Net Present Value

Read this section that discusses Net Present Values (NPV), calculating and interpreting NP, and the advantages and disadvantages of using NPV. It also gives examples of how these concepts are implemented in practical applications.

Disadvantages of the NPV Method

NPV is hard to estimate accurately, does not fully account for opportunity cost, and does not give a complete picture of an investment's gain or loss.


  • Discuss the disadvantages of using the NPV method


    • 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.
    • Other metrics, such as internal rate of return, are needed to fully determine the gain or loss of an investment.


  • Opportunity cost

    The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative.

There are a number of disadvantages to NPV. NPV is still commonly used, but firms will also use other metrics before making investment decisions.

The first disadvantage is that NPV is only as accurate as the inputted information. It requires that the investor know the exact discount rate, the size of each cash flow, and when each cash flow will occur. Often, this is impossible to determine. For example, when developing a new product, such as a new medicine, the NPV is based on estimates of costs and revenues . The cost of developing the drug is unknown and the revenues from the sale of the drug can be hard to estimate, especially many years in the future.

Drug developers must try to calculate the future revenues of a drug in order to find the NPV to determine if it is worth the cost of development.

Furthermore, the NPV is only useful for comparing projects at the same time; it does not fully build in opportunity cost. For example, the day after the company makes a decision about which investment to undertake based on NPV, it may discover there is a new option that offers a superior NPV. Thus, investors don't simply pick the option with the highest NPV; they may pass on all options because they think another, better, option may come along in the future. NPV does not build in the opportunity cost of not having the capital to spend on future investment options.

Another issue with relying on NPV is that it does not provide an overall picture of the gain or loss of executing a certain project. To see a percentage gain relative to the investments for the project, internal rate of return (IRR) or other efficiency measures are used as a complement to NPV.