (usually when the cash flows begin). As such, the discount rate used in the denominators of each present value (PV) computation is critical in determining what the final NPV number will turn out to be. A small increase or decrease in the discount rate will have a considerable effect on the final output.

Let's say you were trying to value an investment that would cost you $4,000 up front today, but was expected to pay you $1,000 in annual profits for five years (for a total nominal amount of $5,000), beginning at the end of this year. If you use a 5% discount rate in your NPV calculation, your five $1,000 payments are equal to $4,329.48 of today's dollars. Subtracting the $4,000 initial payment, you are left with an NPV of $329.28. (To learn more about calculating NPV, see Understanding The Time Value Of Money and Anything But Ordinary: Calculating The Present And Future Value Of Annuities.)

However, if you raise the discount rate from 5% to 10%, you get a very different NPV result. At a 10% discount rate, your investment's cash flows add up to a present value of $3,790.79. Subtract the $4,000 initial cost from this amount, and you're left with a negative NPV of $209.21. Simply by adjusting the rate, you have gone from having an investment that creates $329.28 of value to having one that destroys $209.21 instead.

Of course, you'll want to undertake the investment if 5% is the correct rate to use, and reject it if 10% is the correct rate. But how do you know which discount rate to use? Accurately pegging a percentage number to an investment to represent its risk premium is hardly an exact science. If the investment is very safe, with low risk of loss, 5% may be a reasonable discount rate to use, but what if the investment harbors enough risk to warrant a 10% discount rate? Bottom line, since NPV calculations require a discount rate, there is no way to get around this issue; therefore, it is a big disadvantage to the NPV methodology.

Making matters even more complex is the possibility that your investment won't have the same level of risk throughout its entire time horizon. In our example of a five-year investment, how would you handle a situation in which the investment had high risk of loss for the first year, but relatively low risk for the last four? You can try to use different discount rates for each time period, but this will make your model even more complex and require a lot on your part to peg not only one discount rate accurately, but five. This is another disadvantage to using the NPV model.

Finally, another major disadvantage to using NPV as an investment criterion is that it wholly excludes the value of any real options that may exist within the investment. Consider again our five-year investment example - suppose this is a startup technology company, which is currently losing money but is expected to have the opportunity to expand greatly in three years' time. If you know the company has this valuable real option of expansion in the future, shouldn't you incorporate the value of that option into the total NPV of the investment? Clearly, the answer is "yes", but the standard NPV formula provides no way to include the value of real options. (For further reading, see An Introduction To Real Options.)

Thus, NPV is a useful starting point to value investments, but certainly not a definitive answer that an investor can rely on for all investment decisions. To learn more, check out Discounted Cash Flow Analysis and What's the difference between net present value and internal rate of return?

RELATED FAQS
  1. When and why should the terminal value be discounted?

    Find out why investors use the terminal value, why the terminal value is discounted to the present day, and how it's related ... Read Answer >>
  2. Which of the following is not needed to calculate the net present value of an investment?

    A. The amount of interest expected to be generated each year B. The time horizon – how long the investment is expected to ... Read Answer >>
  3. How do you use net present value to calculate a capital budget?

    Learn about the net present value calculation (NPV) and how the NPV rule is used in capital budgeting to compare the expected ... Read Answer >>
  4. How is perpetuity used in determining the intrinsic value of a stock?

    Learn about the basics of a perpetuity, its valuation, how it is calculated and how it is used when evaluating the intrinsic ... Read Answer >>
  5. What is the formula for calculating net present value (NPV) in Excel?

    Understand how net present value is used to estimate the anticipated profitability of projects or investments, and how to ... Read Answer >>
Related Articles
  1. Financial Advisor

    A Guide on the Risk-Adjusted Discount Rate

    When a project or investment faces higher amounts of risk or uncertainty, it may be appropriate to utilize the risk-adjusted discount rate.
  2. Small Business

    Calculating Net Present Value at Different Points Using Excel

    Calculating the net present value (NPV) of your investment projects using Excel.
  3. Investing

    Understanding the Time Value of Money

    Find out why time really is money by learning to calculate present and future value.
  4. Investing

    Time Value Of Money: Determining Your Future Worth

    Determining monthly contributions to college funds, retirement plans or savings is easy with this calculation.
  5. Small Business

    Capital Budgeting: Which is Better, IRR or NPV?

    Using internal rate of return and net present value for capital budgeting evaluations often end in the same result. But there are times when using NPV to discount cash flows makes more sense.
  6. Financial Advisor

    Value Investing Strategies in a Volatile Market

    Volatile markets are a scary time for uneducated investors, but value investors use volatile periods as an opportunity to buy stocks at a discount.
  7. Investing

    Calculating the Present Value of an Annuity

    The present value of an annuity is the current, lump sum value of periodic future payments as calculated using a specific rate.
  8. Investing

    Key Fundamental Investment Metrics

    Fundamental investors believe certain factors dictate a stock’s performance. There are a few key indicators that fundamental investors should know.
  9. Investing

    Using the Dividend Discount Model

    The dividend discount model is a way of applying net present value analysis to estimate the future dividends a stock will pay. Those dividends are then discounted back to their present value. ...
RELATED TERMS
  1. Present Value - PV

    The current worth of a future sum of money or stream of cash ...
  2. Discounting

    The process of determining the present value of a payment or ...
  3. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present ...
  4. Rate Of Return

    The gain or loss on an investment over a specified period, expressed ...
  5. Discounted Future Earnings

    A method of valuation to estimate the value of a firm.
  6. 1%/10 net 30

    A way of providing cash discounts on purchases. It means that ...
Hot Definitions
  1. Profitability Index

    An index that attempts to identify the relationship between the costs and benefits of a proposed project through the use ...
  2. Restricted Stock Unit

    Compensation offered by an employer to an employee in the form of company stock. The employee does not receive the stock ...
  3. Operating Ratio

    A ratio that shows the efficiency of a company's management by comparing operating expense to net sales. Calculated as:
  4. Expense Ratio

    A measure of what it costs an investment company to operate a mutual fund. An expense ratio is determined through an annual ...
  5. Pro Forma

    A Latin term meaning "for the sake of form". In the investing world, it describes a method of calculating financial results ...
  6. Trumpcare

    The American Health Care Act, also known as Trumpcare and Ryancare, is the Republican proposal to replace Obamacare.
Trading Center