NPV

Advantages:

Value

An advantage of using the NPV method is being able to determine whether the project will
increase your firm's value. The NPV calculation reveals the dollar amount that the project will
produce. A five-year project with an NPV of $100,000 will increase profits by $100,000.
Projects with a negative NPV will decrease a firm's profitability. The NPV reflects the amount
of income that the project will produce at a predetermined rate of return. For instance, your
firm requires a return of 10 percent on the investment. The present value of the project's
income is discounted at the 10 percent rate.

Cash Flow

The NPV method considers when the project will earn income. For example, some projects
may not have a positive cash flow until the third year. Some projects will start contributing to
profits in the first year. The NPV method also shows what the amount of that income will be
each year. A three-year project may have projected cash flows of $5,000 in year one, $10,000
in year two and $15,000 in year three. The NPV method reveals how soon a project will start
producing income and how significant that income will be.

Another advantage of the NPV method is that it allows for easy comparisons of potential
investments. As long as the NPV of all options are taken at the same point in time, the investor
can compare the magnitude of each option. When presented with the NPVs of multiple options,
the investor will simply choose the option with the highest NPV because it will provide the most
additional value for the firm. However, if none of the options has a positive NPV, the investor
will not choose any of them; none of the investments will add value to the firm, so the firm is
better off not investing.

Disadvantages:.

With the NPV method, the disadvantage is that the project size is not measured.

In addition, the NPV method

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.

Estimations

A disadvantage of the NPV calculation is that it requires you to make projections. You must
estimate the dollar amount of the project's cost as well as its future income. In most cases, the
NPV calculation will not be 100 percent accurate. A project may incur unforeseen costs that
decrease its profitability. Income projections are difficult to determine with exact precision. In
addition, a project may incur a negative cash flow instead of the projected positive one.

Estimations

A disadvantage of the NPV calculation is that it requires you to make projections. You must
estimate the dollar amount of the project's cost as well as its future income. In most cases, the
NPV calculation will not be 100 percent accurate. A project may incur unforeseen costs that
decrease its profitability. Income projections are difficult to determine with exact precision. In
addition, a project may incur a negative cash flow instead of the projected positive one.

Prone to Forecasting Errors

In order to forecast a project’s cash flows to calculate its NPV, a business makes various
assumptions using incomplete information. The longer a project’s expected life, the harder this
becomes. A two-year forecast might be fairly accurate, but a 10-year projection is essentially
a guess. If a project’s actual cash flows turn out to be less than your estimates, you could lose
money on your investment. For instance, if a project has a $50,000 NPV but ends up
generating negative cash flows, it could become unprofitable.