General limitations of Net Present Value when applied to investment appraisal
NPV is a generally used technique employed in investment appraisal but is subject to a number of restrictive assumptions as well as limitations which call into question its general relevance. However if the assumptions and limitations are understood then its application is less likely to be undertaken in error.
A few of the difficulties with NPV are listed below
- NPV presumes that firms pursue an objective of maximising the wealth of their shareholders. This is doubtful given the wider range of stakeholders who might have conflicting interests to those of the shareholders.
- NPV is mainly redundant if organisations are not wealth maximising. For instance public sector organisations may wish to invest in capital assets but will use non profit objectives as part of their assessment.
- NPV is potentially a hard method to apply in the context of having to estimate what is the correct discount rate to use. This is particularly therefore when questions arise as to the incorporation of risk premier in the discount rate since an evaluation of the risk of the business or of the project in particular will have to be made and which may be difficult to discern. Other approaches to risk analysis such as sensitivity and decision trees are subject to fairly severe limitations.
- NPV suppose that cash surpluses can be reinvested at the discount rate. This is subject to other projects mortal available which produce at least a zero NPV at the chosen discount rate.
- NPV is able to most easily cope with cash flows arising at period ends and isn't a technique that is used easily when complicated mid-period cash flows are present.
- NPV isn't universally employed especially in a small business environment. The available evidence proposes that businesses assess projects in a variety of ways (IRR, payback, accounting rate of return). The reality that such methods are used which are theoretically inferior to NPV calls into question the practical benefits of NPV and therefore hints at certain practical limitations.
- The conclusion from NPV examination is the present value of the surplus cash generated from a project. If reported profits are significant to businesses then it is possible that there may be a conflict between undertaking a positive NPV project and potentially adverse consequences on reported profits. This will mainly be the case for projects with long horizons large initial investment and very delayed cash inflows. In such conditions businesses may prefer to use accounting measures of investment appraisal.
- Managerial incentive schemes mayn't be consistent with NPV particularly when long time horizons are involved. Thus managers possibly rewarded on the basis of accounting profits in the short term and may be encouraged to act in accordance with these objectives and thus ignore positive NPV projects. This may be a difficulty of the incentive schemes and not of NPV however a potential conflict exists and represents a difficulty for NPV.
- NPV treats all time periods evenly with the exception of discounting far cash flows more than near cash flows. In other sense NPV only accounts for the time value of money. To several businesses distant horizons are less important than near horizons if only because that is the environment in which they work. Other factors moreover applying higher discount rates may work to reduce the impact of distant years. For instance in the long term nearly all aspects of the business may change and hence a too-narrow focus on discounting means that NPV is of limited value and more so the further the time horizon considered.
- NPV is of restricted use in the face of non-quantifiable benefits or costs. NPV doesn't take account of non-financial information which may even be relevant to shareholders who want their wealth maximised. For instance issues of strategic benefit may happen against which it is difficult to immediately quantify the benefits but for which there are immediate costs. NPV would treat such a circumstances as an additional cost since it could not incorporate the indiscernible benefit.