If you are considering investing in an energy-efficiency improvement for your home — for example, additional attic insulation or a photovoltaic system — you probably expect the investment will lower your energy bills. So it’s only natural to ask, “Is this a good investment?”

For example, let’s say that you are considering spending $5,000 on an improvement that will save you $350 a year on your energy bills. Does the investment make economic sense? The answer, of course, is “it depends.” Among the factors affecting such a decision:

- How soon do you expect to move? Most people are more likely to invest in home energy improvements if they plan to stay in their house for a long time.
- Will the improvement increase the value of your home?
- Do you expect energy costs to rise in the future? If the cost of energy rises quickly, home energy improvements will prove to be a better investment than if energy costs stay flat.
- Can you finance the work with a low-interest loan? The lower your borrowing costs, the better the investment.
- What is the expected lifetime of the measure you are contemplating? A long-lived measure like attic insulation is likely to be a better investment than the purchase of short-lived equipment like a new water heater.
- Will there be any maintenance costs associated with the energy improvement?
- Do you value the environmental benefits associated with reduced energy use, even if the cost of achieving that goal is high?
- Do you value the peace of mind that comes from lower energy bills?
- Do you value the comfort improvements that may accompany some energy-efficiency improvements?

Some of the items on this list — for example, the interest rate on a loan — are quantifiable. Others — for example, the rate of energy cost inflation — can only be estimated. And some — for example, how much one values having a reduced carbon footprint — can’t be quantified at all.

### Sick and tired of payback questions

There are so many variables in this list, in fact, that some home performance contractors and solar equipment installers are sick and tired of hearing payback questions. The usual reaction from the sick-and-tired crowd is, “Nobody ever asks what the payback period is for a granite countertop or an SUV!”

(Where would we be without granite countertops? They’re such handy devices for making almost any argument…)

However, I’ve noticed that the people who make this speech are usually people who sell home improvements with a very long payback. You never hear CFL manufacturers make the same speech.

Let’s face it: payback matters. It isn’t the only factor in making home improvement decisions — other factors are important, including improved comfort and a smaller carbon footprint — but it’s an important one.

So now we come to the question: How should we calculate payback?

### There are many ways to perform these calculations

If you start diving into the world of payback calculations, you quickly learn that there are many ways to perform such an analysis. Among the terms you are likely to encounter:

- Simple payback
- Cash flow analysis
- Net present value
- Internal rate of return
- Return on investment

If you’re an accountant, all of these terms are familiar to you. If you’re like me, however, you may need to study up a little before these terms become clear.

### Simple payback analysis

Let’s go back to our original example: you are considering a $5,000 improvement that will save $350 a year on your energy bills. To calculate the simple payback period, just divide the cost of the work by the annual savings to find the payback period in years. In this example, 5000 ÷ 350 = 14.3, so the improvement has a simple payback period of 14.3 years. In a little over 14 years, you will “break even.” If the improvement lasts longer than 14.3 years, then all subsequent savings are gravy.

The main advantage of a simple payback calculation is that it is simple. It may not consider a variety of factors — for example, maintenance costs or energy cost inflation — but it’s quick and easy to understand. And it’s even arguable that, considering the fact that many of the factors it ignores can’t be determined precisely anyway, such a calculation may be accurate enough for many routine decisions we make.

### Cash flow analysis

If you are borrowing the money to pay for the home improvements, a cash flow analysis probably makes more sense than a simple payback analysis. For example, let’s say that the $5,000 measure is being rolled into a new home mortgage. Since you know your mortgage interest rate and term, it’s fairly easy to calculate the annual cost to borrow $5,000. (One easy way to do this is with an .) If it’s a 20-year mortgage at 6% interest, the cost to borrow $5,000 is $35.82 per month, or $430 per year. If the $5,000 improvement saves you only $350 per year on your energy bill, then borrowing money to pay for the improvement doesn’t work out on a cash-flow basis.

But if the $5,000 improvement saves you at least $431 a year on your energy bills, then the improvement is “cash flow positive” from Day One. If the cost of energy increases, your cash flow position improves.

