Net Present Value (NPV) is the difference between the current value of cash inflows and the present value of cash outflows. This figure gets based on a specific time period, and it is useful for capital budgeting and investment planning. This process provides a straightforward way to analyze the profitability of a potential project of investment.
The summation notation of NPV equals TVECF – TVIC.
When there is a positive NPV, then this outcome indicates that the projected earnings from an investment or project exceeds the anticipated costs in present dollars. The assumption is that an investment with a positive Net Present Value will be profitable, while one with a negative ratio will result in a net loss.
Several advantages and disadvantages of Net Present Value are worth reviewing when considering the financial situation of a project or new investment.
List of the Advantages of Net Present Value
1. It takes into account that a dollar today is worth more than a dollar tomorrow.
When you look at the value of a single dollar throughout U.S. history, dramatic changes have occurred over the past century. The impact that this amount makes on personal and corporate finances as time passes grows less. That means the NPV will discount the cash flows by another period of capital cost to ensure that the projections have more accuracy. If every future cash flow of $3 million received a discount back at 10%, then the ratio would get based on $3.3 million for the entire project.
2. NPV allows risk factors to enter into the calculation.
Cash flows are always uncertain. Even when an agency has a regular pattern of incoming or outgoing figures, there are no guarantees that this money movement will continue. The Net Present Value works to account for this risk so that investors can get a clearer picture of what to expect over the lifetime of a project.
This advantage makes it easier to see if profitability is possible from a potential activity. Having an understanding of what the final costs of a project are can also lead to better future decisions because of the information the NPV offers.
3. It takes the cost of capital and risk factors into consideration.
It considers risk and capital costs when making future projections. Cash flows that are up to ten years into the future are much less certain than one that will happen in the next 12 months. This ratio considers the projections from the most recent years as a more valuable resource than the ones that are at the end of the forecast period.
This advantage is the reason behind the unique accuracy that the NPV holds as an evaluation tool for agencies and investors.
4. NPV can determine what the value outcomes could be.
Net Present Value is a critical component of what is called the “profitability index.” This took looks at what a potential investment could offer to the value of a business, providing an opportunity to see if an infusion of capital can improve the firm’s bottom line. When this figure comes back positively, then investors know that an opportunity is present. Then you can determine if the value an organization or investor provides can help everyone involved in the project or get lost in the shuffle with everything else.
5. It takes all cash flows from a project into consideration.
Some investment ratios only use the published cash flows from an organization to determine the Net Present Value available for a project. Others exclude specific ones that may not directly impact the results of an investment. The NPV is a popular tool to use because it takes a different approach. You must use every cash flow that a business generates, including any that may be off of the books. It’s the only way to calculate the final equation correctly.
This advantage means that investors have access to valuable data to help them determine if a specific activity makes sense
6. It gives you ranking information about projects while rationing capital.
Investments frequently occur in the corporate world. The Net Present Value does more than calculate an equity investment for individuals. Businesses can also use this ratio to determine if specific projects are worth a future investment. The figures developed from this model can let everyone know if one project will be more profitable than another. That allows for the selection of the better option for long-term development and growth from either a percentage-based or total-value perspective.
7. NPV tells you if an investment can create value.
Net Present Value method lets us know if an investment has a strong likelihood of creating value of an investor or agency. It will describe that advantage by looking at the actual expected increase that’s expected in time, even when all cash flows get discounted back to today. Although there isn’t a 100% guarantee that any investment will follow its NPV, this information can get used with other tools to provide a fairly clear picture of an expected outcome.
8. Net Present Value ratio is easy for the average investor.
The formula used to create the NPV is one that uses simple division to produce meaningful information. As long as you know the current value of every cash flow and the initial available investment, then you can ascertain the ratio through this tool.
Although more than just this one ratio should get used when making an investment decision, the answer it provides will give investors a base value of 1 to consider. If the result is less than that figure, then the project has more risk connected with it. If the calculation is above it, then there are fewer risks affiliated with the project.
9. It doesn’t work on the assumption of reinvestment.
Using Net Present Value makes sense for investors because it doesn’t assume that cash flows will automatically go into the Internal Rate of Return (IRR). IRR is the interest rate at which the NPV of all cash flows, both positive and negative, equal zero. Reinvesting the cash flows in IRR would mean that a business is investing back the cash flows from its project into the market at the equivalent rate as that of its effort’s rate of return. It would be best if a company in this position found another investment yielding the same returns as your project for the reinvestment effort in this circumstance.
List of the Disadvantages of Net Present Value
1. It is highly sensitive to the discount rate used.
Net Present Value has a significantly high sensitivity to the discount rate when figuring out this ratio because it’s the summation of multiple discounted cash flows. It then takes positive and negative information to convert the figures into a present value. The discount rate used in the denominators of each present value calculation is a crucial component in the determination of the final NPV figures. If there are small increases or decreases in this figure, then it can have a considerable impact on the final output.
