NPV Problems

Several problems inherent in the use of Net Present Value are :

Reinvestment Assumption

The Net Present Value method incorporates an assumption that all cash inflows from the project will be reinvested at the required rate of return, which may not be the case. The project’s cash inflows probably cannot be reinvested in the same project because that project will most likely not need more money invested. Furthermore, even if the cash flows could be reinvested in the same project, there is no reason to believe that additional investment would increase cash inflows. Since a project’s cash flows probably cannot earn a return from the same capital project, they would need to be invested elsewhere. The alternative investment of the cash inflows may or may not generate as high a rate of return as the initial capital project. The assumption that the cash inflows from a project can be reinvested at the same rate used in the NPV calculation may lead to an incorrect evaluation of the project’s true worth.

NPV Expressed as a Monetary Amount

Since the NPV is expressed as a monetary amount, it does not provide an expected rate of return on the investment. The NPV can indicate whether a project’s rate of return is higher or lower than the required rate of return, but it cannot provide the project’s actual rate of return.

Incorrect Assumptions Affect Validity

Assumptions made in the calculation of the NPV may be incorrect, and the incorrect assumptions can affect the validity of the results. The risk can be mitigated by using a higher than usual required rate of return, which causes the resulting NPV to be lower. A lower NPV increases the probability that the project will be judged unacceptable

The Discount Rate Used Affects the Results

The discount rate used may be very different from the firm’s actual cost of capital due to market fluctuations. Over the term of a project, the actual change in shareholders’ value can vary significantly from the initial estimates.

Cash Flows Beyond the Project’s Term

A project may provide cash flows beyond its initial expected lifetime, which can provide additional shareholder value; but those additional cash flows are not recognized in the NPV analysis.