Project evaluation: NPV, IRR, and payback – with an example using solar energy.

VAN, TIR, and payback periods appear together in any project evaluation, but they address different questions. Confusing them, or focusing solely on one of them, is the most common way to make a poor investment decision, despite appearing to have good numbers.

What does each one mean?

• Payback (repayment period). How long does it take for the cumulative savings or income of a project to equal the initial investment? This is the easiest to calculate and the most limited: it doesn't factor in the value of money over time, nor does it address what happens after the investment is recovered.
• Net Present Value (NPV). Bring all future cash flows for the project back to today’s value, using a discount rate, and then subtract the initial investment. If the result is positive, the project creates value above that rate; if it’s negative, it destroys value, even if it generates accounting profits.
• Internal Rate of Return (IRR). The discount rate at which the project’s NPV is exactly zero. This is compared to the rate the company demands: if the IRR is higher, the project is worthwhile; if it’s lower, it’s not.

Example with a 10 kWp solar project

A commercial solar system of 10 kWp in the Magallanes region, according to Ditap Energía figures, has a reference investment ranging from $7,000,000 to $9,000,000, with a typical return of 3 to 6 years. To illustrate the method, one case within that range is taken:

With a payback period of 3 years and an evaluation horizon of 10, the project generates seven years of savings that no longer factor into the payback period, but do contribute to the NPV, which explains a TIR significantly higher than the discount rate used. This calculation is a considerable simplification: it doesn’t incorporate system maintenance, gradual panel degradation, or future changes in electricity rates – variables that would be included in a comprehensive financial model.

A portion of the monthly savings in this example relates to the netbilling under Law 21.118, which allows the sale of excess energy generated by the system to the grid – energy that the company is unable to consume – up to 300 kW of installed capacity.

Risks that a simplified model doesn’t capture.

The example above uses a consistent monthly savings over ten years to make the calculation easy to follow, but a real project has variables that fluctuate:

• System maintenance. Panel cleaning, inverter inspection, and replacement of minor components, which, in aggregate, is typically estimated as a percentage of the equipment’s annual value.
• Panel damage. Solar panels lose efficiency over time, typically between 0.3% and 0.5% per year, which reduces the projected savings in the later years of the investment horizon.
• Changes to the electricity rate. If the rate increases, the savings per kWh generated also increase; if it decreases, the project yields less than projected.
• Exchange rate, if the team cares. A portion of the initial investment may remain exposed to the dollar between the quotation and installation.

A comprehensive financial model incorporates these variables as explicit assumptions, rather than ignoring or hiding them behind an average.

Why it’s beneficial to look at all three numbers together.

A project can have a short payback and a weak IRR if future cash flows are low, or a long payback and a solid IRR if the project continues to generate value for many years after the initial investment is recovered. Payback answers the question “when will I recover the money?”; the NPV answers “does this project add value at the rate I require?”; and the IRR answers “how good is that return, compared to other alternatives.” None of them replace the others.

When is it advisable to request a comprehensive evaluation?

The example used in this article employs simplified, hypothetical scenarios for demonstration purposes. A real-world project – such as a solar installation, a plant expansion, or a new hotel – involves fluctuating revenues depending on the season, operating costs that increase with scale, and specific risks inherent to the industry, which a generic calculation cannot capture. project evaluation Ditap Capital needs to develop a complete model, using the assumptions of the actual project and at least two scenarios, before the company commits capital.

A project that “pays for itself in three years” can still be a poor investment if the company’s required rate of return is high and the cash flow stops in the fourth year. The combination of these three factors is what prevents that confusion.