I recently spoke with Chris Lord and Keith Cronin about some of the financial modeling tools and sample documents that they frequently use to teach solar professionals working on commercial projects. Chris and Keith, who co-teach our Solar Executive MBA course, first talked about the financial modeling tools, how they came to use them, and […]
Understanding finance is required to sell renewable energy projects. It’s needed to communicate the value of both residential and commercial projects, and for all types of technologies: solar PV, solar hot water, and geothermal heat pumps.
The reason financial metrics are important is that all of these technologies are financial investments. Thus, you must be able to communicate the financial value of the system to the client and ‘payback period’ does not do this. I repeat, don’t use ‘payback period’, and we’ll talk about why later.
The key to understanding financial analysis is a small contradiction. The actual financial calculations are not difficult once you have all the numbers. The challenging aspect of financial analysis is that many of the numbers the model depends on are assumptions and projections — things you can’t always nail down. Thus, it’s important to perform sensitivity analysis to see how a few critical variables will impact a project’s returns.
Another challenge is communicating exactly what these numbers mean to a consumer, so they understand it. In order to do this, you need to understand what each term represents and how to explain it in plain language.
I’ve noticed that the information and educational resources on basic financial analysis for the renewable energy industry is lacking. While many PV installers can derate conductors easily, they may not know what the NPV of an array is. Most geothermal contractors can size of a heat pump, but few know that the typical IRR of a system is when it’s replacing an oil boiler. We need to change this.
Let’s Start With the Basic Terms
Below are the basic financial terms you will need to understand to perform financial analysis on any renewable energy project. I’m simply going to discuss what each variable is and how to calculate it, with an example from excel. At the bottom of the article you’ll be able to download the excel file, so you can play with it yourself.
It’s critical to remember that the variables that impact these metrics will change based upon technology and incentives, but the underlying cash flows that create the financial returns will remain the same. NPV is NPV.
Here are the terms will will discuss
Net Present Value (NPV)
Internal Rate of Return (IRR)
Net Present Value (NPV)
NPV is the most recognized metric used to analyze capital projects. NPV takes every known cash flow in a period, negative and positive, and discounts back to today to see if the project is profitable or not. If a profit has a negative NPV, it should not be completed. If it’s zero, it doesn’t matter if a project is completed or not, from a pure financial perspective. If it’s positive, all else equal, it means the project should be completed.
Unlike ‘payback period’, NPV provides a specific dollar amount that you can use to determine if a project is profitable or not. HOWEVER, NPV analysis can vary widely because it is extremely dependent on the discount rate used. On residential sales in particular, an acceptable discount rate can change greatly depending on the customer.
The analysis can also vary widely due to the confidence one has in the financial assumptions used to create the model. It is key to perform a sensitivity analysis when performing NPV analysis because most times the cash values being used are projections and it cannot be said with 100% confidence the numbers will be exact.
The equation to calculate NPV is to add together the present values of each cash flow for each period for a project. Here is the formula to calculate present value for a single period.
Present Value = Net Cash Flow / (1 + i)^t
i = discount rate
t = time period.
**Note, I’m using “^” meaning to the power of X, or in replacement of a supercript because our publishing software does not allow superscript. This is also the same script that excel will use if you want to raise a integer to a power of X**
If we had 5 periods, we could calculate the present value for each period, then add those numbers together.
What is the net present value of $500 investment, with 5 unequal cash flows, 50, 200, 200, 300, and 300 at a 5% discount rate?
Figure 1: Adding together the present values of 5 future cash flows to determine NPV
A few notes: The cell in C13 is simply summing the values of C6:C11. Each of the values in C6:C11 is calculating the present value of a single cash flow. Notice how $200 in 2 years, is worth more then $200 in year 3? This is because it’s getting discounted by 5% every year.
Present Value (PV):
Present value is the present value, today, of a future cash amount discounted back to today. Net present value is thus, a series of cash flows all discounted back to today’s terms. For example, what is $50 worth today? It’s worth $50. However, if you wanted to find out what $100 in 5 years would be worth today at a 5% interest rate, you’d need to calculate the present value. Here is the equation.
