Discounted cash flow offers a more realistic way of establishing payback. There are three stages for estimating DCF:
- Estimate the resulting cash flow;
- apply the discount rate;
- calculate the end value (net present value).
The cash flow is taken from the estimated savings in energy cost resulting from the measure taken. This will depend upon projections of future energy cost. (For example, energy prices over the last three years can be projected on a median basis into the future. But these figures will then need to be discounted at a discount rate to be chosen.)
Discount rates are a function of the rate of inflation and represent what one unit of currency will be worth in a year’s or 10 years’ time. An average price is calculated this way for each year of the projected lifetime of the project. Each of these figures is then multiplied by the amount of energy expected to be saved every year.
The lifetime period chosen for the project will depend upon the expected lifetime of the technology. If it were a boiler, for example, it could be 15 years. Should it be an insulation measure, it could be 30 years.
The total cost savings from not using energy compared to not doing the project over the lifetime of the project will then be the sum of the cost of the saved energy used each year.
Applying this to the two projects above, with a 10 per cent discount rate, we can see that over three years it yields $81,300, not $90,000, but over six years it will give you back $103,083 not $132,000.
Remember, both projects cost the same –$60,000.
Subtracting this from the cost savings reveals that the net present value of the first is just $21,300, while that of the second is $43,082.98 – more than double.
Wow, only a pretty dumb boss would not now choose Project 2.