Economics of Going Solar

Solar Finance 101

Financing options are simple, but not easy.  These decisions involve an understanding of the time value of money.  In the following section, we discuss financial metrics such as NPV, IRR, and payback period.  The goal is to make it clear why one option might be better than another – and how much better it is.

The Time Value of Money

We have to start with one of the core principals of finance: A dollar today is worth more than a dollar tomorrow

Having a dollar today is worth more, because you could invest it today (in a savings account, for instance) and have a little bit more than a dollar tomorrow.  So, just one dollar tomorrow is worth less to you than one dollar today.

Discount Rate

The discount rate is essentially an interest rate that describes how much less a dollar is worth tomorrow than it is worth today.  Higher discount rates should be applied to riskier projects, since similarly risky outcomes demand higher rates of return in financial markets.

Measurement Tools in Solar Installations

There are three numbers that are frequently used to evaluate financial propositions such as solar panels: NPV, IRR, and payback period.  All three take into account the cash invested and received every year the project or investment exists (these are the “cash flows”).

Net Present Value (NPV):  NPV is the total value of an investment. It uses a discount rate to bring all dollars saved or earned over the life of the system back to today’s dollars. The discount rate reflects the risk of a project and the potential return of safe alternative investments you could also make.  To find the NPV, apply the discount rate to every year’s cash flow (using negative amounts for what is paid out and positive amounts for what is received in) and total them all up.  If the NPV is positive, it’s a financially positive thing to do; the size of the NPV corresponds to how good (or bad) the prospect is.  On pure financial terms, someone should be very excited about a project with an NPV of $10,000, they should be somewhat excited about an NPV of $100, and they should not do a project with a negative NPV.

Economists feel that NPV is the best method to evaluate projects, but IRR and payback period are often used because they are much easier to envision and calculate.

Internal Rate of Return (IRR) or Annual Return:  The IRR is the discount rate that would make a project have an NPV of zero.  It takes into account the compounding effects of an investment, whereby interest is earned on the interest from previous years.  This number is often referred to as the Annual Return or the CAGR (compound annual growth rate.)  The IRR helps make decisions because if it is greater than one’s discount rate, then the project is worthwhile; if it is lower than the individual’s discount rate, then that individual would make more money by investing the cash instead.

Payback Period

Payback calculates the amount of time it takes to earn back the cash you invested up-front. This uses a simple calculation to find what year it is that the total cash paid equals or is exceeded by the total cash received.  What it doesn’t mention is how much is made after the investment has paid back, nor does it consider the time value of money or the riskiness of the venture.

Issues with Measurements

CollectiveSol addresses a number of issues that come up when measuring the value of solar installations.  It is important to understand all three measures because each one on its own has flaws.

• NPV uses a discount rate that is difficult to measure and that has a major impact on the final value.  In other words, the result is highly sensitive to the discount rate assumption.
• IRR is problematic because it assigns a single “interest rate” for all years, regardless of the actual market conditions. In actuality the risk-free rates can change drastically over time.  It is also difficult to compare IRR when paying all cash versus financing part or all of the system because the debt on the investment provides a skewed set of cash flows.
• Payback: is misleading when comparing across different financing methods. If you pay with all cash your payback could be 5-10 years, but if you only put $1000 down in a lease your payback could be less than 2 years even though the NPV and IRR will be higher with the cash purchase.  If you finance the entire purchase and are cash flow positive from day 1, your payback period is 0. Lastly, Payback only counts the time to recover initial costs and doesn’t account for the substantial savings after payback is reached. The problems as addressed by using all three measurements to evaluate a system and are all calculated for you in a comparison matrix that CollectiveSol produces once all the bids are collected. 

More Information on: Calculating Discount Rates for Solar Investments