### Integrating inflation considerations into a cash flow analysis

The cash flow example I provided is fairly simple, but a cash flow analysis can account for more factors than I included. For example, if you are considering the purchase of a solar hot water system, it would be wise to budget for system maintenance. Maintenance costs are a negative cash flow, just like a mortgage payment.

It’s also possible to include inflation assumptions in a cash flow analysis. Let’s assume that a homeowner borrows $5,000 to install a solar hot water system that saves $350 on energy bills during the first year of operation. The homeowner wants to budget $50 per year for system maintenance, and assumes that maintenance costs will rise at the rate of 3% per year.

Let’s also assume that this homeowner wants to account for energy cost inflation. Of course, the future cost of energy is hard to predict. Building scientist John Straube has argued that the cost of energy has increased 8% per year in recent decades — a rate that is higher than the underlying rate of inflation. However, this conclusion depends on your time frame; from 1981 to 2009, for example, energy cost inflation was actually *lower* than the general rate of inflation.

In this example, we’ll assume that energy cost inflation is 7% per year. What would a cash flow analysis look like over the next 20 years? One way to answer this question is to create a table that breaks down cash expenses and savings by year. (If you create this table on a spreadsheet program, you’ll save yourself a lot of data entry.)

## Table 1 – Cash flow analysis assuming 7% energy cost inflation

This investment begins generating a positive cash flow in Year 6, and continues to generate a positive cash flow through the end of Year 20. If we total all of the annual cash flow amounts, we discover that after 20 years, the homeowner has saved $4,405. So far, so good.

However, let’s perform the same exercise with a different assumption. What if the cost of energy only increases at a rate of 3% a year instead of 7% a year?

## Table 2 – Cash flow analysis assuming 3% energy cost inflation

In this case, even though this investment is cash flow positive in Year 14 and subsequent years, the outlays are greater than the credits. If we total all of the annual cash flow amounts, we discover that after 20 years, the homeowners have shelled out $539 more than they saved.

These two different results — one showing an investment that yields $4,405 in savings, and another showing an investment that results in a loss of $539 — demonstrate how our conclusions about payback depend heavily on our assumptions.

Or, as a cynic might say, all you have to do is tweak your assumptions, and you can prove any conclusion you want.

### Net present value

Alert readers will note a problem with both methods of analysis introduced so far: they fail to account fully for the fact that the value of money changes with time. If we total all of the positive and negative cash flows in the last column of our table, the calculation assumes that $100 in Year 2 has the same value as $100 in Year 19. Of course, it doesn’t; because of inflation (or, to put it another way, to account for the opportunity cost incurred by spending money on an energy improvement instead of on a potentially more profitable investment), money held today is worth more than the same amount in the future.

If we go back to Table 2, we see energy savings of $371 in Year 3. For a homeowner who might earns 4% interest on a certificate of deposit, the present value of $371 received in three years is only $330 in today’s dollars.

To compare cash flows that occur in different years, we need to discount the cash flows in future years to calculate the present value of these cash flows. This is the first step in performing a net present value analysis. We use a “discount rate” to perform the calculation; a discount calculation is simply the reverse of an interest rate calculation. (In the previous paragraph, I assumed a discount rate of 4%. The cash flow of $371 three years from now must be discounted to determine its present value of $330.)

Once all of the anticipated cash flows over the life of an energy improvement measure have been discounted, we can add them all up and determine the net present value of the proposed improvement. (In other words, net present value is defined as the sum of the discounted net cash flows.)

If an energy-efficiency improvement is expected to last 20 years, we would calculate the net cash flow for each year; then we would discount each amount to determine its present value. Finally, the column of figures can be added up to determine the net present value of the proposed improvement. If the net present value is greater than zero, the proposed investment would be considered profitable. (These calculations are made easier if you use an .)

Here is the formula to determine net present value (NPV), assuming that r is the discount rate, and n is the number of years under consideration:

When the numbers from Table 2 are entered into a net present value calculator, we learn that the net present value of the project is -$595, which is a lower value than the -$539 total that we obtained by simply adding up the cash flows without discounting them. The reason for the difference is that the *present* value of the positive cash flows in Year 14 (and subsequent years) is less than the dollar value of the cash flow in Year 14.