The equation to find present value of a future cash flow is:
PV = FV / (1 + i) ^ n
i = interest rate
n = number of period.
So, what is the present value of $100 payment in 5 years at a discount rate of 5%
PV = $100 / (1 + .05) ^ 5
PV = $100 / 1.28
PV = $78.15
This means that is someone gave you $100 in 5 years, and you have a bank account with a yield of 5%, it would have been the same value of money if they would have given you $78.15 today and you put the money into the bank for 5 years.
Future Value: (FV)
The future value is asking what the future value is of a present day cash amount, given it is accumulating at a specific interest rate. The best way of describing future value is a typical savings accounts.
If you put $50 dollars into a savings account with a 5% interest rate and take it out in 10 years, how much will it be worth?
The equation to calculate future value is
FV = PV (1+i)^n.
FV = the value of a future cash flow today, given x % interest rate.
PV = the present value of the investment
i = the interest rate of the investment
n = number of periods of the investment
FV = $50 (1+.05) ^ 10
(1.05)^10 = 1.63
$50 * 1.63 = $81.44
In other words, $50 today at 5% interest is EQUAL TO be given $81.44 in 10 years
How about a 10% interest rate?
FV = $50 (1 + .10) ^10
FV = $129.69
As you can see, the interest rate used over the term has a huge impact on the value of the investment.
Discount Rate / Interest Rate:
In the calculations of NPV, PV, and FV, you’ve noticed that we’ve been using an interest rate to calculate the value of money in different parts of time. This value is called the discount rate. Sometimes, it’s referred to as the interest rate (for future value), or minimal attractive rate of return (MARR), which we’ll discuss below.
The discount rate can be somewhat confusing to some. There are critical pieces to understand about the discount rate. First, what it does. Second, how you determine it.
In the above examples of calculating PV and FV you noticed I used an interest rate to calculate the value of cash between a certain period in time and another period in time. So, to define it very simply the discount rate is an interest rate that is the difference between a present value and future value of the same dollar amount. The difference between $100 today and in five years is the discount rate.
How one should select the discount rate is a little more difficult. Many times the discount rate is selected based on a few characteristics. None of these is wrong, it simply depends on the circumstances.
A comparable investment or savings rate. If a homeowner could invest the same money in a CD at risk free interest rate of 5.6%, they will likely use 5.6% as a discount rate for other investments. Also, keep in mind that many times a homeowner might add a few percentage points to a different investment that is not risk free to cover the additional risk.
The inflation rate. If I had $100 in cash and stuffed it in a safe (a place that is not getting interest), and took it out in 5 years, it would have lower purchasing power. To understand how the purchasing power changes, we would calculate the FV of $100 in 5 years with the discount rate being the expected rate of inflation.
Risk tolerance. The more risky the investment, the higher discount rate you’d need to satisfy the level or risk. Having a higher discount rate will decrease the time it takes for you re-coup your investment, given the NPV is still positive. When risk tolerance is being used to determine need returns, it’s sometimes referred to as “Minimum Attractive Rate of Return” (MARR), or the “hurdle rate”.
The thing to remember about discount rate is that while it’s use in the financial analysis is extremely clear, determining what exactly to use as a discount rate is extremely subjective or will vary widely between homeowners.
The impact of a different discount rate can be huge when talking about renewable energy projects because an acceptable discount rate between different homeowners can vary widely. Let’s walk through some examples to demonstrate.
CASE STUDY: A Sample Solar Hot Water Customer in Greenfield, MA.
Net Installed Cost After Incentives: $4,000
Displaced Oil : 130 Gallons with 3 Full Time Occupants
Value of Displaced Oil @ 3.00 Gallon = $390
The life of the system will be 20 years.
Maintenance costs are $200 at year 10.
All other equipment failures will be paid by the manufacturer
Here’s the T*Sol estimation for the system production and load.