2. The only way to get to the value is through guesswork.
Net Present Value must guess at what a company’s cost of capital will be in the future. If one assumes that this figure is too low, then the outcome will be a series of suboptimal investments. When it is too high, then the ratio will keep people away from a lot of good investments. That’s why it can be useful to take data from a variety of providers before calculating this ratio so that it is easier to obtain a clear picture of what to expect.
3. NPV typically focuses on short-term projects because of future uncertainties.
Net Present Value produces an investment ratio that typically focuses on short-term projects instead of looking for long-term results. If a company were to evaluate a project looking at the near-term profit potential it creates, then the decision-makers may undervalue what the long-term profitability of a project could be.
When the NPV gets used with the profitability index, then the ratios tend to score short-term gains better than long-term benefits. This disadvantage means that some companies may select the incorrect project to pursue when comparing their options.
4. NPV ignores the “sunk cost” figures in cash flow calculations.
When a project is first getting started, capital budgeting tasks classify the incurred costs that happen before a starting date as a “sunk cost.” Let’s say that an organization has research and development expenses for a project to pay before it reaches the groundbreaking stage of a project – then the R&D costs would qualify in the NPV ratio.
When the NPV works with the profitability index, it does not consist of these expenses as part of the cash outflows that get calculated when determining this ratio. Ignoring these expenses could have significant consequences for a business that includes the rejection of a financing plan because the data from the Net Present Value got used.
5. Some costs can be almost impossible to estimate when calculating the NPV.
The cash inflows and outflows are not the only estimates that get used when calculating a Net Present Value. Although they are the primary components of the equation, one must also estimate the opportunity cost. This figure gets defined as an expense that occurs by not accepting alternatives that could have generated a positive cash inflow.
Some companies may not even try to calculate these expenses. If the alternatives are challenging to estimate, then the results from the NPV may not have the desired levels of accuracy or authenticity.
6. It does not compare two projects of different sizes.
Net Present Value method of calculation isn’t useful for comparing projects of different sizes. If you have a $10,000 and $1 million project that you’re reviewing, the latter option is going to have a much higher NPV even if the former one has a higher percentage return available in the calculation. Since capital is always considered scare, this option is a poor method to use because the output of each project doesn’t compare well.
If you were to choose the one with the higher percentage, then the amount of future profits could be much lower. Earning 20% on $10,000 ($2,000) is not as spectacular as earning 10% on $1 million ($100,000). If an investor went by the percentage alone, the loss of potential would be considerable.
7. NPV often takes an optimistic approach to future calculations.
Net Present Value usually gets calculated by teams or individuals that are close to the projects getting examined by this resource. Investors often look at equity possibilities that they feel closest to at first, like when a leadership team calculates the NPV with optimistic figures because of their hopes to have a specific project conclude successfully.
Before making a final determination, a review of all cash flow predictions must happen because internal projections are often set too high. This disadvantage then creates an upward bias when trying to build a final estimate.
8. Choosing a specific discount rate can be almost impossible with NPV.
How does an investor know what discount rate to use when calculating NPV? The ability to accurately peg a percentage estimate to an investment that represents its risk premium is not an exact science. If the investment is safe and comes with a low risk of loss, then 5% might be a reasonable discount rate to use.
What if the investment holds enough risk to justify a 10% discount rate? Because the calculations for Net Present Value dictate the selection of a discount rate, it can be an unreliable tool to use if an incorrect standard gets selected.
9. Risk levels can change for a project as time passes.
What makes the NPV challenging to calculate is its expectation that risk continues at the same level over the lifetime of the effort. What happens if there are significant risks to manage during the first year of a project, but that figure reduces dramatically in the next three years of a four-year effort? Investors could apply a different discount rate for each expected change, but then that would eliminate the efficiencies found in using this calculation in the first place.
When risk levels change over the lifetime of a project, then the Net Present Value ratio becomes a less reliable tool to use.
10. NPV may not boost the earnings or return on equity for a company.
Because there is such an emphasis on Net Present Value and short-term projects, the decisions made to pursue projects like these might not boost the earnings per share or the return on equity for the business. These two outcomes are what will increase shareholder value over time, which means this ratio tends to work against the outcomes that those with equity ownership expect.
When an organization makes an investment, it becomes the first cash flow that the Net Present Value calculates. You must identify the number of periods that generate monthly cash flow, and then include the discount rate. These figures allow you to determine the periodic rate.
Then you must assume that the monthly cash flows happen at the end of the month. All future payments happen regularly, but they get deducted by periodic rate to determine the NPV. Each recurring payment receives an additional multiplier, reducing the overall value by that amount.
When looking at the advantages and disadvantages of Net Present Value, there are some specific qualities that must get taken into consideration with this calculation. It can be a useful resource to look at a project’s future potential, but the weaknesses of this approach can sometimes lead decision-makers down an incorrect path.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.