One problem with net present value calculations is that we don’t really know what the discount rate should be over time, since it’s hard to anticipate future inflation or future interest rates. Like many other factors under consideration, including energy cost inflation, the discount rate is basically a guess.

### Internal rate of return and return on investment

If you love accounting, you can calculate the internal rate of return of a proposed energy improvement, using the net present value formula provided above. The internal rate of return is simply the discount rate (r in the formula) when the net present value is equal to zero.

It’s also possible to calculate the return on investment for your proposed energy improvement. To do this you need to calculate your annual net cash flow, which is the sum of the present values of the anticipated cash flows divided by the number of years under consideration. The return on investment (ROI) formula is:

ROI = (annual net cash flow) ÷ (capital cost)

Once you know the internal rate of return or the return on investment for a proposed energy improvement, you could presumably compare the investment with a more conventional investment vehicle — for example, an investment in U.S. government bonds. However, note the following important distinction: if you invest $5,000 in a solar hot water system, the equipment will wear out in 20 years and be carted off to the dump. On the other hand, if your money is invested in a government bond, you might earn 2% interest per year — and you’ll still have the $5,000 of capital at the end of 20 years.

### The bottom line

I’m glad that accountants have given us tools to perform a cash flow analysis and to calculate the net present value of a proposed investment. Because these calculations have been made, energy experts can advise homeowners that it always makes sense to swap their incandescent bulbs for CFLs, while window replacement doesn’t make financial sense.

Every few years, it’s important to take a fresh look at these calculations. As Jesse Thompson pointed out in his recent guest blog, falling prices for photovoltaic modules mean that investing in a PV system makes a lot of sense in areas with high electricity costs. Just two years ago, however, it was hard to make the same statement.

Many energy-efficiency measures — for example, installing exterior rigid foam on an existing house — are hard to justify using any economic analysis. But that doesn’t necessarily mean that they aren’t worth considering. Remember, all of these cash flow and net present value calculations include a great many unknowns, most notably our assumptions about energy cost inflation. Whenever we’re making a prediction about future prices, it makes sense to be humble.

On the other hand, many energy-efficiency advocates are overly optimistic in their cash flow predictions. For example, techno-nerds often underestimate maintenance costs and overestimate equipment lifetime — for example, in cash flow predictions for ground-source heat pumps or solar hot water systems. If you are hoping to save $350 a year on your energy bills, a single service call to repair a broken pump can wipe out one or two years of anticipated savings.

### Determining the real cost of energy

The exercises presented in this article show how different assumptions about the future cost of energy produce widely differing conclusions about payback. From the perspective of an environmentalist, however, trying to guess the future cost of energy is an irrelevant exercise.

Since the continued burning of fossil fuels at current rates is likely to lead to catastrophic environmental disruptions whose effects could linger for thousands of years, it’s fundamentally impossible to choose an appropriate price for fossil fuel. Seen from this perspective, efforts to reduce our use of fossil fuels is a moral imperative, and the actual payback periods for energy efficiency measures are irrelevant.

We still need to make some simple calculations, however, so that we invest our money wisely. Efforts to reduce energy use should always start with the low-hanging fruit. To determine which fruit hangs lowest, it turns out that simple payback calculations are accurate enough for our purposes.

So, here’s my advice: sharpen your pencil if you want to, but in the long run, you really don’t need a fine point. You can forget the exponents; fourth-grade long division is all you need.

*Last week’s blog: “The Third Annual Christmas Parody.”*

## 22 Comments

ChristmasMartin,

Thanks for the Christmas-themed post. It's all about the $$$!

Seriously, though...this is a great reference for those who want to do financial analysis of energy improvements. My personal preference is to do a cash flow analysis using only the "known" variables - interest rate, term, and a conservative estimate of current energy savings and maintenance costs. I try to leave discussions of energy cost inflation and discount rate to those that possess a crystal ball.

