Problems of “Net Present Value” Part 1: Fit only for “Bond based scenarios”

I will not describe the theory of NPV, as I assume that you already are familiar with it, and if not, you can easily get. However I will make a stand on the fact that the numbers of problems it has, is legion.

The first and most obvious problem, one that can be spotted even by non Accounting & Finance professionals, is that it has only one discount rate. The NPV method does not calculate interest, but it integrates both the principal and the interest into a new calculated number, who’s nature is closer to a ratio, that to what Accountants understand as a result.

In order to understand the nature of the problem, you must realize that there are two distinct types of Interest. In a company, because of the numerous daily deposits and withdrawals, on some days of the month the Bank account’s balance is a positive number (so it’s a deposit from us to the Bank), and we collect “Interest Income” (for example at 0.50%), while on some other days the balance is a negative number (so it’s a loan from the Bank to us) and accordingly we pay “Interest Expense” (for example at 6.00%).

To begin with, in the NPV method, a calculation of the sum of the daily balance of the Bank account is not anticipated, or even possible. But the obvious main problem is that the NPV method has only one discount rate, and so in effect, the “Net Present Value” method treats two materially different situations in the same manner (in the above example: 0.50% and 6.00%).

So, we see that in a “Company based scenario” the NPV method has problems from the get-go. NPV is meaningful only in situations where there is only one cashflow that doesn’t interact with other ones. Such a situation can realistically be found only in “Bond based scenarios”.

Stick around, as we will continue to visit other problems of the “Net Present Value” method. You are guaranteed to have a good belly laugh with some of them.

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