Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.
While net present value (NPV) calculations are useful when you are valuing investment opportunities, the process is by no means perfect.
The limitations of NPV are as follows:
- The NPV is expressed in absolute terms rather than relative term and hence does not factor in the scale of investment.
- The NPV rule does not consider the life of the project. Hence, when mutually exclusive projects with different lives are being considered, the NPV rule is biased in favor of the longer term project.
- NPV is based on future cash flows and the discount rate, both of which are hard to estimate with 100% accuracy.
- There is an opportunity cost to making an investment which is not built into the NPV calculation.
Essentially, net present value measures the total amount of gain or loss a project will produce compared to the amount that could be earned simply by saving the money in a bank or investing it in some other opportunity that generates a return equal to the discount rate.