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# IRR, ROI and payback periods with commercial solar

## Financial proposition

A commercial solar system is a financial proposition so:

- Salesperson must understand financial concepts
- Both from a borrower’s perspective and also
- From a business owner investing their money into something other than solar

## Case study, 100 kW system

A business owner is contemplating a 100 kW solar system to negate his incredibly high electricity bill but this is one of other options he has looked at:

- Could invest the money in the bank
- May spend more on marketing and advertising
- Purchase another machine

## You need to know the value of money

Now money has a value and in a previous presentation we looked at:

- Present value
- Future value
- Net present value.

But what about ROI ( Return on investment),IRR ( Internal rate of return) and Payback period?

The question is what is the relationship between all these financial concepts?

Before that we have to look at the commercial solar system details and make some assumptions.

## A Commercial solar project

In this example we will look at a commercial solar investment:

- 100 kW system
- Cost to the business is $100,000
- The W.A.C.C. ( weighted average cost of capital ) is 10%
- The length of the investment is 6 years

## Assumptions on the 100 kW system

The assumptions around this particular system include:

- The system is installed in Melbourne, Australia, North facing
- Energy produced per 1 kW installed is 3.6 kWh on average
- Initial electricity price is $0.25 kWh
- Feed in tariff price is fixed at $0.7 kWh
- Electricity price increases 2% every year
- System maintenance is $500 and increases 2% every year after
- 80% of the solar goes to the loads, 20% to the grid

## ROI

Below you can see the savings per year and the total savings after 6 x years is $170,097.54. So what is the ROI?

## ROI

Return on investment (ROI) is an approximate measure of an investment's profitability

ROI= (Net Return on Investment)/(Cost of Investment) x 100%

- So: ($170,097.54-$100,000)/$100,000 X 100%
- = 70.10%

## ROI: pros and cons

Advantages of Return on Investment (ROI:

- It is a relatively uncomplicated metric
- Easy to calculate
- As a measurement, it is not likely to be misunderstood

The disadvantages though are:

- It does not take into account the holding period of an investment, time period
- In this case 6 x years
- ROI does not adjust for risk
- Figures can be exaggerated if all the expected costs are not included in the calculation

## Annualised ROI

Annualized ROI helps account for a key omission in standard ROI—namely, how long an investment is held.

- Annualised ROI= ((1 + ROI)1/n - 1) X 100%
- Where n is the number of years of the investment,
- Annualised ROI = 9.26%
- A big difference between the standard ROI of 70.1%

## Solar produces benefits for longer than 6 years!

With the scenario we have looked at,the time period is 6 years but with solar the reality is that the system will produce for far longer than that.

Let’s look at 10 years for a variety of measures:

- Total savings after 10 years is $292,585.78
- ROI is 192% but
- Annualised ROI is 11.3%

## There is another measure

What about payback period? Is this a valid measure of the worth of an investment?What is the Payback Period?

Payback period (PBP) is the time (number of years) it takes for the cash flows of incomes from a particular project to cover the initial investment.

When a CFO faces a choice, he will prefer the project with the shortest payback period.

## Payback period: pros and cons

Advantages of Payback Period

- Simple to Use and Easy to Understand
- All that you need to calculate the payback period is the project’s initial cost
- Annual cash flows

Disadvantages of payback periods

- Ignores Time Value of Money
- This distorts the true value of the cash flows
- Can use the Discounted Payback Period that can do away with this disadvantage.

## So what is the payback period for this scenario?

The cost of the system is $100,000 and the payback period turns out to be a little over 3.5 years.

But if we look at the discounted payback figure we get a different result as this takes into account the time value of money.

In fact the payback is a little under 5 years ( **5 year point present value savings of $109,715.2**)

## Conclusion

There are many ways that the worth of a particular investment, 6 years, in this case a 100 kW solar system, can be looked at:

- Using NPV have a figure of $20,924.17
- An IRR of 17%
- ROI of 70.10%
- Annualised ROI of 9.26%
- Payback period of under 4 x years
- Discounted payback period of just under 5 x years

The importance of understanding these financial metrics applies to both the renewable energy sales person presenting these proposals and the business person who needs to make an assessment on a range of options.

Go solar!

If you’d like to see more of what Greenwood Solutions get up to in the real world of renewable energy, solar, battery storage and grid protection check out the following pages:

https://www.greenwoodsolutions.com.au/industry

https://www.greenwoodsolutions.com.au/commercial

https://www.greenwoodsolutions.com.au/commercial/customer-stories

https://www.greenwoodsolutions.com.au/news