You're considering two different investments, one has a simple payback of 5 years, the other a payback of 7 years. Which one would you choose? Okay, it’s a bit of a trick question, but this is the reality of many businesses and individuals making investment decisions. Which is the better deal for you?
I once worked for a business that used a 3 level test, the first was simple payback, the second was Return on Investment (ROI) and the third level was Internal Rate of Return (IRR). These can sound confusing if you are not familiar with them, but they are common measurements that accountants use. Each level gives a more complete analysis of the investment.
My initial question dealt with the level 1 test, but the greatest clarity comes from level 2 and then level 3. Why is that? Because of the important role the time value of money plays in the investment. Time value of money is the concept that money available today is worth more than the identical amount received sometime in the future due to its earning potential between today and the future date. Everyone would likely agree they would prefer $100 today versus $100 five years down the road. This is because if you take the $100 today and invest it, that money will earn compounding interest and it will be worth significantly more in five years. This is why a solar energy investment is such a compelling option.
A solar energy investment has an incredibly rapid year 1 payback. This is because of the 26% federal tax credit and 100% accelerated depreciation (at the federal level, states may vary), both of which can be utilized in year 1. Depending on your tax situation, your business could recoup over 50% of your solar investment in year 1. This has incredible implications because that money can be used for other investments or to pay down the debt that may have been incurred to install the solar system.
With that, let's return to my initial question. Which is a better deal - a simple payback of 5 years or a payback of 7 years? Solar's rapid payback in year 1 may very well make it a much better investment than an alternative investment that has a shorter total payback period with a slower year 1 rate of return. How the payback actually occurs will ultimately determine which is the best investment. And typically early payback forecasts, like solar, are much more reliable to forecast. In fact, a solar investment requires very few projections compared to many investments in revenue growth strategies for businesses.
"Solar has a guaranteed return, or we like to think of it as a guaranteed cost reduction."
How do you calculate the rate of return when comparing investment options? Fortunately, we've been able to develop some very powerful spreadsheets to calculate this for us. One is the IRR Formulate, and the other is the NPV Formula. Both have the ability to calculate the interest rate earned on a given series of cash flows or the present value of a similar series of cash flows. We won't dive into those here, but we have provided a few links below to help you. And we are available to assist you with a solar investment if you're looking at a cost reduction strategy for your business.
When comparing investments, don't assume a 5-year return is superior to a 7-year return until you understand when the money will actually come back to you.