Definition of Net Present Value:
Net Present Value (NPV) is defined as the difference between the present value of the future cash flows because of the amount your are investing and the amount you are investing. In simpler terms, it is converting the profit/loss we may get from an investment in the future to the current day (present).
The most basic application of NPV is to decide if the investemt you are planning to do will be profitable or not. NPV can be either positive or negative. A positive NPV indicates the investment to be profitable and negative NPV indicates the investment to be incurring losses.
Limitations of Net Present Value (NPV):
While calculating NPV, we use discount rate, which is assumed. There are two possible assumptions while considering the discount rates to calculate NPV. First is, we assume the discount rate to be constant throught out the time period of the project. Second is, we assume the discount rate itself to be a specific number i.e., 5% or 10% or 12.5% depending on our understanding to the business we are planning to invest in. These two assumtions are tend to be volatile. Thus, changing the NPV value i.e., we get differnt NPV values if different discount rates are assumed. This is the first and major limitation of net present value approach when used in investments.
The other limitation of net present value is it also depends on the time period of the investment i.e., if a same amount is invested for a period of ‘n’ years, the NPV calculated will be different from the NPV calculated when the same amount is invested for a period of ‘n+1’ years. This will not help us accurately in deciding if the investment is going to be profitable or not.