While net today value (NPV) calculations are useful when you are valuing investment opportunities, the process is by no means perfect.
For review, money in the hand-out is worth more than the same amount of money in the future because of inflation, and earnings from alternative investments that could be elect during the period. In other words, a dollar earned in the future won’t be worth as much as one earned in the present. The discount status element of the NPV formula is a way to account for this.
For example, an investor could receive $100 today or a year from now. Ton 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% status of return for waiting one year might be worth it for an investor, unless there was an alternative investment that could throw in the towel a rate greater than 5% over the same period.
If an investor knew they could earn 8% from a to some degree safe investment over the next year, they would want $100 today and not opt to invest in the 5% investment. In this the actuality, the 8% is called the discount rate.
The biggest disadvantage to the calculation of NPV is its sensitivity to discount rates. After all, NPV computations are in effect just a summation of multiple discounted cash flows – both positive and negative – converted into present value span of times for the same point in time (usually when the cash flows begin). As such, the discount rate used in the denominators of each tender value (PV) computation is critical in determining what the final NPV number will turn out to be. A small increase or decrease in the mark-down rate will have a considerable effect on the final output.
Let’s say you were trying to value an investment that wish cost you $4,000 upfront today but was expected to pay you $1,000 in annual profits for five years (for a total nominal amount of $5,000), commencement 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 endorse payment, you are left with an NPV of $329.28.
However, if you raise the discount rate from 5% to 10%, you get a very different NPV development. At a 10% discount rate, your investment’s cash flows add up to a present value of $3,790.79. Subtract the $4,000 incipient cost from this amount, and you’re left with a negative NPV of $209.21. Simply by adjusting the rate, you have gone from must an investment that creates $329.28 of value to having one that loses $209.21 instead.
How do you know which omit 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 darned safe, with low risk of loss, 5% may be a reasonable discount rate to use, but what if the investment harbors enough jeopardize to warrant a 10% discount rate? Bottom line, since NPV calculations require a discount rate, there is no way to get surrounding 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 bear the same level of risk throughout its entire time horizon. In our example of a five-year investment, how would you handle a employment in which the investment had a high risk of loss for the first year, but relatively low risk for the last four? You can try to use different disregard rates for each time period, but this will make your model even more complex and press for a lot on your part to peg not only one discount rate accurately, but five. This is another disadvantage to using the NPV model.
For good, another major disadvantage to using NPV as an investment criterion is that it wholly excludes the value of any real options that may prevail within the investment. Consider our five-year investment example again – suppose this is a startup technology company, which is currently trifle away money but is expected to have the opportunity to expand greatly within three years. If you know the company has this valuable actual option of expansion in the future, shouldn’t you incorporate the value of that option into the total NPV of the investment? Clearly, the riposte is “yes,” but the standard NPV formula provides no way to include the value of real options.