Limitations of NPV: When Net Present Value Can Be Misleading
While NPV is the theoretical gold standard, practical application requires understanding its limitations, including rate sensitivity and lack of managerial flexibility.
Key Takeaways
- NPV depends heavily on long-range forecasts that may be inaccurate.
- It does not reflect project scale: A ₹10,000 NPV on a ₹10,000 investment is very different from ₹10,000 NPV on a ₹10,00,000 investment.
- It assumes the discount rate remains constant over the entire project life.
- It treats investments as rigid and fails to capture managerial flexibility (real options).
1. The Scale Problem (NPV vs Profitability Index)
Consider two competing proposals: - **Project A:** Requires ₹1,00,000 CapEx and yields ₹1,50,000 PV (NPV = +₹50,000, PI = 1.50x). - **Project B:** Requires ₹1,00,00,000 CapEx and yields ₹1,00,50,000 PV (NPV = +₹50,000, PI = 1.005x).
Both report identical absolute NPVs of ₹50,000. However, Project A delivers a 50% surplus buffer while Project B risks catastrophic losses if revenues fall by just 0.5%. Under budget limits, ranking by Profitability Index ($PI = PV / I$) is essential.
2. Omission of Managerial Real Options
Standard DCF models treat capital investments as "now-or-never" decisions with rigid fixed cash flows. In reality, managers have the flexibility to expand successful ventures, defer development during recessions, or abandon failing assets for salvage value. NPV alone undervalues projects with high strategic optionality.
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