Payback on Energy Projects, Part 2

Here’s another trap to avoid when relying on “payback” as a way to evaluate energy improvement projects. Once again, payback is a measure that describes the number of years that it takes for an investment to "pay for itself" through the annual savings or benefits that the investment creates. To calculate it, one merely divides the total cost of a proposed investment by the annualized savings (or benefits) that the investment will provide.

Look closely at the different cash flows in examples one and two below:

Click on image to enlarge

Click on image to enlarge
Example 2 provides additional years of cash flow, but the payback measure is the same! An alternative approach uses internal rate of return:

Click on image to enlarge
By relying on payback alone for investment analysis, there’s a good chance of rejecting or mis-prioritizing valuable projects. Try considering IRR results in combination with payback measures.