NPV Advantages and Disadvantages
The advantages of the net present value includes the fact that it considers the time value of money and helps the management of the company in the better decision making whereas the disadvantages of the net present value includes the fact that it does not considers the hidden cost and cannot be used by the company for comparing the different sizes projects.
Net Present Value (NPV)(NPV)Net Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not. is one of the discounted cash flow techniques used in capital budgeting to determine the viability of a project or an investment. NPV is the difference between the present value of cash inflows and the current value of cash outflows over a while. The cash flows are discounted to the present value using the required rate of return. A positive NPV denotes a good recovery, and a negative NPV indicates a low return. Below is a summary of the advantages and disadvantages of NPV.
Advantages of using NPV
#1 – Time Value of Money
The primary benefit of using NPV is that it considers the concept of the time value of moneyConcept Of The Time Value Of MoneyThe Time Value of Money (TVM) principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment. i.e., a dollar today is worth more than a dollar tomorrow owing to its earning capacity. The computation under NPV considers the discounted net cash flows of an investment to determine its viability. To understand how present value figures are essential in capital budgetingCapital BudgetingCapital budgeting is the planning process for the long-term investment that determines whether the projects are fruitful for the business and will provide the required returns in the future years or not. It is essential because capital expenditure requires a considerable amount of funds., let us consider the following example –
A company is looking to invest $100,000 in a project. The required rate of return is 10%. The following are the projected earnings of project A and project B.
- Project A – Y1 – $10,000, Y2 – $12,000, Y3 – $20,000, Y4 – $42,000, Y5 – $55,000 and Y6 – $90,000.
- Project B– Y1 – $15,000, Y2 – $27,500, Y3 – $40,000, Y4 – $40,000, Y5 – $45,000 and Y6 – $50,000.
If the time value of money is not considered, the profitability of the projects would be the difference between the total inflows and total outflows, as depicted in the table below –
Judging by these figures, Project A would be considered profitable with a net inflow of $129,000.
In the same example, however, if the time value of money was considered,
*Discounted at 10%
Project B is more profitable in terms of the present value of future cash flows with a discounted net inflow of $49,855. Therefore, the time value of money must be considered to determine, more accurately, the ideal investment for a company.
#2 – Decision-Making
NPV method enables the decision-making process for companies. Not only does it help evaluate projects of the same size, but it also helps in identifying whether a particular investment is profit-making or loss-making.
Let us consider the following example –
A company is interested in investing $7500 in a particular venture. The required rate of return is 10%. The following are the projected inflows of the venture –
Y1 – $(500), Y2 – $800, Y3 – $2300, Y4 – $2500, Y5 – $3000.
NPV of the project (as computed using the formula) = $(1995.9)
In the given case, the present value of cash outflow is higher than the current value of cash inflows. Therefore, it is not a viable investment option. Another advantage of NPV is that it helps to maximize the earnings of the entity by investing in ventures which provide the maximum returns.
Disadvantages of Using Net Present Value
#1 – No Set guidelines to Calculate Required Rate of Return
The entire computation of NPV rests on discounting the future cash flows to its present value using the required rate of returnRequired Rate Of ReturnRequired Rate of Return (RRR), also known as Hurdle Rate, is the minimum capital amount or return that an investor expects to receive from an investment. It is determined by, Required Rate of Return = (Expected Dividend Payment/Existing Stock Price) + Dividend Growth Rate. However, there are no guidelines as to the determination of this rate. This percentage value is left to the discretion of companies, and there could be instances wherein the NPV was inaccurate due to an erroneous rate of returns.
Let us consider a project with an investment of $100,000 with the following inflows –
Y1 – $10,000, Y2 – $12,000, Y3 – $20,000, Y4 – $42,000, Y5 – $55,000 and Y6 – $90,000.
The following table depicts the changes to the NPV when the company chooses a different rate of return –
As depicted in the above table, changes in the rate of return have a direct impact on the NPV values.
Another disadvantage is that NPV does not take into account any changes in the rate of returns. The quality of recovery is considered stable for a project, and any variations in the rate of returns would require fresh NPV computation.
#2 – Cannot be used to Compare Projects of Different Sizes
Another disadvantage of NPV is that it cannot be used to compare projects of different sizes. NPV is an absolute figure and not a percentage. Therefore, the NPV of larger projects would inevitably be higher than a project of a smaller size. The returns of the smaller project may be higher than its investment, but overall the NPV value might be lower. Let us understand this better with the following example –
- Project A requires an investment of $250,000 and has an NPV of $197,000 whereas,
- Project B requires an investment of $50,000 and has an NPV of $65,000.
Judging by the absolute figures, project A is more profitable; however, project B has a higher return on its investment. Therefore, projects of different sizes cannot be compared using NPV.
#3 – Hidden Costs
NPV only takes into account the cash inflows and outflows of a particular project. It does not consider any hidden costs, sunk costs, or other preliminary costs incurredCosts IncurredIncurred Cost refers to an expense that a Company needs to pay in exchange for the usage of a service, product, or asset. This might include direct, indirect, production, operating, & distribution charges incurred for business operations. about the specific project. Therefore, the profitability of the project may not be highly accurate.
This has been a guide to the Advantages and Disadvantages of NPV. Here we discuss the NPV formula and examples to explain the advantages and disadvantages of Net present value. You can learn more about financing from the following articles –