The last thing any retrofitter wants is for the project to get within a hair’s width of approval … only for the whole thing to come to a screeching halt when the CFO pokes holes in the metrics.
However, many retrofit companies take that risk by using popular metrics that fall apart upon closer scrutiny.
In our previous article on this topic, we discussed three popular—but somewhat misleading—metrics that should be set aside: Simple Payback Period (and its two variants), Return on Investment (which has three variants), and Internal Rate of Return. Here’s a quick reminder of how they work:
- Simple Payback Period focuses on how quickly the customer will make their money back via savings.
- Return on Investment calculates what percentage of an investment is returned over a set period.
- Internal Rate of Return is the discount rate at which the present value of the sums invested equals the present value of the sums received, which results in a net present value of exactly zero.
In this installment, we’ll consider the “proper,” more meaningful metrics you should be using to demonstrate your projects’ financial merits.
Three Lighting Retrofit Metrics to Embrace
Modified Internal Rate of Return
Unlike Internal Rate of Return, Modified Internal Rate of Return (MIRR) considers two additional inputs:
- Reinvestment Rate: At what rate could you reinvest the proceeds you get from this investment?
- Finance Rate: What does it really cost you to finance additional investment?
In the overwhelming majority of cases, a project’s MIRR (also sometimes known as AIRR, or Adjusted Internal Rate of Return) will be lower than the project’s IRR simply because the customer will be reinvesting the project’s savings at a rate that is lower than the project’s IRR.
Here’s an odd example where the reverse would be true. Let’s say an entrepreneur who funded his business with credit cards invests in a lighting retrofit with an IRR of 21%. He uses his monthly utility savings to pay down a credit card balance that has been accruing interest at 29%. In this situation, his 29% reinvestment rate is higher than his project’s 21% IRR, and as a result, his project could have an MIRR that is higher than its IRR.
Bottom line: The MIRR provides a more accurate picture of the rate of return, as it looks at the investor’s reinvestment rate and finance rate.
Net Present Value
A cash flow’s present value is what it is worth to you today. Hence, a future cash flow is said to be “discounted back to present value,” using the assumption that money generates returns over time. In simple terms, if you could earn 10% on your money, we could assume your discount rate for present value calculations would be 10%.
If I gave you a $1 today, it would be worth $1 to you. However, if I gave you $1 a year from today and your discount rate (see above) was 10%, that dollar would be worth only about $0.91 today, since you could invest that $0.91 at your 10% presumed rate of return and wind up with a $1 a year from today (i.e., the sum of your $0.91 principal and the interest you earned at a rate of 10% for one year).
As the name would suggest, Net Present Value (NPV) adds the present value of all your cash outflows (each of which is a negative number) to the present value of all of your cash inflows (each of which is a positive number) and tells you how much present value you’ve really created after deducting the present value of your investment.
Bottom line: Net Present Value considers all cash flows both in and out, nets them against each other, and perhaps most importantly, discounts each of those cash flows back to its present-day value. It’s perhaps the easiest way for an investor to know if he/she would realize an attractive return on an investment after discounting all cash flows back to today’s dollars.
Savings-to-Investment Ratio (SIR) is a close cousin to NPV. Simply put, it’s the present value of your cash inflows divided by the present value of your cash outflows (which are first converted to absolute value since cash outflows are by definition negative cash flows and you don’t want to be dividing by a negative number). Essentially what you have with SIR is a “bang for your buck” index expressed in present value terms.
For this one, I like to use an analogy. Let’s say I have a mythical ATM that returns $2 for every dollar you insert. How many dollars would you deposit into that machine? Most people reply that they would insert every dollar they had, every dollar they could borrow, and every dollar that popped out! Guess what? That ATM simulates an investment with an SIR of 2.0. Every dollar of present value you insert instantly pops back out as $2 in present value.
Now, ask your customer how much they’d deposit into that ATM. If they say they’d invest every dollar they have, how could they then rationally say they wouldn’t invest in a lighting retrofit with an SIR of 2.0 just because it had an SPP that was greater than 2 years?
No one wants to be incongruent, so pointing out this flawed logic would definitely “shake the Etch-A-Sketch®” in the conversation and make your prospect rethink their automatic reflex of rejecting projects based on their inability to satisfy an arbitrarily low SPP threshold.
Bottom line: SIR is an excellent metric to know and understand because it completely disarms anybody saying they’re not going to do the project if it doesn’t have a payback that is less than two years. Do the math on how many times they can recoup their initial investment over the course of their agreed-upon analysis term – in other words, what the project’s SIR is – and you’ve completely changed the discussion.