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Merits and demerits of using NPV as an investment evaluation method
Net Present Value or NPV is a true measure of an investment’s profitability and gain. However, like all the other methods, the NPV calculation has its own merits and demerits.
Merits of NPV Method
Following are the merits of using the NPV Method as an investment evaluation method −
NPV deals with the time value of money. According to the time value principle, a rupee today is more in worth than a rupee tomorrow. Including time value helps the principle earn true profits on a future date.
NPV is the measure of true profitability as considers all cash flows of the investment. Estimating and adjusting the cash flows make NPV a true way to measure the profits of an investment project. Depending on estimated cash inflows rather than any other arbitrary method makes the process effective and resilient.
NPV relies on the value additivity principle which states that the total value of NPV is equal to the added sum of individual subsidiaries of the project. This helps in accurately measure the true worth of an investment.
The best virtue of NPV is that it is aimed to maximize shareholders’ wealth. By estimating and measuring the shareholders’ wealth, NPV offers a true insight into the profitability of the project.
Demerits of NPV Method
Following are the demerits of using the NPV Method as an investment evaluation method −
The NPV process considers cash flows in the future at the present value which may not be correct practically. In fact, the cash inflows and outflows estimates may not even occur in the future. Therefore, NPV is not a completely flawless procedure.
The measurement of discount rate is also erroneous in the case of NPV. Although much care is taken to appropriately measure the discount rate, it is impossible to find the most accurate rate for NPV calculation at any time.
In case of mutually exclusive investments or investments that are equivalent, NPV may not identify the best project. This is so because the results of the projects may not be known to managers in general or ahead of time. It is hard to identify mutually exclusive principles too because there is no pre-set rule in NPV to identify them.
In order to rank the projects, the interest rate has to be considered. In other words, the NPV process is not free from discount rate effects while considering the ranking of the projects. As investors seek the best project to maximize the returns, not being able to provide an accurate ranking is a major demerit of the NPV process.
While it is important to note that there are some demerits of the NPV process, it is still a very popular Discounted Cash Flow (DCF) method. Estimating cash flows and depending on discounted rates make it a stable DCF technique that can be used in a lot of financial and economic cases.
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