## Is Payback the Wrong Tool for Evaluating Energy Projects?

**Key Points**

- Payback is a simple, widely used method to measure the financial value of energy upgrades.
- Net present value and internal rate of return better take into account the changing value of money.
- Lifecycle cost analysis estimates the total financial impact of a project over its projected lifetime.

Simple payback is a widely used tool to demonstrate the financial value of energy efficiency upgrades. It answers the question "*When will I get my money back*?" Payback, however, treats money only at it current value, not taking into account the fact that money changes value over time. More sophisticated financial analysis tools—such as net present value, internal rate of return and lifecycle cost analysis—take into account the time value of money and may provide a more accurate picture of the cost and benefits associated with an energy project.

## Net present value (NPV)

NPV measures the financial worth of an energy project over time. It's the difference between the initial cost of the energy project and the present value of the annual savings or cash flows that result 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. The discount factor (DF) is the discount rate compounded annually and is used to calculate the present value based on the number of years. The choice of a discount rate can have a significant impact on an NPV calculation. The interest rate associated with the investment is often used. For example, if an energy project requires financing at 7 percent, then that could be the discount rate.

## Internal rate of return (IRR)

IRR is closely related to NPV. IRR is a percentage figure that estimates the return on an energy efficiency investment over time. In contrast to calculating 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 involves a tedious process of testing different discount rates until finding one where NPV equals zero. Fortunately, the task can be automated using a spreadsheet program or a financial calculator.

## Lifecycle cost analysis (LCCA)

LCCA is the total cost of owning, operating, maintaining and disposing of equipment or building systems over the proposed lifetime of the project. A number of value categories are incorporated into an LCCA, including:

- Initial equipment purchase and installation
- Financing—loan payments and other financing charges
- Energy costs
- Non-fuel operating, maintenance, and repair costs
- Disposal cost or residual value
- Equipment replacement costs

While the initial purchase price and financing costs are fixed, other costs can be more difficult to estimate. Calculate annual energy costs by multiplying the equipment nameplate (kW or Btu) energy rating, energy-efficiency rating, estimated operating hours, and the average utility rate. Estimating operating, maintenance, and repair over the life of equipment can be challenging. Projecting replacement costs is also difficult; use current equipment costs as a starting point.

Energy efficiency projects typically involve some degree of uncertainty as to their cost and potential savings. Using these sophisticated analysis tools, you can more accurately demonstrate the financial impact of long-term energy investments.

*Image source: iStock*