Like all capital investment evaluation methods, the NPV is not 100% perfect. Previously we examined the benefits Now, let us examine the drawbacks of using the NPV method.
Disadvantages
1] Assumptions have to be made – The NPV is only good if the data inputs are accurate. The NPV assumes that cash flows are certain. The size and duration of the project is not usually factored into the formula. Careful comparison must be made between the NPV result vs the initial investment.
2] Subjectivity with the discount rate or interest rate – The interest rate used is a reflection of the premium that is meant to compensate the investor for the risk that they undertake with that project. Subjectivity and bias can creep in when adjusting the interest rate for risk. The lack of available data for a similar project can make it challenging to come up with a fair, reasonable discount rate. The NPV assumes that the interest rate is constant throughout the entire duration of the project.
3] Possible to manipulate – Using spreadsheets may be great for analyzing how a project might behave under various scenarios, however, the data inputs may be manipulated to achieve a desired outcome if a person has a very strong interest or bias in getting involved in that particular project.
4] Ignores qualitative factors – The NPV calculation is a purely numerical calculation. All of its data inputs are numerical in nature. The NPV method does not consider non-numerical data such as the impact of a project on society or the environment, the branding image or market strategy. A project with a negative NPV may be rejected in mathematical terms. However, the intangible value that the project may provide to the broader society cannot be mathematically measured.
5] Challenges with comparing mutually exclusive projects – If two projects have different investment factors and scopes, the NPV method is usually not the best technique to use. The NPV method assumes that all projects have the same scope.
