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NPV, IRR and Payback Period

 By Siddharth Gangal and Aarushi Dave 

Your solar plant is an asset that makes you money. In fact presently, higher prices are recorded for property with solar installation! While the journey to an installation may be technically complex, there are financial details too that you must get clear.  

As a consumer, viewing multiple quotes before making the purchase is critical financially. However, we understand that all the metrics can be confusing, especially when you have to make a decision.   

The returns are measured by the Net Present Value (NPV), Internal Rate of Revenue (IRR) and Payback Period. With this article, we aim to help you understand these terms, their implications and attempt to make this journey smoother for you as a consumer.  

Payback Period

As mentioned earlier, consumers might find all the parameters for judgement confusing. But one the simplest one’s is Payback Period.   

Payback Period is the time taken for a project to pay for itself i.e. time taken to recover the cash outflow. It is the amount of time taken for savings made from the installed solar system to equal the amount of money invested into the project.  

However, it must be noted, that “simple payback period” does not consider inflation, depreciation, maintenance costs, project lifetime, and other factors. For this, we use more complex terms like NPV and IRR.

This means the true worth of your solar system over its lifetime is not obtained. Most commercial installers take into account the net cost of the solar system after incentives have been applied and divide it by your projected annual electric bill savings  

To put it simply, if you have invested Rs. 2,00,000 into your initial installation, you earn Rs. 40,000 as savings each year, it will take you 5 years to recover the initial investment.  

Therefore: Net Solar System Cost/Annual Utility Savings from Solar = Simple Payback in Years  

In fact, payback period is one of the easiest parameters to comprehend and very often consumers rely on it for quote comparison. Let us dive right in! 

Steps to calculate Payback Period:  

1.Installation Expenditure = Total cost of Solar installation – value of upfront financial incentives  

The ‘Total cost of solar installation’ is the gross cost of installation of the solar system over your property. The size of your installation and the various components are considered while calculating this cost.    

Upfront financial incentives are tax breaks and rebates.  

2. Average Cost of electricity = total annual cost of electricity / total annual electricity consumption   

3. Yearly savings = average cost of electricity * yearly energy production from solar system  

The more energy you generate, the more you will save from your regular electricity bill.  

4.Payback period = cost to install / yearly savings  

The greater your yearly savings are, the shorter your payback period will be! 

Net Present Value   (NPV)

The next key criteria a consumer must be aware about is the NPV or the Net Present Value of the installation.   

NPV is how much return the solar plant will make, accounting for the time value of money. Factors such as opportunity cost, inflation and risk are all accounted for in NPV to give the overall value of the project in today’s time. 

Hence NPV accounts for the “future value” of the investment made into an installation project. Infact, ROI does not consider inflation, risk, or the lost opportunity of investing in another type of investment, such as stocks and bonds. Thus, consideration of the “time value” of money is the key difference between the two criteria.  

This is similar to the analogy that a commodity worth Rs. 50 as of today will not be worth the exact same amount in the future. It could amount to Rs. 51 or even Rs. 51.5 depending on factors like inflation. Thus, if that project returned the same Rs. 50 to you at the end of a said time period, it would not be profitable. But if it gave back Rs. 52, it would be profitable when compared to the present value of Rs. 51 or  Rs. 51.5.  

A positive value for NPV indicates that the project is set to make money or prove profitable to clients over the time period considered. Vice versa is the case for a negative NPV. Hence this means that a project with a positive NPV is considered to be a “good investment” and is a criteria for deciding whether to consider a particular project.    

An important part of evaluating the NPV is the Discount Rate of a project. This is explained ahead.   

 INTERNAL RATE OF RETURN (IRR) 

The next important parameter a consumer must be aware of is IRR.  

IRR or Internal Rate of Return is the discount rate at which the sum of Net Present Value (NPV) of the current investment and all future cashflow (positive or negative) is zero. It is an indicator of the growth of the project is expected to generate. 

With regards to installing a solar panel system, the IRR is a criterion which indicates the returns that your installation is expected to generate for you as an investor and serve as a benchmark for future projects.  

Hence the discount rate has an impact on the NPV of a project.   

 While all of this might sound too complicated, we will attempt to simplify it a bit.

NPV displays a particular project’s net present value in currency. Meanwhile, the IRR stands for the rate of return on the NPV cash flows received from a solar investment. For example, if the IRR of a project is 12%, it means that your solar energy investment is projected to generate a 12% annual return through the life of the solar system. 

This makes IRR a useful parameter for comparing the returns different investment opportunities and choosing rightly between them. This also means that on obtaining accurate data of each investment, comparison between the IRR of investing in solar to the IRR of otherwise capital investment can shed light on the one with the highest return. Or even help make a choice between different solar projects.  

 How you choose to finance your commercial solar installation is one of the factors which influences the calculation of the IRR.

If you choose to take a loan, data will include details such as:  

  1. The net cost of the system after upfront rebates and tax incentives 
  2. Debt amount 
  3. Interest rate present on debt  
  4. Debt term  
  5. Projected annual cash flow from utility savings  
  6. Pre-tax performance-based incentives plus O&M costs. 

A glance at the IRR on a project is good indicator of the prospects of a project and should be done before considering an installation.  

The key differences between NPV and IRR : 

 

Net Present Value  Internal Rate of Return 
1. Calculated as the present value of cash inflow minus the present value of cash outflow.  1. Discount Rate that makes the Net Present Value (NPV) of all cash flows from a particular project equal to zero. 
2. Expressed in the form of currency return expected from a project.  2. Expressed in the form of percentage returns expected from a project. 
3. Absolute Measure: Currency value gained or lost on a project. 3. Relative Measure: Rate of return of a project over it’s lifespan. 

 

The calculations of both NPV and IRR are given here:  

NPV Calculation: 

Present Value = Cash Inflow or Future Value x (1 + rate)^-(time) 

NPV = sum of all PV – Cash Outflow 

If NPV > 0 accept 

 

IRR Calculation: 

Set NPV to zero 

0 = [Cash Inflow x (1 + IRR)^-(time)] – Cash Outflow 

When IRR > rate accept 

The discount rate is a critical part of calculating the NPV. Higher the discount rate, lower is the NPV. 

 

So, let’s take a hypothetical example: 

Say our solar system: 

* costs Rs. 100 

* returns Rs. 25 per year for 5 years 

* discount rate of 5% 

 

Therefore NPV 

= 25*(1.05)^-1 + 25*(1.05)^-2 + 25*(1.05)^-3 + 25/(1.05)^-4 + 25/(1.05)^-5 – 100 

= Rs. 8.236 

 

And therefore, for IRR for 5 years 

0 = 25*(1/(1+IRR)) + 25*(1/(1+IRR)^2) + 25*(1/(1+IRR)^3) + 25*(1/(1+IRR)^4) + 25*(1/(1+IRR)^5) – 100 

 

IRR = 7.9% 

 So, for our example payback period is 4 years.

So, in both cases we should go ahead with the transaction. 

Both NPV and IRR are criterion that could be used to evaluate how profitable a project is. 

 

To a consumer the decision of going solar can be intimidating enough, but we get it! Going solar is one of the best investments that you can make, for yourself and the planet. Before investing in a project, do compare and evaluate these parameters to make the best returns from potential investments. We hope this guide helped simplify some of the doubts that you had regarding the finances!  

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