By ArtIn Energy
May 17 – 2024
Investor’s Guide to Solar IRR: Calculating Returns for Solar PV Projects
The environmental benefits of investing in solar energy are undeniable, from preventing the emission of greenhouse gasses that contribute to climate change to preserving ecosystems by reducing the use of fossil fuels. However, it is crucial for a company to understand the profitability and potential financial return of an investment such as transitioning its operations partially or fully to sustainable energies. This is where IRR (Internal Rate of Return) comes in.
Knowing a project’s Internal Rate of Return allows companies to make informed decisions, knowing they have a clear picture of the potential financial rewards. At ArtIn Energy, we want to guide you on every step of your journey toward sustainability, so contact us to learn the economic and technical aspects of your company’s transition to solar energy.
What is Solar IRR?
IRR is a financial metric to evaluate an investment’s profitability over a specific timeframe. In simpler terms, it tells the annualized percentage return that an investment would need to generate to break even on all the costs and cash flows associated with the project.
At ArtIn Energy, we proudly offer high-quality, customized solar solutions that deliver significant environmental and financial advantages to companies, like an immediate IRR of over 32%. To guarantee a good outcome, our team of experts will analyze your energy needs and design a solar system optimized to maximize your IRR and ROI while minimizing your impact on the planet.
Differences Between IRR and ROI
Both IRR and ROI are metrics to evaluate the performance of a project, but they have different purposes.
ROI (Return on Investment) is a percentage that indicates the total profit, considering how much it was invested. It is a simple formula where you subtract the total profit from the initial investment and divide it by the initial investment. For example, if the total saving on electricity costs is $150,000 and the initial investment in solar energy is $100,000, the ROI will be:
($150,000 profit – $100,000 investment) / $100,000 investment = 50% ROI
Read our post on commercial solar ROI to learn more about how it can help your business make an informed decision.
On the other hand, IRR considers the time value of money, showing the yearly growth rate of the investment as if the same rate was earned every year over the entire time.
ROI and IRR are helpful tools and are worth considering before investing. ROI is good for quickly determining how profitable something was overall, while IRR is better for comparing different investments that might have different cash flow patterns over time.
How To Calculate IRR for Solar PV Panels?
Understanding IRR is crucial for evaluating the financial viability of a project such as installing commercial solar panels. As this metric considers many aspects, it presents a higher complexity.
IRR Elements
IRR is a valuable tool for investors because it considers all the particular cash flows associated with solar projects. Cash flow refers to the movement of money in and out of a business. It can be:
- Cash Inflows represent all the money received. Cash inflows for a solar project might be limited to government incentives received upon installation.
- Cash Outflows represent all the money spent. When talking about solar installations, the primary cash outflow would be the upfront investment cost.
- Positive Cash Flow: When cash inflows are greater than cash outflows.
- Negative Cash Flow: The opposite case, when cash outflows are greater than cash inflows. In the case of a solar project, the initial investment will create a negative cash flow in year 0 of the calculation.
Cash flows generally associated with solar projects are:
- Upfront Investment (Negative cash flow in year 0):
This is the initial cost to acquire and install a solar system. It includes:
- Cost of solar panels (and/or any other type of solar service).
- Inverters.
- Mounting equipment.
- Electrical upgrades (if necessary).
- Permitting fees.
- Labor costs.
Since this is an initial expense, it is a negative cash flow in year 0.
- Annual Electricity Production (Positive cash flows in subsequent years):
The estimated amount of electricity a solar system will generate each year throughout the project’s lifespan. Factors influencing this value include:
- Efficiency of the solar panels.
- Average sunlight hours in the project’s location.
- Size of the solar panel system.
The electricity production produces positive cash flows each year after the initial investment (Year 1 onwards) as it offsets electricity usage and reduces the company’s electricity bill.
- Electricity Bill Savings (Positive cash flows in subsequent years):
The annual reduction in electricity costs due to the clean energy generated by the installed solar systems. Essentially, it’s the financial benefit of using solar power instead of traditional electricity. These savings contribute to positive cash flows each year after the initial investment.
- Government Incentives (Positive cash flow potential in year 0):
Many regions offer financial incentives to encourage investment in solar projects. These incentives can take the form of:
- Tax credits: Reduce tax liability in the year the solar system is installed.
- Rebates: Provide a direct cash payment from the government or utility company.
- Grants: Contribute financially to the upfront cost of a solar project.
Depending on the specific incentive program, the government incentive might be reflected as a positive cash flow in year 0 (reducing the negative impact of the upfront investment) or spread out over multiple years.
- Maintenance Costs (Negative cash flows in subsequent years):
While solar panels are relatively low-maintenance, there are some ongoing expenses to consider:
- Periodic cleaning.
- System inspections.
- Potential minor repairs.
Thanks to the high quality of our solar systems, these maintenance costs are minimal. However, they are factored into the IRR formula as negative cash flows spread out over the project lifespan.
- Project Lifespan: Solar panels are built to last, typically operating for 25 years or more. Other solar solutions have a similar operative time. The IRR formula considers the project lifespan to account for all the cash flows, both positive and negative, that will occur throughout this extended period.
Other elements that don’t fall into the category of cash flows but should also be considered are:
Current electricity rates: Higher electricity rates lead to greater cost savings from solar power generation, potentially boosting the IRR.
