While net present value (NPV) calculations are useful when valuing investment opportunities, the process is by no means perfect. Thus, NPV is a useful starting point for valuing investments, but it is not a definitive metric that an investor should rely on for all investment decisions.
NPV and Investing
In some instances, money in the present is worth more than the same amount of money in the future. Money loses value over time due to inflation. Also, money invested in one way could be invested in another that might provide a higher return. In other words, it is possible that a dollar earned in the future will be less than a dollar earned in the present. The discount rate element of the NPV formula accounts for the potential drop in value because it subtracts the current value of invested cash from the current value of the expected cash flows.
For example, an investor could receive $100 today or a year from now. Most investors would not be willing to postpone payment. However, what if an investor could choose to receive $100 today or $105 in one year? The 5% rate of return for waiting one year might be worthwhile for an investor unless there was an alternative investment that could yield a rate greater than 5% over the same period.
If an investor knew they could earn 8% from a relatively safe investment over the next year, they would choose to receive $100 today and not for the choice with a 5% rate of return. In this case, the 8% is called the discount rate.
NPV and Discount Rate Sensitivity
The biggest disadvantage to the calculation of NPV is its sensitivity to the discount rate. After all, NPV is 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) calculation is critical in determining what the final NPV number will be. A small increase or decrease in the discount rate will have a considerable effect on the final output.
For example, consider an investment that would cost $4,000 upfront today but is expected to pay $1,000 in annual profits for five years (for a total nominal amount of $5,000) beginning at the end of this year. Using a 5% discount rate in the NPV calculation, five $1,000 payments are equal to $4,329.48 in today's dollars. Subtracting the $4,000 initial payment gives an NPV of $329.28.
However, raising the discount rate from 5% to 10% results in a very different NPV. At a 10% discount rate, the investment's cash flows add up to a present value of $3,790.79. Subtracting the $4,000 initial cost from this amount gives an NPV of -$209.21. Simply by adjusting the rate, the investment had changed from one that creates value to one that loses value.
Selecting a Discount Rate—The Disadvantage of Using NPV
How does an investor know which discount rate to use? Accurately pegging a percentage number to an investment to represent its risk premium is not an exact science. If the investment is safe with a 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? Because NPV calculations require the selection of a discount rate, they can be unreliable if the wrong rate is selected.
Making matters even more complex is the possibility that the investment will not have the same level of risk throughout its entire time horizon.
In our example of a five-year investment, how should an investor calculate NPV if the investment had a high risk of loss for the first year but a relatively low risk for the last four years? The investor could apply different discount rates for each period, but this would make the model even more complex and require the pegging of five discount rates.
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 our five-year investment example again. Suppose the investment is in a startup technology company that is currently losing money but is expected to expand significantly within three years. If an investor is confident that expansion will occur, they should incorporate the value of that option into the total NPV of the investment. However, the standard NPV formula provides no way to include the value of real options.