Risk assesmentThanks for both the detailed how-to and the notes about non-monetized factors.

Another factor to consider is risk exposure. People usually think of that in terms of stocks vs. bonds, but the risk of high energy prices is more vital to our survival. What if energy prices go up and up and up, and you have to severely limit your energy use and/or cut back on other essentials? What if utilities are out for a few days or a few weeks? The risk of these things happening is low, but increasing from both environmental and economic factors. Because many of us haven't experienced these events in our lifetimes, we don't consider them. But the Great Depression, the energy crisis of the 70's, and even events like the earthquake in Japan should make us think twice about assuming energy security. How valuable is energy security and energy independence?

I also think that your note about granite countertops and SUV's reveals that it's socially acceptable to "splurge" on these things, but sometimes it's not acceptable to spend extra money on green features that may not pay back, or even to consider factors like risk of energy insecurity, which I mentioned above. I find myself having to justify taking the bus to work to myself and others, I'm sure folks have gone through similar experiences with green buildings.

ThanksThanks for another great article Martin. I've had a lot of people look at me with googly eyes when i tell them i'm putting 4" of foam on my house, and I'd have a hard time recommending it to someone else. But for me, It makes sense. The foam is free, minus cost of renting a lumber truck/driver, and labor is free. I don't anticipate having more than $700 into this, and I'll be here for a long time. So it makes sense to me. But at the end of the day, I really don't think there's a one size fits all answer.

energy calculationsGREAT ARTICLE!!! Loved it. 10 star hit.

G. Batema; licensed Michigan GC.

Comfort is an aesthetic valueI have designed and built over 45 custom sustainable homes over the past near 20 years. Most all were very energy efficient. Most all of my clients were impressed most with the comfort factor. After the first few years, I used comfort as a selling point. I think it counts as much or more than the granite countertops. People like to live in a comfortable home, free of cold drafts, cool in the summertime, and clean air to breathe. Worth every penny!

Energy Calculations Too Difficult for Average HomeownerYou've done a fantastic job of laying out from simple to more complex, how anyone can calculate the true savings from making energy improvements. There are 2 key items to make this process viable - a table of realistic energy use for existing & proposed new home features ... plus a simple to use, calculator program that lets you include (or omit) the figures you suggest.

My biggest problem is when you add up all the theoretical energy savings promoted, it's like 3 to 5 times the actual utility bills.

Dollars, comfort, health, safety!Simple payback is a start but we are always ready to highlight other factors besides the financial factors. Comfort, health, safety, longevity, enviroment, sustainability, local products, etc... Each plays a part & should be at least quickly mentioned, or even be the "driver" when it is appropriate!.

Another good article Martin!

Errors in your energy inflation analysisMartin, you stated above that energy inflation was less than the over-all inflation between 1981 and 2009. Absolutely not true! The attached graph starts in 1980, and goes through 2011. The dip in the energy inflation graph near the end represents the drop in energy prices in 2008. This data was taken directly from the US Dept. of Commerce website, I created the graph. The average energy inflation for the period you named was about 6.33% per year, while the over-all inflation rate was only 3.34%. What is worse, for most of that time, up until the world economy collapsed in 2008, energy inflation was averaging well over 7.5%. If you drew a line roughly through the middle of the colored section between the curve representing the compounded 6.33% rate of inflation and the actual inflation year-over-year figures at the top of the graph, you would get to what a financial advisor would describe as the mean inflation rate on energy, around 7.5%.

The slow curve at the bottom represents the 3.34% total CPI curve, compounded evenly, the dashed line just above that represents the actual year-over-year rate of inflation. Any way you look at it, if you are counting on being able to purchase your future energy needs with the same percentage of your income that you are spending today, you'd better plan on getting some nice pay-raises over the next few years! What are you going to do once you are an a fixed income, at the mercy of Congress?

Jill Eikenhrst hit the nail on the head, it is all about risk exposure. None of us can afford the risk involved with ignoring our energy future!

