Advantages of the NPV Method
The key property of present value calculations is that they align all forecasts to a scale based on today's value of cash. This enables a fair comparison between projects and/or investments regardless of their duration or cash flow profiles, making it a useful portfolio management tool. It also provides a basis on which groups of independent projects can be aggregated. Thus, if we have two independent projects A and B:
NPV (Project A + Project B) = NPV (Project A) + NPV(Project B)
This property also makes the method suitable for:
- Comparing mutually exclusive options e.g. different options or option combinations for any particular project.
- The support of project go / no go decisions.
Another point in favour of NPV modelling is that it requires projects to take into account costs and benefits both during the project delivery phases and subsequent exploitation of the project's benefits. This helps to counter the danger that a project manager might choose to control project implementations costs at the expense of the value that the project adds to operations.
Internal Rate of Return (IRR) is often used as a means of comparing mutually exclusive options as an alternative to NPV. However IRR is a less reliable method, since, when comparing two projects of the same size, one can have a higher IRR but lower NPV than the other. IRR may be particularly unreliable when used for projects with unusual cash flow profiles.
Advantages of NPV Risk Modelling
A number of other advantages of the NPV method can be obtained by simulating the effects of project-specific risk. Integrating a risk-based approach into NPV modelling can improve on deterministic NPV modelling methods by producing forecasts that are more realistic, whilst differentiating between projects that are high risk and others that are not.
Many of the advantages of NPV risk modelling can be realised in the earliest project phases as early estimates are produced and the project solution is being developed. In particular it should be noted that:
The earliest phases of a project usually mark the period when uncertainty is greatest and risk management thus has the most potential to add value.
Traditional risk register techniques tend to be less useful during early project phases due to the lack of a well-defined baseline plan.
NPV risk modelling can support the selection of project options, thus developing a risk-efficient solution.
Early estimates may set management cost and schedule expectations despite the fact that they tend to be optimistically biased. The use of risk estimating methods helps to make early estimates more realistic.
A risk specialist developing an NPV risk model will need to engage actively with people developing the project business case. Indeed, the risk model may be the first step in business case development. When I have used this approach in practice, the consequences have been beneficial to both business case development and the effectiveness of the risk management process itself.