Pitfalls of Simple Payback: Capital Budgeting Decisions in Renewable & Energy Efficiency Projects
– By Kevin Poulsen; CEO, LittleFoot Energy Corporation
While simple payback is a convention that thrives in today’s renewable energy conversations, it does not represent an adequate financial indicator in the development of investment grade energy projects. In many organizations, financial officers arm managers with a simplified payback criterion as the lone identifier of attractive energy projects worthy of development. The justification seems to be that simple payback is just that, simple; so much so that anyone involved in the project is able to easily understand the basic cost-benefit relationship. While “simple payback” paints a decent picture of a project’s cost recovery schedule, it dramatically fails to paint the whole picture.
Using discounted cash flow analysis, capital budgeting decision makers are able to arrive at much more informed decisions regarding what capital investments look like in today’s dollars, accounting for time value of money and investment life. Tools like IRR (Internal Rate of Return) and NPV (Net Present Value) do a much better job of factoring in future energy savings in today’s real terms. Taking into account that the capital structure of most organizations is complex; consisting normally of a mix of debt and equity (and potentially other instruments), projects must be considered within the firm’s weighted average cost of capital (WACC), the blended rate at which they can access monies to finance projects. If the cost of funds for an organization to fund a new project is 7%, this is the target rate of return to capture a positive value addition to their balance sheet. A spread may be added to this WACC, to arrive at a minimum target return or discount rate. The discount rate becomes a key indicator for comparing alternative investments options competing for funds. When the discount rate equals the IRR of a project, that project produces a NPV of zero. Positive cash flows generated from an investment beyond the discount rate yields additional positive NPV or excess return on investment. The benefit of performing IRR and NPV analysis is that it brings to light key differences between alternative competing investments.
For a closer look at some hypothetical project examples that demonstrate the importance of considering metrics beyond simple payback, check out the Annual Green Issue of High-Profile Monthly at the upcoming Build Bosotn trade show.
