Understanding Net Present Value

net-present-value

One of the keys to developing successful solar projects is to understand how to measure and communicate value. We need to frame the value conversation with our customers.

Several days ago we talked about how payback is not a good measurement for conveying the value of solar to a customer.

We covered how using the simple payback method is not effective with projects that have very long useful lives. It overemphasizes the short term and does not convey the total long term value of the system.

Two better ways to consider the value of a solar project:

IRR and NPV

IRR= Internal Rate of Return

NPV= Net Present Value

IRR and NPV are two measurements that are very often used in capital budgeting to measure and compare the profitability of investments. They are terms that take the total return on investment into consideration.

We will spend today discussing what NPV is and how it works.

Net Present Value

Simple Version:

NPV is a way to assess whether the cash flow of a project is positive while taking into account the time value of money. In its simplest form it means that a dollar today, is worth more than a dollar tomorrow.

Why?

Because of three factors:

  • Opportunity Cost- what you couldn’t do with that money, like invest it.
  • Inflation- that dollar will have less purchasing power tomorrow.
  • Risk- are you really going to get that dollar tomorrow?

So NPV is a way of factoring the time value of money into project cash flows in the future.

In general if a project has a positive NPV that means it will make money over the time analyzed and is a “good investment”. So we want to see a positive NPV on our solar projects.

Deeper Explanation

Let’s first understand what present value means.

Pretend you are presented with these two options:

  1. Someone offers you $100 today.
  2. Someone offers you $100 one year from now.

Which would you choose? As a sensible person you’d pick Option 1.

If you received $100 today, you can invest it, and in a year from now you might have $105 if your investment has a return of 5%.

In addition, inflation would steal part of your $100, so in a year from now, the same bill might buy you only $97 worth of products. We prefer to get money sooner rather than later, so you’d need some form of compensation to get the money later.

So Present Value is the value today of an amount of money in the future.

How about this choice:

  1. Someone offers you $100 today.
  2. Someone offers you $105 one year from today.

You get options like this often in everyday life, like the option to pay upfront for a year instead of making monthly payments.

So, which option would you choose? Basically, you are offered a 5% return that needs to reimburse you for the loss of investment (i.e. you can’t do anything else with $100), the risk involved (will you actually get the $105 in a year from now?), and the expected rate of inflation.

These factors, opportunity cost, inflation and risk are used to set something called the Discount Rate. The Discount Rate is key in calculating NPV and can change the calculation dramatically based on the discount rate chosen. (Note: Working with your customer to understand their Discount Rate is important)

Let’s assume you could put the money in the bank and would receive 3% interest. Inflation is currently rather low, let’s say 1%. The person is creditworthy so the risk of not getting paid is extremely low. With your 3% investment, you’d have $103 in a year. Given 1% inflation, the $103 would be worth only $101.97.

So if you’d take the $100 today, you’d have 101.97 in a year. Option 2 would be favorable, as you would get $105.

The NET portion of the term simply refers to all the cash flows over the term of the project. If you apply the Discount Rate to ever years cash flow and add them all together you get the Net Present Value.

To Sum Up:

  • Net Present Value is a way to value an investment that takes into account the time factor of money.
  • The Discount rate used has a tremendous impact on NPV
  • A positive NPV means that the project is worth considering
  • A negative NPV means the project will loose money
  • NPV is a good way to screen projects but is not a great tool for prioritizing projects because a the size of the project will impact the NPV
  • Engage your customer in a discussion of what the right discount rate to use.
  • The higher the discount rate the lower the NPV

Helpful Links:

How to Calculate Net Present Value 

How to Use Excel Formulas to Calculate NPV

Bonus:

David Roberts at Grist has an excellent piece on how setting a discount rate has tremendous impact on modeling climate change economics.

Original Article on Tipping Point Renewable Energy





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