Unlocking the Pitfalls of Net Present Value: Why Accurate Estimation of Cost of Capital is Key to Sound Investment Decisions

What is one disadvantage of NPV as a capital budget method?

Although the weighted average cost of capital is commonly used as the discount rate, it is not a perfect input.

One disadvantage of the Net Present Value (NPV) method as a capital budgeting technique is that it requires an estimate of the cost of capital or the discount rate used to calculate the present value of future cash flows. Estimating the cost of capital can be a challenging and subjective task, and small changes in this estimated rate can significantly impact the NPV of the investment. Additionally, determining the appropriate discount rate can be difficult as it requires assumptions about the risk associated with the project. If the discount rate used is too high, certain projects might be wrongly rejected, while if it is too low, the firm might accept projects that would not generate as much value as expected. Therefore, care should be taken to ensure that the cost of capital or discount rate estimation is accurate and reasonable to avoid making poor investment decisions.

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