Shortcomings of NPV Calculation: Does One Error Annul the Other?

Abstract

The research aims at analyzing the aggregate effect of possible errors related to the "textbook" method of present value calculation. Two main errors could stem from end-of-period convention and calculation according to expected lifespan. The magnitude of such errors depends on the cash flow pattern and the probability distribution of asset life, therefore the combination that may be regarded as the most typical in practice has been chosen as the subject of the examination, i.e., the continuous exponential cash flow pattern with exponentially distributed life. Based on the result of previous studies examining the errors separately, it seems possible that the two errors lead to a more accurate approximation – considering the absolute value of the relative error – compared to making only one of the errors. After the examination, I conclude that in the most typical cases of practice, it is not worth to take either the correct cash flow pattern or the life uncertainty into account beyond the "textbook" method.