Limitations of net present value techniques
Shareholder wealth maximization. NPV is based on the assumption that the primary aim of
the organisation is to maximise the wealth of the ordinary shareholders. This is valid for
many companies, but in some investment decisions there may be other overriding factors
that make the NPV approach less relevant. This is particularly true when the investment
under consideration is fundamental to the strategic direction of the business.
Public sector problems. The technique is difficult to apply in the public sector, partly due to
methods of accounting, and partly because other organisational aims will be more
important than the maximisation of profit. Public sector operations are commonly judged
in terms of economy, efficiency and effectiveness, and the NPV approach can only provide a
partial answer to these issues.
Discount rate. A major problem in the use of NPV in practice is the choice of the discount
rate. It is generally accepted that the rate to be used should be the cost of capital, but this in
itself may be difficult to determine. The problem is particularly tricky when the size of the
investment means that the company will need to acquire a significant amount of additional
capital, and there is uncertainty about the cost of new funds.
Risk. A related problem to the choice of the discount rate is the incorporation of risk. The
simplest approach is to apply a risk premium to the cost of capital, but the amount of this is
subjective. Other approaches include the use of sensitivity analysis and probability
analysis, but these too have limitations, and involve the use of subjective judgements.
Subjectivity. It follows from (iv) that NPV techniques may appear to be very scientific and
rational whereas in fact there is a large component of subjectivity in the assumptions and
forecasts used. However, this subjectivity is masked by the precise format in which results
are communicated.
Cash flow timing. The technique assumes that all cash flows arise at the end of the time
period (which is usually one year). This is obviously untrue, and large fluctuations in this
pattern may distort the results. Breaking the analysis down into small periods leads to
complication, and may be unsatisfactory due to the problems of forecasting in such a
precise way.
Long-term measure. Although the NPV approach may lead to the correct financial decision
in the long-term, this timescale may be too long to be appropriate for the business to use in
practice. For example, it could lead to an unacceptable reduction in short-term accounting
profits which will impact upon the share price and on confidence in the company. Similarly,
it may conflict with incentive arrangements for managers, which are usually geared to
short-term profitability.
Non-qualifiable costs and benefits. Some costs and benefits that arise are not quantifiable.
There may be important non-financial factors that are relevant to the decision, but which
are difficult to quantify. For example, undertaking a new investment may enhance the
standing of the company, making it more attractive to customers, investors and potential
employees. This could have an important impact on the performance of the company, but
cannot be quantified in an NPV analysis.