The Typical Mistake in Renewable Energy Investment Discussions
When a buyer and a seller meet to discuss a renewable energy project the question of return will inevitably come up. The dialogue often starts with the investor asking the seller:
”What is the return?”
And invariably often the answer may be a simple and direct:
”The return is 7%”
That simple answer is perhaps in a sense a bit misleading, since it is very rare that two parties would come up with the same figure, when calculating the return of the exact same project.
Why Financial Returns Are Often Misleading
The interesting question is why one calculation results in a return of 7%, while another results in 10% or any other figure for that matter.
The reason for the disparity is that the assumptions behind the calculation are often different, and the way the term ”return” is construed varies a great deal.
An Example of Calculating Financial Returns
In this example let us base our assumption on two definitions of return:
- Return on Investment (ROI): Calculated as the EBITDA divided by the total investment.
- Internal Rate of Return (IRR): Calculated using a financial calculator or using the =IRR function in Microsoft Excel.
We will base the return calculations on a wind turbine project with the following characteristics:
- EBITDA: €2 M
- Total Investment: €25 M
- Equity: €25 M (100%)
In this example, the ROI will be calculated as:
ROI = 2/25 = 8% (pre-tax)
In the above example, we have assumed that the project will be calculated over 25 years and that the EBITDA of €2 M is the average over the 25 years.
When calculating the ROI, we do not take into consideration the annual impairment of project assets or the expected financial leverage that occurs if the project is partially financed with debt.
Instead we use the IRR, which takes into consideration the Net Present Value (NPV) of all the cash flows generated by the project.
The IRR method uses the future free cash flow projections and discounts them to arrive at a present value estimate of the project, which is used to evaluate the project’s return potential.
In our example with 100% equity, the IRR would be calculated as a 5.8% return.
If we instead assume that the project was financed with 80% debt, there would only be €5 M in equity.
Therefore, the IRR would be calculated as an 11% return.
Returns Varying from 5.8% to 8% to 11% for the Same Project
All calculations mentioned above can be considered as pre-tax numbers and, therefore, for many buyers, they could yield a tax advantage that would in turn increase the after-tax benefit of the project.
In the example we used here, the return would vary from 5.8% to 8% to 11% for the same project – all depending on the definition of ”return” that we are using.
Written by / Author; Kenn Righolt, 16. January 2016.