PV economics . . . calculating the present value rate of return (IRR)
February 19, 2011 § 5 Comments
What is this? OK, you are considering a serious capital investment in your home or business; so you should consider a serious investment metric to qualify your investment!
The present value rate of return, aka internal rate of return (IRR) is the interest rate at which the net present value of costs equals the net present value of benefits. The IRR metric considers the time value of money – that is, the concept that $100 today is worth more to an investor than $100 20 years from now. This is how sophisticated investors consider the desirability of a capital investments.
An IRR of 0% means that the time value of costs and benefits over the investment horizon are equal or breakeven. If the IRR is less than zero, you have lost money. If the IRR is greater than zero, you have received a compounded rate of return on your investment over the investment horizon at that interest rate.
Yikes! How do I do this? Well, it only takes minutes with a spreadsheet; longer with a financial calculator, or if you must, Google IRR for the formula and take a day of vacation. Let’s assume the spreadsheet!
Remember, a PV system is a long-term investment, so we are going to reduce all costs and benefits to a single row of annual cash flows that sum costs and benefits. In previous writings, we have discussed how to estimate the electricity generated from your PV system and how to convert these kWh’s to a 40 year monetary value stream.
We know that for a PV system, the capital costs are incurred in year one. Maintenance and operating expenses are nominal. You effectively are purchasing 40 years of electricity with an upfront investment.
There is one exception. Your PV system includes a component called an inverter. The inverter is the electronic component that converts the DC current produced by the modules to AC current connected to your electricity panel on the load side of your meter. Most inverters have a warranted life of 15 years. So, when calculating the costs and benefits, include the cost of a replacement inverter in years 15 and 30.
Create your spreadsheet with a 40 year annual cash flow summing benefits and costs. Your capital investment is in the first year, so that year will have a negative cash flow. Now, simply select a rate of return function to apply to the data (for Excel, it is IRR), and in less than a second your IRR calculation is complete.
Once the IRR is determined, you can perform sensitivity analysis on your result by making changes to your system costs and benefits and seeing how those changes impact the IRR.
Congratulations! It’s your home or business; it’s your PV system investment; and it’s your analysis. Don’t rely on a canned solution. You know best.
The three most important variables are:
- How much electricity will your PV System produce? (See PV Watts)
- How do you value that electricity?
- What does your PV system costs?
Remember; do not sacrifice long-term performance for lesser upfront costs. Quality counts! It’s a long-term investment, so strive to maximize your price/performance ratio.
Chet Boortz, CEO