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Advantages And Disadvantages Of Net Present Value (NPV)

Advantages Of Net Present Value (NPV)

1. NPV gives important to the time value of money.
2.In the calculation of NPV, both after cash flow and before cash flow over the life span of the project are considered.
3. Profitability and risk of the projects are given high priority.
4. NPV helps in maximizing the firm's value.

Disadvantages Of Net Present Value (NPV)

1. NPV is difficult to use.
2. NPV can not give accurate decision if the amount of investment of mutually exclusive projects are not equal.
3. It is difficult to calculate the appropriate discount rate.
4. NPV may not give correct decision when the projects are of unequal life.

1 comments:

Anonymous said...

What are the disadvantages of using net present value as an investment criterion?
By Chris Gallant

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.

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