Why discounting is important while calculating Solar Return?

13/9/2020

Your solar power system is an investment and you are going to reap its benefits in the future.

Can you name the benefits?

Simple…

It’s clean, economical and smooth electricity for decades.

We invest money ($) [Input] in the solar power system and we get electricity (kW-hr) as an Output.

One cannot calculate the return directly as we have different units for the Input and the Output.

How to calculate the return?

For calculating the return, we need to keep the units same on both sides (Input and Output), either $ or kW-hr

The returns are generally calculated over money.

Therefore, we should convert kW-hr into an equivalent amount of $ by calculating the monetary value of the electricity units produced by the solar power system.

How should we do it?

Let us understand this conversion process with the help of an example:

A 5-kW system in California will produce an average of 6956 units every year for the next 25 years.

Why I specifically mentioned the location “California”?

Because the same 5-kW system will produce a different number of units in different places.

It depends on the sunlight of that place.

The same 5-kW system in Arizona will produce an average of 7728 units every year.

Or

It will be 5410 units in Massachusetts.

By looking at the units produced, one can say that Arizona receives more sunlight and Massachusetts remains behind when compared with the sunlight received by California.

It is the amount of sunlight that decides the units produced by solar panels.

Units produced by solar system in different locations

I hope this justifies my reasoning for mentioning the place.

Let me now clear the concept of “average” 6956 units.

It is not that the solar power system is going to produce the same number of units every year.

The system will produce more units in its initial years of operation and this output will decrease gradually with time.

Let me show you with the help of the graph:

Average units produced by the solar system

Several factors (like aging, transfer loss, conversion loss, environmental loss, etc) affect and decrease the output of the solar power system.

When I add all the expected units produce by the solar panels in the next 25 years (the useful life of the panels) and divide this by 25.

I’ll get the average units produced in 1 year.

The 5-kW solar power system in California is expected to produce a total of 1,73,911 units in 25 years.

When I divide those units by 25 (1,73,911/25), I’ll get the average value of 6956 units per year.

This is done to make things simpler and easier to understand.

When your solar power system is producing 6956 units every year, it means you are saving the same number of grid units every year.

1) The monetary value of those units is 6956 x 0.1725 = $ 1,200

(The cost of 1 grid-unit in California = $ 0.1725)

2) It means the solar power system is saving you $ 1,200 every year.
3) We’ll be getting this cash flow for another 25 years.

(I have excluded maintenance cost and the grid escalation from this cash flow)

The concept of discounting

Our point of concern is to learn the concept of discounting and including these factors in our calculation will unnecessarily make the process complex.

Now the basic structure for finding the return from the solar power system is ready.

It can be shown as follows:

Let’s calculate the total value of these cashflows:
$ 1200 x 25 years = $ 30,000
Profit = Total cash flows – Investment
= $ 30,000 - $ 15,000
= $ 15,000

Are we going to get 100% profit?

Something is MISSING in this calculation.

I have invested $ 15,000 now and the cash flows are received in the future.

The purchasing power of $ 1 in the future will not be the same as that of the same dollar in the present.

Today, you can have a full cup of coffee (100 ml) in $1 but you will get the reduced quantity (maybe 90 ml) at the same cost after 1 year from now.

In other words, I can say that the purchasing power of $1 that you receive after 1 year is equivalent to $0.9 in present.

This is called the discounted value of $1.

In simple words, the purchasing power of the dollar will reduce in the future.

Why the purchasing power of money reduces with time?

It is due to INFLATION.

Inflation is the rise in the prices of goods, commodities, and services over a period that reduces the purchasing power of the money.

Similarly, the purchasing power of the future cash flows from the solar power system will get reduced due to inflation.

How to calculate the discounted present value?

The inflation rate will help us in finding the discounted present value of the cash flows.

The average inflation rate in the USA for the last 20 years is around 2.2 %

The discounted present value of cash flows, $1,200, that we receive after 1 year would be:
= $1,200/ (1+ Inflation rate) ^year
= $1,200/ (1 + 2.2%) ^1 = $1174

Similarly,

The discounted present value of the same cash flows received at the end of the 2nd year would be:

= $1,200/ (1+ 2.2%) ^2
= $1149

In the last, the discounted present value of the cash flows received in the 25th year would be:

= $1,200/ (1 + 2.2%) ^25
= $696

The whole discounting process can be shown as below:

Let me highlight the present values of future cash flows:

When I add the present value of the cash flows shown above, it comes out to be $22,887.

The Investment is $15,000
My real profit would be:
= $22,887 - $15,000
= $7,887

Now, you can see that discounting is important so that you come to know the right value of your future cash flows.

Calculating Net Present Value (NPV) in Excel

You might be scared of the calculation for finding the discounted values of the future cash flows.

Hold on!

This is for your understanding.

You can easily calculate the profit from your solar power system using the formula NPV (Net Present Value) in Excel.

You want me to do that!

Okay, no worries ?

Let’s do it.

Syntax: NPV (rate, value1,[value2], ...)

rate = Discount rate; it is inflation rate 2.2% in our case
value1,[value2], … = future cashflow values; In our case it is $1200

Write the whole scenario in the Excel sheet as shown below:

Rate: in cell C2
Cash flows: $1200 from B2 to B26

Profit = E2 + B2
= $22,887 - $15,000
= $7,887

Which is same as calculated above.

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Conclusion

Discounting gives you the real scenario of the system.

I have taken a discounting rate as the average inflation rate in this example.

You can take a discounting rate like what is your expectation from the solar power system.

If you want at least 5% from your solar power system then the discounting rate would be 5%.

The discounting rate is your choice.

But don’t take an unrealistic value.

People do take long term govt. bond yields as the discounting rate for the cash flows from the solar power system.

One more thing,

The profit shown in the above example is $7,887 from the solar power system.

Don’t go by this!

I have excluded costs like the maintenance cost every year which when adds up will reduce the profit from your solar power system.

Read this post for understanding the concept of discounting and its importance while calculating the return from the solar power system.

Moreover, the cash flows from your solar power system would be uneven.

I have taken the average of these cash flows to make the calculation easy to understand.

If you want to know the financial feasibility of the solar power system then go to the Solar Feasibility Spreadsheet.

One of the biggest advantages of discounting cash flows is that it brings all your future cash flows in the present, helping you in finding the actual profit out of your investment.

If the difference between the present value or the discounted value of the all the cash flows and the investment made is positive then the investment is profitable otherwise it is not.

I hope this post helps in understanding the concept of discounting.

Please let me know your queries.

2 Comments

Charu

13/9/2020 08:51:03 pm

Very nice. This detailed information shall be very useful for making right decision for going Solar.

YASH KUMAR link

13/9/2020 09:12:46 pm

Thank you for reading the post.

I have seen many sales professional do not consider discounted cash flows while informing the actual return from the Solar Power System to their clients.

This results in inflated expected profits, leading to the unrealistic expectations from the Solar Power System.

Therefore, it is very important to consider every aspect while calculating the return from the solar power system so that correct information is delivered to the clients.

Hence, promoting Solar in a right way!

Thank you

Yash:)