The truth about lighting retrofit one-page financial analysis with the one-page narrative proposal that focuses on the “WHY,” BUY A LIGHTING RETROFIT PROJECT
Consider the following popular metrics:
Simple Payback Period focuses on how quickly the customer will make their money back via savings.
Return on Investment calculates what percentage of an investment is returned over a set period.
Internal Rate of Return is the discount rate at which the present value of the sums invested equals the present value of the sums received, which results in a net present value of exactly zero.
Simple Payback Period (SPP) attempts to answer the question, “How quickly will I get my money back via savings?”
Seems straightforward—and it is, but that’s the problem. This grossly oversimplified metric does not account for a host of other factors that determine the true financial value of a project, a) it ignores how the value of money changes over time depending on your “discount rate,” which incorporates your opportunity cost, inflation, and other factors, a dollar you receive in a future period could be worth considerably less than a dollar you receive today. b) Depending on your “discount rate,” which incorporates your opportunity cost, inflation, and other factors, a dollar you receive in a future period could be worth considerably less than a dollar you receive today.
Cumulative Payback Period considers all the cash flows you’re anticipating, whether they’re going up or coming down over time, to calculate a more accurate payback period. However, it still ignores the present value of the cash inflows you’re expecting. And, like SPP, it’s blind to how long those financial benefits might continue after the Cumulative Payback Period.
Discounted Payback Period determines the present value of incoming cash flows using the timing of each one and your discount rate. For example, this metric knows that dollars you receive in Year 5 are worth less than dollars you receive in Year 1, and it doesn’t consider your investment fully recouped until the sum of the discounted values you receive over time equals your first cost. Unfortunately, it still ignores how long you will continue to receive financial benefits after the Discounted Payback Period.
Bottom line: Simple Payback, Cumulative Payback, and Discounted Payback are variations on a theme, and although they may be popular (especially SPP), their shortcomings make them misleading yardsticks for selecting expense-reducing capital projects.
When it comes to Return on Investment (ROI), most people look at the simplest way of calculating it: If you invest $1,000 in a retrofit that returns $200 in the first year, they say the project has a 20% ROI. This simplest version of ROI is essentially the reciprocal of SPP. It also shares many of the same flaws: not accounting for the time value of money, being blind to how many years the savings will persist, etc. Additionally, the “annual ROI” might very well increase over time as inflation raises the value of the energy savings.
Another version of ROI is derived by simply adding all of the cash inflows you receive over the entire multi-year analysis term, subtracting the original investment from that sum, and then expressing the “Total ROI %” as that “net return” divided by the original investment. So, a consistent “20% ROI per year” would manifest as a “200% ROI” over 10 years. Again, many of the above-referenced shortcomings of SPP come into play.
These two methods of calculating ROI are popular. However, they’re both misleading. Why? Well, for one, they completely ignore the concept of compound interest.
To figure out the true annualized ROI, you should calculate the compounded interest rate you would need to earn on your investment to create a sum that is equal to the total amount of returns accumulated over the entire analysis term less the amount you invested. Calculated that way, you see that the annualized ROI percentage on our example above is much lower than the current year ROI percentage.
Interestingly enough, as the investment analysis term is extended to include more years, the annualized ROI percentage typically goes down. Why? Because with more years of compounding, you’d need a lower compounded annual rate of return to equal the sum of the cash inflows less your investment, even though the analysis term includes more years of cash inflows. To some observers, that characteristic of annualized ROI percentage can be counterintuitive.
Internal Rate of Return (IRR) is defined as the discount rate at which the present value of the sums invested equals the present value of the sums received, which results in a net present value of exactly zero.
This popular metric has two principal flaws that make it less than ideal for investment decision-making.
In situations where the stream of cash flows has multiple changes in sign (i.e., positives and negatives), you open the possibility of getting multiple right answers. So, for example, if you invested $1,000 (a negative cash flow), received $200 per year in savings for three years (each one a positive cash flow), but then had to reinvest $201 the following year for a relamping (a negative cash flow since that $201 expense would overwhelm the $200 in savings, resulting in a subtotal of negative $1 that year), you’d have three changes in sign (-$1,000 at the beginning, $200 for three years, then -$1 in the fourth year). That’s why Excel asks for your “guess” as part of the IRR function. If there’s a possibility for multiple right answers, Excel wants to return the answer that is closest to your expectation. Many professionals are unaware of that nuance of Excel’s IRR function since it automatically assumes that your guess is 10% if you don’t enter a guess in the function! Don’t believe me? Check out Excel’s “Help on this function” footnotes on IRR.
While the possibility of multiple right answers described above can be unsettling, there is a second shortcoming of IRR that is the real reason I don’t consider it to be a useful metric for evaluating the efficacy of expense-reducing capital projects. The answer generated by the IRR function is only correct if the investor can reinvest every dollar returned by the investment at the calculated IRR percentage from the time the dollar is received until the end of the analysis term. Assume your project has an IRR of 22%. Do you really think your investor will take his/her utility savings and reinvest them in another project at 22%? Not going to happen. In fact, as far back as 2004, the McKinsey Quarterly posted on CFO.com that IRR was a terrible way to assess capital projects for this very reason and provided a great case study to prove the point.
Bottom line: IRR incorporates faulty assumptions about reinvestment rates and opens the door to multiple right answers when cash flows involve multiple changes in sign over time.
Additionally consider the following proper metrics:
Modified Internal Rate of Return
Unlike Internal Rate of Return, Modified Internal Rate of Return (MIRR) considers two additional inputs:
Reinvestment Rate: At what rate could you reinvest the proceeds you get from this investment?
Finance Rate: What does it really cost you to finance additional investment?
In the overwhelming majority of cases, a project’s MIRR (also sometimes known as AIRR, or Adjusted Internal Rate of Return) will be lower than the project’s IRR simply because the customer will be reinvesting the project’s savings at a rate that is lower than the project’s IRR.
Net Present Value
A cash flow’s present value is what it is worth to you today. Hence, a future cash flow is said to be “discounted back to present value,” using the assumption that money generates returns over time.
As the name would suggest, Net Present Value (NPV) adds the present value of all your cash outflows (each of which is a negative number) to the present value of all of your cash inflows (each of which is a positive number) and tells you how much present value you’ve really created after deducting the present value of your investment.
Bottom line: Net Present Value considers all cash flows both in and out, nets them against each other, and perhaps most importantly, discounts each of those cash flows back to its present-day value. It’s perhaps the easiest way for an investor to know if he/she would realize an attractive return on an investment after discounting all cash flows back to today’s dollars.
Savings-to-Investment Ratio (SIR) is a close cousin to NPV. Simply put, it’s the present value of your cash inflows divided by the present value of your cash outflows (which are first converted to absolute value since cash outflows are by definition negative cash flows and you don’t want to be dividing by a negative number). Essentially what you have with SIR is a “bang for your buck” index expressed in present value terms.
Bottom line: SIR is an excellent metric to know and understand because it completely disarms anybody saying they’re not going to do the project if it doesn’t have a payback that is less than two years. Do the math on how many times they can recoup their initial investment over the course of their agreed-upon analysis term – in other words, what the project’s SIR is – and you’ve completely changed the discussion.
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