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A Guide to Energy Efficient Technologies
11
Deciding Among Several Different Energy Efficient Options
A detailed financial analysis helps us to determine which options will add the most value to the firm by
determining the appropriate level of investment. We will show that law of diminishing returns does not apply if
efficiency options are effectively packaged.
Table 1 summarizes several energy efficient lighting retrofit options. In order to make a decision on which
option to select, a financial analysis provides the bases for determining the most cost effective solution. To
simplify this analysis we will consider only the direct energy savings opportunities and will not quantify other cost
benefits such as reduced maintenance or reduction cooling loads.
Simple payback tells us that all the available options will return our investment within a three year period.
Payback time is less than the expected life of the equipment and we should further our analysis. The next step is
to determine if savings are sufficient to cover the risk of investing in an energy project.
The four options offer a return on investment (ROI) of 27% to 46% over the ten year expected life of the
retrofit. Because ROI does not take the time value of money into account or the timing of the cash flows it
should only be used as a rough guide to determine the relative profitability of the four options. If we use ROI to
make a financial decision on an energy project we run the risk of accepting a project that does not meet our
company hurdle rate. This can occur when energy saving cash flows occur towards the end of the project. On
the other hand, we could also reject a profitable project when the benefits of compounding principle are not
taken into account and ROI understates the attractiveness of the project. In our case, cash flows are constant
and the returns calculated actually understate the attractiveness of the project. Knowing this, we can conclude
that with a minimum ROI of 27% all of these projects are profitable and further analysis should be undertaken to
determine the best project.
The Internal Rate of Return (IRR) numbers give us a direct comparison of investing in energy efficient lighting as
opposed to leaving our money in the bank and collecting compound interest. All of the proposed retrofits offer a
return above the company hurdle rate and should be considered. IRR also allows us to make investment
decisions based on alternative means of financing. For instance, if we needed to borrow money we can add the
additional cost of borrowing to our company hurdle rate and make a direct comparison to the project IRR.
Although it is a useful financial tool, IRR should not be used by itself as it does not take into account the relative
size of the savings. A project with a lower IRR can be a better investment. For example, if we had to choose
between two projects. Project A: $10 investment with an IRR=40% or Project B: $1 with an IRR= 60%. The
$10 investment will add $4 to the value of the business while the smaller project will add only $0.60. Project A
would be the best choice if the company hurdle rate is less than 40% and they have the $10 to invest.
In our case we will assume that we have financial resources to invest in the best option. Because these are
mutually exclusive projects (can only do one of the proposed options) we should select the one that adds the
most value to the company. Since Net Present Value is the only financial tool we have discussed that takes into
consideration timing and size of cash flows, time value of money, initial investment and the company hurdle rate,