NPV, IRR and Payback Period

Posted by The Solar Labs on July 12, 2018 | 1 Comment

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  

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