A few pointsWe use NPV all the time in our industry (high tech) to justify projects and investments. A couple of observations:

I have never seen any payback calculations on green investments that include maintenance or replacement. You should take an annual maintenance reserve into the equation to be honest with a home owner. If payback is 20 years and replacement life is 20 - there is only break-even.

You also don't take into account the declining cost of green technologies. In many cases, you will have a much better NPV if you wait to invest - depending in the retrofit costs. CFL's used to be $5 - now they are $1 - it's good to consider this when investing. Solar is dropping in cost annually.

As far as determining an interest rate - or "cost of money": I would just use the average inflation of energy over the economy in general. The difference will provide an IRR / NPV that makes the most sense. I checked the average US cost of electricity over the past 20 years. It is running at a 2% inflation rate. The US economy is running around 3% for that period (and on the general decline) - so your cost of energy money is -1% - power is getting a bit cheaper. I'm sure this figure will make me a ton of friends in the green energy industry (vested interest is tough to deal with).

Finally, I would not think about getting a specific figure, but create an "upside / downside" analysis that provides the anticipated NPV and break-even points. In simple terms, you could say "upside is payback in 8 years, downside is 20 years." I think helps people frame the risk in their minds.

Response to Ted CliftonTed,

I respectfully disagree. Anyone who wants to verify the information on the Consumer Price Index from 1980 to 2010 can view the data here:

Just like you, I took my data from the U.S. Department of Commerce Web site.

The Web site uses the period from 1982 to 1984 as its benchmark. The CPI for that period is given the arbitrary value of 100. In 1980, the CPI for all items (indicating overall inflation) was 82.4. That indicator rose to 218.1 in 2010, indicating an inflation rate of 264% for the time period in question.

The same Web site includes a column showing the CPI for energy during the same period. The index for energy rose from 86.0 in 1980 to 211.4 in 2010, indicating an inflation rate of 246% for energy for the time period under discussion -- a rate lower than the overall rate of inflation.

I have attached my own Excel spreadsheet with these numbers.

Concerning predictions of energy price inflation: my own position is that of the cynic. As I wrote in my article, "All you have to do is tweak your assumptions, and you can prove any conclusion you want." It's certainly possible to choose a historical time frame that shows that energy prices increase at a faster rate than the general rate of inflation. Conversely, it's equally possible to choose a historical time frame that shows that energy prices increase at a slower rate than the general rate of inflation.

Right now, natural gas prices are dropping. Good luck predicting the future!

Response to Thomas FarwellThomas,

You wrote, "I have never seen any payback calculations on green investments that include maintenance or replacement." It's surprising that you are posting that comment on this blog page, since my article specifically addresses both points.

In one of my examples, I wrote this concerning maintenance costs: "For example, if you are considering the purchase of a solar hot water system, it would be wise to budget for system maintenance. Maintenance costs are a negative cash flow, just like a mortgage payment.... Let’s assume that a homeowner borrows $5,000 to install a solar hot water system that saves $350 on the energy bills during the first year of operation. The homeowner wants to budget $50 per year for system maintenance, and assumes that maintenance costs will rise at the rate of 3% per year."

This is what I had to say on replacement costs: "If you invest $5,000 in a solar hot water system, the equipment will wear out in 20 years and be carted off to the dump. On the other hand, if your money is invested in a government bond, you might earn 2% interest per year — and you’ll still have the $5,000 of capital at the end of 20 years."

For three years I had my own business providing capital needs assessments for multifamily housing projects, so I am well acquainted with replacement reserve accounts.

Concerning another one of your points -- "You also don't take into account the declining cost of green technologies" -- the point applies to some but not all technologies. Moreover, future prices are hard to predict. Cellulose insulation hasn't gotten cheaper over the last 30 years; nor have replacement windows. The cost of these items has tracked overall inflation rates, or perhaps increased at a faster rate.

On the other hand, you're right about the cost of PV systems and CFLs. However, the cost of these items won't continue to drop indefinitely, and it's hard to predict future costs. In 1980, widely publicized predictions of dropping PV prices were uniformly overoptimistic.

Finally, I agree with your "upside/downside" approach -- that makes sense.

