What is NPV on a solar loan, and why does it matter?
Rooftop solar in the US has taken off. Hundreds of thousands of households around the US have installed rooftop solar, creating deeper financial independence while generating clean, renewable energy. And heeding the calls of constituents, environmentalists and fiscal conservatives around the nation, more and more states are adopting policies that pave the way towards rooftop solar.
If you’re curious if rooftop solar is good for individual households, or good for you, note the desperate opposition to unchecked rooftop solar from utility commissions around the US. As public private partnerships, utility companies have had a monopoly on energy generation and transmission in the US for decades (basically since the creation of electricity!), but residential solar and battery storage technologies are finally disrupting an industry that has too often failed to deliver sufficient value to ratepayers.
If you’re looking into taking out a loan to finance your new system, you’ll want to completely understand your loan options and how they impact the ultimate value of your investment. This article walks through the concept of Net Present Value (NPV), NPV of your solar system and how to maximize that value to you as the homeowner.
What is Net Present Value?
First, it’s helpful to run through a quick primer of NPV.
Net Present Value (or NPV) refers to the present value of cash inflows and outflows associated with a capital investment. It’s a generally accepted measure of value among financial professionals and is most commonly used as a method to objectively assess the value of one investment over another. The concept of NPV can be equally used to analyze investment opportunities for individuals (or households) or businesses.
By definition, if the NPV of an investment is positive (greater than $0), the investment generates value and might be pursued. Conversely, if the NPV of an investment is negative (less than $0), then the investment erodes value and should be avoided. The formula for NPV is the following:
Net Present Value = [ Year n Total Cash Flow / (1+ Discount Rate)n ]
This formula expresses NPV as the sum of the present value of cash flows (positive and negative) for each year associated with the investment, discounted so that it’s expressed in today’s dollars. The trick (or art!) for many investors or capital managers is assessing the relative value between investment opportunities that both return positive NPV.
And as you review your financing options for solar, this is the conundrum you find yourself in.
How to calculate the NPV of a solar system
When it comes to assessing a rooftop solar system, NPV can be a very effective method to objectively evaluate your financing options.
It is the sum of annual savings from your solar installation, discounted so that it’s expressed in today’s dollars. Stated another way, your solar NPV is calculated as your required cash investment to install the equipment and the present value of future free cash flow generated from that system.
Since a rooftop solar system often generates free cash flow for homeowners over the life of the asset, it is often (but not always!) a good financial investment.
Model Assumptions for NPV of Solar
Since we don’t have a crystal ball, there are a few assumptions you must make in order to project future free cash flow and NPV for your solar system.
- Effective life. Your analysis will need an end date. Industry experts typically review the associated cash flow over the useful life of your solar system, commonly accepted as 20-25 years, though you can confine the evaluation term if you prefer. So, when it comes to calculating your free cash flow, it is the amount of money you can expect to spend/save over that 20-25 year period (or shorter if you prefer) compared to your base case scenario of doing nothing and continuing to pay your local utility provider.
- Utility costs. The average annual increase of your utility bills is unknown, but history teaches us that utility expenses increase year-over-year at a rate of approximately 2% over the long-term. Short-term spikes (or rate hikes) would impact your projected free cash flow. If you’re an energy industry analyst perhaps you can get this granular. For the rest of us, however, an average annual increase over time tends to be good enough.
- Discount rate. You’ll also need to assume a discount rate to analyze the NPV on your solar financing options. The discount rate is person/household/business specific. It refers to the cost of money. Put another way, in normal economic times, due to inflation and interest rates, $1 today is worth just a little bit more than $1 tomorrow. So the discount rate attempts to calculate the compounded benefit of your future cash flow in today’s terms. When it comes to analyzing solar, using a standardized modest discount rate tends to be the most effective.
Calculate Free Cash Flow
Now that we’ve made our model assumptions, we can calculate our free cash flow.
Remember, the free cash flow generated from your solar system is simply equal to the savings you generate from your solar system.
If you pay for your system outright with cash, your free cash flow simply equals the ongoing reduction in your utility bill (adjusted for rising utility costs) over the effective life of the asset. In some cases, you can offset the entirety of your utility bill and in other cases you will only offset a portion of it.
If you finance your system with a loan, your free cash flow is the difference between i) paying the entirety of your utility bill (adjusted for rising utility costs) and ii) the monthly cost of your system financing plus any applicable ongoing utility costs, over the effective life of the asset. The monthly costs of your system financing is equal to the fixed monthly payment of your loan, and the ongoing utility costs is equal to the amount of household energy consumption not generated from your system.
Maximize the Net Present Value of your Solar Loan
Now that we’ve reviewed the concept of NPV and how to calculate it for your solar system, you can feel empowered to make the right financing decision when it comes to your solar loan.
If you have the cash on hand sitting idly in a bank, you may be considering paying for your solar with cash. While cash is typically a great method to maximize the NPV on your solar installation, for many of us, utilizing a loan is a more realistic path to solar.
Remember that the interest rate is only one aspect used to calculate the monthly payment on your solar loan and shouldn’t be relied on exclusively. By maximizing the Net Present Value on your solar system, you will maximize the financial benefit to you.
