The concept of net present value is based on the basic principle of finance which is quoted everywhere. A dollar today is worth more than a dollar one year later. It is simple to understand; a person can instantly invest his dollar in government security today and increase the future value of its dollar one year later by earning interest on that. Conversely, the present value of a dollar one year later is definitely less than one dollar.
The relevance of relationship of net present value with risk is explained by another basic principle of finance. A safe dollar is worth more than a risky one. Suppose there are two options for an investor to invest his money. One, in real estate with 6% rate of return and another in
government security with the same rate of return of 6%. Every rational investor will invest in government security simply because their hard earned money is safe in government security in comparison to the real estate investment.
In the calculation of net present value, we utilize present cash outflow or initial investment, future cash inflows and a discounting rate. Risk has relevance with 2 out of 3 components of net present value.
Normally, initial investment or cash outlay is known with certainty but future cash inflow is an estimation based on certain assumptions which may or may not turn true. Therefore, a risk is associated with future cash flows. If in actual, the future cash flows turn lesser than estimated, the viability of the whole project may go for a toss and it may turn to be a loss making an investment.
Secondly, a decision regarding discounting rate is very critical. It is because this rate is applied to all the future expected cash flows to convert them into their present values and a slight difference of even decimals may change the whole game. A discounting rate of say 9.25% may give positive net present value and a slight change to 9.45% may make it negative.
Discounting rate of return is also known as an opportunity cost of capital or hurdle rate. It is the rate of return which could be earned from the next best alternative investment opportunity having similar risk profile. Considering same investment options discussed above, the rate of return on government security cannot be used for evaluating or finding NPV for real estate investment. Simply because the risk profile of two investments is totally different. One is highly risky and other is highly safe.