Response to Tina GleisnerTina,

You wrote, "There are 2 key items to make this process viable - a table of realistic energy use for existing & proposed new home features ... plus a simple to use, calculator program that lets you include (or omit) the figures you suggest."

Concerning your first suggestion: it is impossible to create "a table of realistic energy use for existing & proposed new home features."

While such a table is impossible, it is possible to identify the current cost of energy use for a specific house, as well as projected savings for various energy retrofit improvements to that house. To do this, one needs to have a complete energy audit of the home, and to input the information into an energy modeling program like REM/Rate.

The reason that this information can't be presented in a table is that it is specific to each home. Variables include the local climate, local energy costs, the home's air infiltration rate, glazing specs, window orientation, insulation levels, etc.

Concerning your second suggestion -- to create "a simple to use calculator program that lets you include (or omit) the figures you suggest" -- that's theoretically possible. But for the reasons outlined in the article -- namely, because many of the variables are unknown and have to be guessed at, and because many of the benefits of energy retrofit work (like improved comfort or energy security) can't be quantified -- I think such a calculator would give the misleading impression that precision is possible in an area where precision is in fact impossible.

PaybackMartin

you ask "Does the investment make economic sense?". I ask: why are thermal improvements the only element of a building project where this question is asked? Does a granite countertop make economic sense? Or a media room? Or the stuff that goes into the media room? And why aren't thermal upgrades evaluated for what they actually do: generate savings over the life of the structure? Perhaps the potential of efficiency to create jobs and reduce carbon is not being realized because too many people ask the wrong question.

Response to Rick BarnettRick,

I agree with you, which is why I quoted the same (oft-delivered) speech in my blog: “Nobody ever asks what the payback period is for a granite countertop or an SUV!”

Interesting Data (or lies, damned lies, and statistics)Martin,

A closer examination of our data from the Dept. of Commerce website shows that it not only makes a difference which years you look at, but which months as well. Because i wrote my article on this topic last February, I used monthly data from January 30th of each year, which was the most up-to-date at the time. Energy costs rose about 10% in 1981, between January and the end of the year, which is when your annual data seems to have been taken for the table supplied in your link. While energy was also rising quickly this year, it did not rise nearly as quickly on a percentage basis as it did in 1981. Either way, however, if you discount the economic collapse of 2008-2009, in which energy costs dropped about 20%, energy still out-paced all other inflation by a considerable margin. If you go back to the Arab Oil Embargo days of 1973, and start your calculations just before then, you get even scarier numbers than you would beginning in 1981.

Response to TedTed,

As I said, all you have to do is tweak your assumptions (or the years of historical data you choose to look at) and you can prove any conclusion you want.

Basis for my graphBTW, the increases in energy costs shown on my graph were taken directly from the Dept. of Commerce year-over-year percentage increases for the years from January of 1981, through January of 2011, and applied to the starting average cost of household energy of $214. I do not remember where I got the $214 number, but I think it was from local Puget Sound area utility company data. You can clearly see the dip in 2008-2009, but it barely takes the cost of energy below the 6.33% inflation line.

One other comment on an opinion stated above by others, regarding the possible advantages of waiting until prices come down to start saving energy. Call me a fanatic, but when it comes to fossil fuels, energy used is energy gone, forever. Once it is all gone, there is no turning back. Does anyone know how to quantify that? The best example I could think of I used during a talk at the National Lakesideca Conference a couple of years ago: We all flew in here from somewhere, what if we suddenly had used the last drop of jet fuel, and all had to walk home. Many of us would have found ourselves thousands of miles from home. It would have been at least four months of walking for me, and I am certain I would have missed my wife and children during that time, if I survived the trip!

Contrarian ThoughtsWe're not so rational as this . . . We are driven to action by our values, such as doing our part for our planet. We invent the economics we need to realize larger values (at least in the long run). Economics available today is helpful for handling risk, keeping essential resource flows in place as we reach for our values (a stone at every step across the river keeps us above the surface through the journey). Economics informs current constraints to realizing our values. Economic analysis is helpful to determine if our seat will remain available once our adrenalin drives us up and away to realize our values. We are not economic animals. I doubt economics drives adrenalin (though I'm willing to learn), so I doubt economics drives much anything -- constrain yes, drive no -- doctrine that humans are economic animals to the contrary.

