What is Discount Rate?

Discount rate is a fundamental assumption in investment analysis. SolarNexus uses the input discount rate in its calculations of investment metrics, such as IRR, NPV, and levelized cost of energy (LCOE). The input discount rate is the nominal discount rate, as we also take electric inflation rate and general inflation rates and apply them as appropriate to relevant cash flows.

NREL published a good analysis of such valuation metrics for PV systems. Another good analysis can be found in this study by a Michigan researcher. Both have discussions of discount rate (as well as other key assumptions) to analysis.

Wikipedia provides a pretty good article on discounting cash flows. From that article:

"The discount rate used is generally the appropriate weighted average cost of capital (WACC), that reflects the risk of the cashflows. The discount rate reflects two things:

1. 1. Time value of money (risk-free rate) – according to the theory of time preference, investors would rather have cash immediately than having to wait and must therefore be compensated by paying for the delay
   2. Risk premium – reflects the extra return investors demand because they want to be compensated for the risk that the cash flow might not materialize after all"

The Michigan research paper presents a nice section on selecting a discount rate. From there:

In corporate cash flow analysis, the discount rate is often set as the company’s weighted average cost of capital – the cost of borrowing money from banks and raising it from investors. In some cases, a risk premium may be added, though this appears somewhat controversial. In the case of a homeowner, the appropriate discount rate depends on their particular financial circumstances. Accordingly, “The discount rate should be the APR [Annual Percentage Rate] of the highest risk-adjusted rate of return that you can obtain by investing your money, or the lowest rate at which you can borrow money, whichever is higher.”

SolarNexus recommends that the discount rate input should be assumed to be at least equal to the assumed general inflation rate, and probably closer or equal to the loan rates used for your project financing.

SolarNexus believes that the risk premium should be considered fairly low for PV systems, and probably not required to increase the assumed discount rate. However, this assumes that the assumed inflation rate for electricity is placed at a reasonable level. We often see overly high utility electric inflation rates as an approach to show shorter PV system payback and IRR. The assumption of overly high electric rate inflation would have to be considered an additional risk in the analysis, thereby increasing your assumed discount rate.

Note that another consideration for specific customers is to ask them about other debts that they may have. For example, if they have a significant balance on a high APR credit card, then you should use that discount rate in your analysis to fairly compare purchase of the PV system instead of paying off the credit card.