- The principle that the value of money changes over time is important in making investment choices.
- Net present value and internal rate of return account for the time value of money.
- The right tool to use depends on the type of financing, and the scope and nature of the project.
When considering energy-efficiency investments, how do you decide whether a project is financially sound? Simple payback is a widely used method for answering "When do I get my money back?" Payback, however, treats money only in its present day value; ignoring the fact that money changes value over time. Net present value (NPV) and internal rate of return (IRR) do account for the time value of money and can provide a more accurate view of the future costs and benefits associated with an energy project.
Net present value
NPV measures the financial worth of an energy project over time in dollar terms. It's the difference between the initial cost of the energy project and the present value of the annual savings or cash flows resulting from it.
Unlike payback, cash values in NPV are adjusted or discounted so that near-term cash flows have a greater value than those in the more distant future. The discount rate is an interest rate used to adjust future cash flows to present value and can have a significant impact on an NPV calculation. The interest rate associated with the investment is often used. The discount factor (DF) uses the discount rate to calculate the present value based on the number of years from the initial investment.
So, how do you use NPV to help make investment decisions? Consider a lighting upgrade from T12 fluorescent lamps to more efficient LED T8 fixtures. With an initial investment of $12,000, the upgrade will have $16,000 in energy savings over four years.
As the graphic below shows, the upgrade provides a simple payback in three years and a positive cash flow of $4,000. Using a discount rate of 7 percent, the present value of the energy savings is reduced to $13,520 over four years, yielding an NPV of $1,520. While the cash flow is still positive, the calculation shows how the changing value of money can influence investments.
NPV incorporates both interest rate and varying cash flows. It captures the financial value of all savings over the period of interest, not just during the simple payback period. Once it's calculated, NPV is an easy way to compare various projects and financing options. NPV, however, is more complex to calculate than simple payback, and requires more information.
Internal rate of return
Internal rate of return (IRR) is closely related to NPV. IRR is a percentage that estimates the return on an energy-efficiency investment over time. In contrast to NPV (where the discount rate is selected) an IRR calculation starts with the cash flow streams and finds the discount rate where the net present cash outflows and inflows break even. In other words, the NPV equals zero.
Determining the IRR of an upgrade requires testing different discount rates to find one where NPV equals zero. A spreadsheet program or a financial calculator automates this task.
In the following calculation—using the same lighting upgrade—a discount rate of 12.6 percent would create an NPV of zero in four years (an NPV of $12,000 savings equals the initial investment of $12,000). Among the multiple investment options, the one with the higher IRR is better. When the IRR is higher than a company's cost of capital, an energy-efficiency project is a financially sound investment.
IRR is easier to understand than NPV and provides a comparison to the cost of borrowing or the benefits of other investment options. However, IRR calculations are restricted to the initial capital investment and don't take into account any subsequent financing. Also, IRR provides a limited view of a project's potential impact on profits.
Which is the better option?
The answer to this question depends on the type of financing, and the scope and nature of the project:
- NPV compares projects with a fixed amount of years where multiple cash infusions may be required. It also provides a view of the financial benefits over the entire life of the project.
- IRR compares projects with savings occurring over varying time periods. Also, since every investment involves risk, IRR helps compare financial options by establishing a hurdle rate, or the minimum amount of return required on an investment.
Whichever analysis tool you use, understanding the time value of money helps you make better financial decisions.