Reducing energy use impacts the income statement AND the balance sheet. Play with a full deck! Carefully selected efficiency and renewable energy upgrades may "pay for themselves" with a balance sheet entry, especially if one's income statement improves. Using ROI: (annual savings - annual maintenance) / (cost - asset value). One may adjust for time value of money, differential energy price inflation, depreciation charges, etc. in pursuit of accuracy (and don't forget reduced utility cost is tax free income).

Chicago-area natural gas prices vary as much as +/- 35% year-to-year and seasonally. Cost to install efficiency measures easily varies as much, as do issues of quality installation, durability, loan terms, etc. Let's not over-rationalize our calculation procedure in a context of real-life uncertainty.

Perhaps most certain: not addressing climate change will be BAD. Without a planet, you can't have an economy.

Remember Taxes ...Good article on the financial and non-financial considerations of investing in energy improvements.

One element that you may wish to add to your calculations is the tax effect of the cash flows. For many people, the interest cost is tax deductible, which lowers the effective cost. On the other hand, the cost of energy is not tax deductible.

Each of the elements in the investment analysis has a tax impact, and they may be at different rates. For example, the capital appreciation may be at a lower rate.

Most people considering investing in home improvement pay income tax, albeit at various rates. And,

those rates may change (e.g., go up?). A robust analysis of investments, even home improvements, should consider the tax effects.

If you are putting a spreadsheet together, it is easy to put in a calculation for the tax effect of each element, and then link that to a tax rate. Do the calculations at 0% tax (I wish!) and then try 10%, 20%, etc. and see how the numbers change.

If you are looking at the various elements in a comprehensive investment analysis, you should include the tax iimpacts of each of those cash flows and see what that does to the numbers.

Response to Bryan MekechukBryan,

At the end of my article, I explained why it is usually unnecessary to get overly fussy and precise with payback calculations. That said, you make a good point, and any accountants among our readers should take your advice to heart.

Although your comment focused on income taxes, property taxes can also affect payback calculations. In some (but not all) communities, tax assessors may assign a higher value to a house with a large PV array on the roof. After all, the PV array makes the house more valuable. If the homeowner ends up paying higher property taxes because of such a higher assessment, the property taxes can take a big bite out of any energy savings.

Nice article -I like the implication that too simple an analysis on a complex decision might be stupid. "Payback" is a term I often hear unsophisticated people using in an attempt to appear sophisticated because they are afraid of being taken advantage of.

When people who hardly have 2 sheckles to rub together tell me they want a 3-4 year payback I have to work hard to stifle laughter. I look for Alan Fundt and wonder who did the makeup on Warren Buffet to make him look like the person in front of me. Anyone with the magic ability to generate 20-30% annual after tax returns doesn't ask for crazy paybacks on home improvements. Their time is too valuable. They simply fix their houses. They want the experiential results of efficiency - quiet, comfort, and control - the portion of these improvements paid for by energy savings is totally anecdotal for these heavy hitters.

I like the cash flow analysis. That's how most people pay for improvements - just happens these improvements help pay for themselves - so we are attempting to do net cost analysis.

As one commentor suggested, when comparing rate of return one DEFINITELY needs to consider the income tax factor of alternative investments.

I liked both the article and the commentsI have been working on cutting my energy costs over several years and recently had my second energy audit completed. Total cost $6,500 - $2000 gov rebate = $4500. Estimated energy savings are $480. Currently our electricity has a sales tax of 13% which takes that saving up to $542. The payment on the 10 year loan is $580 a year + $50 maintenance. $88 a year for the more secure feeling is worth the difference. Using a 3% increase in electricity costs those savings will rise to $707 in ten years. Put in the equation that we will also cut our annual "carbon footprint" by 3.8 tonnes, it becomes a no-brainer. Have a great day, everyone!

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