The net present value (NPV) method can be a very good way to analyze the profitability of an investment in a company, or a new project within a company. But like many methods in finance, it is not the end-all, be-all solution -- it carries a few unique advantages and disadvantages that may not make it useful for some investment decisions.
How net present value worksThe basic tenet of the net present value method is that a dollar in the future is not worth as much as one dollar today. Thus, net present value calculates the present value of future cash flows in excess of the present value of the investment outlay.
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Suppose you have an opportunity to invest $15,000 to expand your business. You believe that this investment will generate $3,000 in cash flow for the next 10 years. Your capital cost is 10% per year.
The table below shows the cash flows (positive and negative) that we expect this project to create, and present value of each cash flow over the 10-year period.
By discounting every future $3,000 cash flow back at a rate of 10%, and subtracting the initial cash outlay of $15,000, we arrive at a net present value of $3,433.70 for this project. Under the NPV method, you should choose to do this project, since the net present value is positive.
Advantages of the NPV methodThe obvious advantage of the net present value method is that it takes into account the basic idea that a future dollar is worth less than a dollar today. In every period, the cash flows are discounted by another period of capital cost.
The NPV method also tells us whether an investment will create value for the company or the investor, and by how much in terms of dollars. In the example above, we found that the $15,000 investment would increase the company's value by $3,443.70 when all cash flows were discounted back to today.
The final advantages are that the NPV method takes into consideration the cost of capital and the risk inherent in making projections about the future. In general, a projection of cash flows 10 years into the future is inherently less certain than cash flows projected next year. Cash flows that are projected further in the future have less impact on the net present value than more predictable cash flows that happen in earlier periods.
Disadvantages of NPVThe biggest disadvantage to the net present value method is that it requires some guesswork about the firm's cost of capital. Assuming a cost of capital that is too low will result in making suboptimal investments. Assuming a cost of capital that is too high will result in forgoing too many good investments.
In addition, the NPV method is not useful for comparing two projects of different size. Because the NPV method results in an answer in dollars, the size of the net present value output is determined mostly by the size of the input.
For example, a $1 million project will likely have a much higher NPV than a $1,000 project, even if the $1,000 project provides much higher returns in percentage terms. If capital is scarce -- and it usually is -- the NPV method is a poor method to use because projects of different size are not immediately comparable based on the output.
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