How to find the IRR of the Solar Power System?

5/9/2020

Solar energy is no doubt one of the cleanest sources of energy and installing a solar power system on the roof top, to harness this energy, is a very good decision.

When you know that your decision is financially rewarding too then it's a kind of icing on the cake.

In this post, we'll learn and calculate the financial feasibility of the solar power system.

The Internal rate of return (IRR) is a metrics that helps you in finding the profitability of the solar power system.

When Internal Rate of Return > Cost of Capital of the project;
the project is profitable and feasible

Before going ahead I think it is better first to understand the concept of cost of the capital.

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(1) The concept of cost of the capital

A simple definition:

It is the minimum rate of return that you expect from your investment in the project (solar power system).

The term "minimum rate" is the benchmark which varies from individual to individual.

For example, I have taken a loan of Rs. 1,00,000 @ 10% per year and I invested this amount in a given project.

My minimum rate of return from the project would be at least 10% per year otherwise it is not feasible.

The other definition of the cost of capital is the rate of return which you could get if you invested your amount in other asset with fairly equivalent amount of risk.

(2) Know your cost of capital

Before going to the next step, I think it is important for us to know the calculation of the cost of capital.

When you have funds then you can invest the amount and purchase the solar power system by your money. It is called 100% Equity.

Sometimes, you prefer to invest part of your money and borrow the remaining amount to purchase the complete solar power system.
It is an example of Equity-Debt mix.

There are times when you borrow the whole amount and invest that in the solar power system. A case of 100% Debt.

The effective cost of capital will be different in all the above cases.

Let us calculate the effective cost of capital in each case:

Case- I: 100% Equity

You are going to invest your funds to purchase the complete solar power system.

Here the effective cost of capital will be the rate of return or the opportunity which you could get if you invested the same amount into another project with fairly same amount of risk.

Let us say that the opportunity cost is 9% per year if the same amount is invested into the another project.

Now, in order to maintain the feasibility of my solar power system,

The IRR from the project should > 9 %, otherwise the project is not feasible.

Case-II: 50% Equity and 50% Debt

I am going to invest in the solar power system through 50% equity and 50% debt route.

Here my effective cost of capital would be:
(cost of capital of equity + cost capital of Debt)/2
= (9% + 10%)
= 9.5 %.

My solar power system must give at least 9.5 % per year to make it a profitable project.

Case-III: 100% Debt

I am going to purchase my solar power system through 100% debt or loan @ 10% per annum.

In this case my expected minimum rate of return should be at least 10% otherwise the project is not going to be profitable option.

Out of the three, case-III is the most expensive option as the cost capital is the highest (10% per year)

I'm showing all the three cases in the form of a chart below:

(3) Understanding IRR:

The solar power system is not a perishable product that you consume and avail its benefit instantly but rather it is an investment whose benefit you realize in future over the period of time.
These future benefits, year after year, are called the cash inflows of the project.
When we discount the future cash flows with a rate in a way that the net present value of the project comes out to be ZERO. This rate is called the Internal Rate of Return
When this IRR > the cost of capital then the project is feasible, otherwise it is not.
It is generally difficult to predict the future cash flows. When you take the right variables that can affect these cash flows, the more accurately you can predict the value of IRR.

However, the formula for the IRR calculation is as follows:

The formula for IRR to find the profitability of the system

It is very difficult to calculate the rate of return but Excel has made our lives easier and you can easily calculate it in excel.

(4) Understanding its calculations

The cost of the project is my cash outflow and the future cash benefits will be my cash inflows.

We discount the future cash flows by that value of rate of return that makes their sum equal to the cost of the project.

Before going to the next step, let us know some of the facts and the assumptions that I have made while arriving at the final value of the Internal rate of return (IRR).

These are as follows:

The solar power system is without the batteries
Location: Delhi/ NCR
Average Peak sun Hours: 5.35 kW/m^2/day
The per unit rate of grid electricity: Rs. 5/ kW-hr
The expected increase in grid rate: 5% per year
The maintenance cost of the system: 1% of the total cost of the system
The expected rate of return or the cost of the capital: 10%
Savings per year = Actual units generated x rate per unit
Actual savings = Savings per year - Maintenance cost

My minimum rate of return is 10% and if the IRR is > 10%

then

my solar power system is feasible otherwise it is not.

The future cash flows are shown in the table below which are calculated by taking into account many relevant variables so as to maintain the accuracy of the cash flows.

Using the formula of IRR in the excel, I found that it is 11.21% which is more than my cost of capital of 10%.
I can say that my solar power system is profitable and I should go ahead in installing it at my roof top. Moreover, this feasibility is without any rebate or incentive.
The payback period in this case is 10.64 years.

Please see the chart below:

(5) New IRR with 30% incentive

If your state provides an incentive of 30% on the cost of your solar power system then the IRR of your project comes out to be 16.07% which is around 61% above my cost of capital (10%).

It is even higher than the average annual stock market return in India.

The chart below shows the future cash-flows calculation and the payback period of the system respectively.

The payback period is 7.97 years when your state provides incentive or subsidy of 30% to the cost of the system:

(6) The real benefit lies somewhere else

When you are using solar energy over fossil fuels you are actually contributing towards preserving the environment by reducing the carbon content in the atmosphere.

The CO2 emissions have increased from 25,000 Mt in 2003 to 32,000 Mt in 2015.

With every unit increase in the CO2 levels in the environment, increases the threat to our sustainability on this planet.

The collective use of the renewable energy sources will help in preserving the environment at the faster rate and this actual benefit surpasses all the financial aspects associated with any project.

(7) What is the point that I want to convey?

The gist of the whole post is that solar power systems are not only financially profitable but also a noble way to preserve and save our environment.
I can say that:

Roof top solar power system has IRR > (cost of the capital + extra advantage of preserving the environment)

Therefore, you should try to implement the use of renewable energy in your daily lives by taking a small step towards it like buying a small solar panel, if you are not initially ready to buy the whole solar power system, and connect it with one or two appliances in your home.

This will not only give you a hand on experiencing about the working of the solar energy but also let you know the right time to install at your roof top that will give you the confidence to fully implement it in near future.

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