The biggest disadvantage to the calculation of NPV is itssensitivity to discount rates. After all, NPV computations are really just a summation of multiple discounted cash flows - both positive and negative - converted into present value terms for the samepoint in time (usually when the cash flows begin). As such, the discount rate used in the denominators of each present value (PV) computation is critical in determining what the final NPV number willturn out to be. A small increase or decrease in the discount rate will have a considerable effect on the final output.
Let's say you were trying to value an investment that would cost you $4,000 upfront today, but was expected to pay you $1,000 in annual profits for five years (for a total nominal amount of $5,000), beginning at the end of this year. If you use a 5% discount rate in your NPVcalculation, your five $1,000 payments are equal to $4,329.48 of today's dollars. Subtracting the $4,000 initial payment, you are left with an NPV of $329.28.
However, if you raise the discount ratefrom 5% to 10%, you get a very different NPV result. At a 10% discount rate, your investment's cash flows add up to a present value of $3,790.79. Subtract the $4,000 initial cost from this amount, andyou're left with a negative NPV of $209.21. Simply by adjusting the rate, you have gone from having an investment that creates $329.28 of value to having one that destroys $209.21 instead.
Ofcourse, you'll want to undertake the investment if 5% is the correct rate to use, and reject it if 10% is the correct rate. But how do you know which discount rate to use? Accurately pegging a percentagenumber to an investment to represent its risk premium is hardly an exact science. If the investment is very safe, with low risk of loss, 5% may be a reasonable discount rate to use, but what if the...