Electricity inflation rate: By considering this, the IRR calculation can reflect the potential benefit of solar power as a hedge against rising electricity prices, potentially leading to a more attractive long-term return on investment.
IRR Formula
Calculating IRR involves a specific formula that considers the cash flows associated with the solar project over its lifespan. Due to the formula’s complexity and the potential for multiple IRR solutions depending on different scenarios, it’s generally recommended to use financial calculators or software programs specifically designed for IRR calculations.
This is a simplified version of the IRR formula:
IRR = r% where:
r = discount rate that equates the Net Present Value (NPV) of all cash flows to zero.
Net Present Value (NPV) = Sum of the discounted cash flows over the project lifespan.
Example: IRR Calculation for a Commercial Solar Project
Here’s a fictional example of an IRR calculation for a solar system installed on a commercial building:
Company: GreenTech Inc.
Project: Rooftop solar panel installation (500 kW capacity)
Assumptions:
- Upfront Investment: $300,000 (includes panels, inverters, installation, and permitting).
- Annual Electricity Production: 750,000 kWh
- Average Electricity Cost: $0.12 per kWh
- Annual Electricity Cost Savings: $90,000 (750,000 kWh * $0.12/kWh)
- Government Incentive: 30% Federal Tax Credit ($90,000) = $27,000 (applied in year 0)
- Project Lifespan: 25 years
- Maintenance Costs: $2,000 per year (spread evenly over the lifespan)
Cash Flows:
Year 0: -$300,000 (Upfront Investment) + $27,000 (Federal Tax Credit) = -$273,000
Year 1-25: $90,000 (Electricity Cost Savings) – $2,000 (Maintenance) = $88,000
IRR Calculation:
Due to the complexity of the IRR formula, we won’t perform the actual calculation here. However, using financial software or a qualified professional, the IRR for GreenTech Inc.’s solar project might be around 12%.
In this case, the solar project offers a competitive return on investment for GreenTech Inc., considering the long-term cost savings and potential environmental benefits.
What Is A Good IRR Rate for Solar Projects?
Establishing a good IRR percentage for a solar project is complicated because all projects and companies are different, so there’s no one-size-fits-all answer. The ideal IRR depends on several factors, like project risk, cost of capital, market conditions, and project goals.
While there’s no definitive “good” IRR rate, industry benchmarks can provide a general reference point. According to various reports, the average IRR for commercial solar projects in the United States can range from 10% to 15%.
The best approach to determining a good IRR for a solar project is to consider the unique circumstances of your project. Here are some key factors to evaluate:
Project Costs: The upfront investment cost and ongoing maintenance expenses directly impact the potential return.
Electricity Rates and Savings: The cost of electricity in the region and the amount of electricity the new solar system will generate significantly influence the financial gains.
Government Incentives: Available tax credits, rebates, or grants can significantly improve the project’s financial viability and boost the IRR.
Risk Tolerance: A company’s comfort level with risk will influence how it evaluates the IRR. A higher IRR might be more appealing if the company has a lower risk tolerance.
Our solar solutions are designed to deliver an IRR of above 30% immediately after installation. If you want to know more about how transitioning to renewable energy can financially benefit your business, contact us to schedule a free consultation.
IRR Limitations To Consider
While IRR is a valuable tool, it has some limitations that are important to consider:
Sensitivity to Assumptions: The accuracy of your IRR calculation depends on the accuracy of your initial assumptions regarding factors like electricity prices, system lifespan, and maintenance costs. If these assumptions are inaccurate, the calculated IRR might not reflect reality.
Multiple IRR Results: In some cases, complex cash flow patterns might lead to multiple IRR solutions. Consulting a financial professional can help interpret these scenarios.
Doesn’t Consider Risk: IRR is a purely financial metric that doesn’t explicitly consider project risk. Other factors, such as project location, permitting processes, and warranty terms, can all influence the overall risk profile.
Limited Time Horizon: IRR focuses on the cash flows over the project’s lifespan, typically 25 years for solar panels. However, solar panels can potentially last even longer. The IRR calculation doesn’t capture potential financial benefits beyond the initial project lifespan.
Reach A 30% IRR With Artin Energy: Your Trusted Partner
At ArtIn Energy, we understand that transitioning to solar power is an important investment that highly benefits the environment and your business. That’s why we’re dedicated to helping companies of all sectors and sizes achieve a win-win scenario, focusing on maximizing their IRR and minimizing their environmental impact.
Our team of experts will work closely with you to design a customized solar system optimized for your specific energy needs, where you can instantly see the financial benefits in the form of increased property value, reduced electricity bills, and tax incentives.
Your investment also contributes to a cleaner and more sustainable future. Choosing solar energy reduces your company’s carbon footprint and combats climate change.
Are you ready to make the switch? Let us guide you! Contact us for a free consultation to discuss your case so we can design a customized solar solution that delivers exceptional value to your company and the planet. Together, we can create a more sustainable tomorrow!
Discalimer: * The projected IRR is based on current market conditions and proprietary, confidential data. This projection is provided for informational purposes only and does not constitute an offer, solicitation, or guarantee of future performance. Actual results may vary due to unforeseen market conditions, regulatory changes, or other risks. Past performance is not indicative of future results.