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Time Value of Money

By June 22, 2016December 27th, 2021Briefs
Time Value of Money, Michaels Energy

Choose the right metric

Every energy efficiency champion faces a time when they need to put together a financial justification for a project. Requirements for the business case differ based on the company’s financial sophistication [read: based on the number of MBAs employed]. For many, many companies, working up a 10 year cash flow will do the job nicely. But, for organizations considering competing investment options, the value of money through time needs to be included.

Capital never rests

Money (capital) either gains or loses value over time. A day’s wages stuffed under a mattress in 1950 ($6) wouldn’t buy a movie ticket today (having lost real value). But those same wages invested and earning 4% interest over those 66 years would be worth $84 today. Despite involving math, the concept is pretty intuitive. If someone asked to borrow $10,000 and offered to pay back that $10,000 in a lump sum five years later, most people, before lending the money, would consider what other purposes that money may serve (for instance a home down payment, college tuition, or a new car). In doing that, the person is considering the opportunity cost of one option over the other.

Making the case

The energy champion for a technology company wants to install LED lighting in the office spaces. The project saves energy and will pay for itself in 5 years. The company CFO wants to take into account the cost of tying up the company’s money for 5 years while the project pays for itself. To do that, she uses a discount rate of 10%, which she chose because it reflects the company’s average cost of borrowing money from banks and investors. This lighting project costs $150,000 and returns $30,000 per year in energy savings. By using a Net Present Value calculation, the CFO is able to discount the dollar savings in the future to account for the opportunity cost of tying up that money. Then, by adding all of those future values together (including the negative ones, like the $150,000 spent in year one), she arrives at the LED project’s Net Present Value of $56,512 over the expected life of the project.. This represents the amount of money the company can reasonably expect to earn over the lifetime of the LED lamps.

Get to know the decision maker

Accounting for the future value of money can help lend credibility and confidence to the investment consideration. It’s worth a second look for those energy champions that need a bit of sophistication to get their project cleared for capital.

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