Question

Environmental Industries is evaluating whether to invest in solar panels to provide some of the electrical needs of its main office building in Schenectady New York. The solar panel project would cost $600,000 and would provide cost savings in its utiltiy bills of $50,000 per year. It is anticipated that the solar panels would have a life of 20 years and would have no residual value.

1) Calculate the payback period in years for the solar panel project.

2) If the company uses a discount rate of 12%, what is the net present value (NPV) of this project ?

3) If the company has a rule that no projects will be undertaken that have a payback period of more than five years, would this investment be accepted ?

Answer 1

The solar panel project would cost $600,000 and will provide the benefit per year till 20 years of life = $50000 per year,

1.

Since payback period is the period in which the initial investment gets collected as a saving, it is simple formula which does not consider the time value of money but takes the overall investment and yearly return.

Payback period = Original Investment / Cash in lnflow per year = $600000 / 50000 = 12 years.

Thus payback period for the solar panel project = 12 years.

2.

Net present value of the project is the net diffetence of the present value of investment and present value of its lifetime cash inflow.

In the given case , the cash inflow in the form of benefit is $5000 evenly throughout 20 years, thus we can use the annuity factor formula for the calculation of benefit at present value.

The formula for calculating annuity = { 1- (1+r)^-n } / r = { 1- ( 1 + 0.12) ^-20 } / 0.12  

here r = discounting factor and n = period

12% discount factor for 20 years the annuity factor will be = 7.4694,

Thus present value for $50000 per monthly = $50000 * 7.4694 = $373470.

Net present value = Estimated present value of cash inflow - cash outflow at present value

Thus net present value = $373470 - $600000

Thus Net present value of the project = - $ 226530.

3.

Since the payback period of this project is 12 years which is much more than the company's policy for selection of project as it considers project having payback period 5 yearss or less , so the project should not be selected and no acceptance of project to be made. Further the NPV is also negative for the given discount rate so the project should not be accepted.