Short Analysis of Practical Difficulties of the NPV-method

The Net Present Value (NPV) is a method to compare the value of an investment now and that amount in the future, taking into account the cost of capital and the cash flows generated by the investment.

The formula to calculate the NPV is as follows:

With t as the time of cashflow, i the discount rate and R the net cashflows.

Although the formula to calculate the NPV is straightforward and takes into account the value of a cashflow (money) over time, there still is a lot of information that is up to discussion, to which numbers to use. The short comic below gives an idea:

One of the umbers that is most easy to calculate is the investment, which is not more than a number. However, from that moment on all are just assumptions. An assumption of the future cash flows that will be generated and the discount rate of cost of capital.

Let me use the example of the initial public offering of Twitter, for which the Financial Times has made a simplistic tool to calculate the market value of the company (http://www.ft.com/intl/cms/s/2/8ae5045c-4159-11e3-b064-00144feabdc0.html#axzz2lynPs27Z). Now, this short analysis does not have the goal to critique the tool, I merely use it to show what a different cost of capital can do with the ‘’market value of the company’’. A cost of capital of 10% will give an enterprise value of 23.1 billion dollar, while a cost of capital of 12% will give an enterprise value of 15.4 billion dollar. A discounted cash flow model was used and this is, of course, not an accurate valuation tool. However, it does show that a small change in the cost of capital can have dramatic effects.

The above is only an example of the discount rate used. Another problem to calculate the NPV is to estimate the future cash flows: a lot can happen in one year, but if cash flows over for