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- If for example the
are generally
negative late in the project (e.g., an industrial or mining project might have clean-up and restoration costs), then at that stage the company owes money, so a high discount rate is
not cautious but too optimistic. Some people see this as a problem with NPV. A way to avoid this problem is to include explicit provision for financing any losses after the initial
investment, that is, explicitly calculate the cost of financing such losses.
- Another common pitfall is to adjust for risk by adding a premium to the discount rate. Whilst a bank might charge a higher rate of interest for a risky project, that does not mean that this is a valid approach to adjusting a net present value for risk, although it can be a reasonable approximation in some specific cases. One reason such an approach may not work well can be seen from the foregoing: if some risk is incurred resulting in some losses, then a discount rate in the NPV will reduce the impact of such losses below their true financial cost. A rigorous approach to risk requires identifying and valuing risks explicitly, e.g. by actuarial or Monte Carlo techniques, and explicitly calculating the cost of financing any losses incurred.
- Yet another issue can result from the compounding of the risk premium. R is a composite of the risk free rate and the risk premium. As a result, future cash flows are discounted by both the risk-free rate as well as the risk premium and this effect is compounded by each subsequent cash flow. This compounding results in a much lower NPV than might be otherwise calculated. The certainty equivalent model can be used to account for the risk premium without compounding its effect on present value.
- If NPV is less than 0, which is to say, negative, the project should not be immediately rejected. Sometimes companies have to execute an NPV-negative project if not executing it creates even more value destruction.
- 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, usually, Internal rate of return is used complimented to the NPV method.
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