The net present value or NPV method is a crucial tool in capital budgeting. It basically gives an idea of the profitability of a project by comparing the present value of its cash inflows and outflows. the net present value method is based on the premise that $1 today won’t have the same value in the future. This is because we can always use the money in hand currently to earn more returns in the future.
NPV’s concept is simple, i.e. time impacts the value of money, and its formula is even simpler. NPV’s formula converts the future cash inflows to their present values and then compares their sum to the initial investment or cash outflow. If the present values of inflows are more than the initial investment, then the project is considered to be profitable.
Such simplicity in NPV’s formula makes it extremely convenient to compare different projects. Let’s talk if we can use NPV to compare projects of different sizes and durations or not.
Can We Use NPV to Compare Projects of Different Durations and Sizes?
No, we should not use NPV to compare projects of different durations. Even though we can use the NPV formula to calculate the NPVs for projects of different durations, it won’t give an accurate picture.
It is just not logical to use NPV in such a scenario because NPV is an absolute value. For instance, a project with positive cash flows for three years will be very different from a project with cash flows for 20 years.
Instead of NPV, we can use Equivalent Annual Cost (EAC) to compare projects of varying durations. In simple words, EAC refers to the average yearly cost of owning and maintaining the assets over their useful life.
Talking about comparing projects of different sizes, it is not recommended to use NPV in this case too. NPV can be used to compare projects with different investment amounts, but this won’t give a clear picture. It is a fact that the NPV of larger projects will be more than that of smaller projects. Since NPV is an absolute figure and not a percentage, it will be more for larger projects.
Let’s understand this with the help of an example.
Project 1 needs an initial investment of $500,000 and has an NPV of $394,000. And Project 2 needs an initial investment of $100,000 and has an NPV of $130,000.
On the basis of these absolute figures, we can say that Project 1 is more profitable. However, if we judge the projects on the basis of ROI (return on investment), Project 2 appears a better option. So, we must not use NPV to compare projects of different sizes.
Thus, the answer is we can’t use NPV to compare projects of different durations and sizes.