How to know the profitability of your solar system?

13/10/2016

The Internal rate of return (IRR) is a metrics which calculates the attractiveness, profitability and the feasibility of your project or the solar power system. In this section of Green Energy, I discussed everything

from the role and importance of each component of the solar power system like solar panels, solar charge controller, solar inverter and the solar battery to designing a complete solar power system by yourself. I also discussed the practical ways to reduce the cost and increase the efficiency of your solar power system. It is true that all the above factors play a crucial role in designing an effective solar power system but before going ahead and installing a solar system at your roof top it becomes mandatory to know the financial feasibility of your solar power system and IRR is one of the indicators to know about it. The internal rate of return as I mentioned in the first line of the post estimates the attractiveness of your solar power system. If your project is not attractive enough then it is no use in carrying on the project. So the internal rate of return (IRR) helps you in deciding the financial feasibility of the project.

if the IRR of the project is > the cost of the capital then it is feasible to start the project otherwise not

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

(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.

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 annum and I invested this amount in a given project. In this case my minimum rate of return from the project should be at least 10% per annum otherwise my investment will be under financial loss and hence 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 the money then you can invest the amount and purchase the solar power system by your money (100% equity). Sometimes, you prefer to invest part of your own money and invest the remaining amount using loan (Equity-Debt mix). There are times when you take loan for the whole amount and invest that amount in the solar power system (100% Debt). The effective cost of capital in will be different from one case to other.
Let us discuss all this debt-equity mix and calculate the effective cost of capital.

Case- I: 100% equity

It means that you are going to invest the whole amount by yourself. 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 annum 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

This case represents that 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 %. That is my solar power system must give at least 9.5 % of the rate of return to make it a financially feasible option.

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 above three cases, the 10% is the highest value of the minimum rate of return and if IRR of the solar power system comes out to be more than 10% then it, automatically fulfills the feasibility criterion of the other two cases that is case-I and the case-II.
I am giving the graphical representation of the all the three cases in the chart below:

(3) Understand the concept of IRR:

The solar power system that you purchase and install at your roof top is not a perishable product which you consume and avail its benefit instantly but rather it is an investment whose benefit you realize in future over the period of time.
This future benefit of the project is measured by the term IRR or the Internal Rate of Return, it measures the profitability and the attractiveness of your project with respect to your cost of capital.
It takes into account the present cost of the project and the future cash flows.
It is easy to know the present cost of the project as you pay in present and get the system installed at your rooftop.
But it is difficult to know the future cash flows, therefore one need to assume and take right and relevant parameters to know the future cash flows of the project. The more accurate you are in predicting the future cash flows the better IRR calculation you will get of your project. The IRR metrics discounts the future benefits into the present value.

Here, I give you the formula for the internal rate of return, 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.

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

\((\frac{first\ year\ cash flows}{(1 + IRR)^1})\ + \ (\frac{second\ year\ cash flows}{(1 + IRR)^2})\ + \ (\frac{third\ year\ cash flows}{(1 + IRR)^3})\ + ....+.... \ (\frac{nth\ year\ cash flows}{(1 + IRR)^n})\ - \ (Initial\ cost\ of\ the\ project)\ = 0\)

(4) Understanding the calculation of IRR:

The cost of the project is my cash outflow and the future cash benefits will be my cash inflows. The IRR discounts my future cash flows by that value of rate of return which make their sum equal to the cost of the project.
Well, before going to the next step of IRR calculation, let us know some of the facts & the assumptions which I have made while arriving at the final value of the Internal rate of return (IRR) and these are as follows:

The solar power system is without the batteries
Location: Delhi/ NCR
Averagae Solar Insolation: \(5.35 KW/m^2/day\)
The per unit rate of grid electricity: Rs. 5/ KWhr
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%
The units generated in 1 year is the product of solar insolation, size of the system and 365 days (\(5.35 KW/m^2/day\) x 1 KW x 365 days)
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%. Here, I can say that my solar power system is feasible 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) IRR value when your state provides incentive on purchasing the rooftop solar power system

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 table & the chart below shows the future cashflows 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 \(CO_2\) emissions have increased from 25,000 Mt in 2003 to 32,000 Mt in 2015. With every unit increase in the \(CO_2\) 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 which I want to convey you?

The gist of the whole post is that solar power systems are not only financially feasible options but also a noble way to preserve and save our environment and the planet earth. The IRR is the one of the effective ways to know the feasibility of any project and in this case it is solar power system. I you want to know the feasibility of your solar power system then buy my solar feasibility spreadsheet, an effective way to know the feasibility of your solar roof.

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 points 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 give you the confidence to fully implement it at your rooftop.