Discount rate: "The interest rate used to discount future cash inflows and outflows related to an investment project, accounting for the timing of these cash flows."
Solar energy installations typically have a long lifespan, often generating cash flows for 25 years or more. When evaluating these future cash flows, it's important to understand that receiving one dollar 25 years from now is not equivalent to having one dollar in hand today.
There are several reasons for this difference in value. First, there is no absolute certainty that the entity promising the future payment will still exist or be able to fulfill its obligation so far into the future; this uncertainty is known as the risk premium. Even if the payment is made as promised, inflation will likely reduce the purchasing power of that dollar over time, meaning it won’t buy as much in 25 years as it would today. Additionally, if you had a dollar today, you could invest it or deposit it in a bank account, allowing it to grow over time; this potential for growth represents the opportunity cost of waiting for future payments. Taken together, these factors illustrate why a dollar received in the future is worth less than a dollar received today. This fundamental idea is referred to as the "time value of money."
In the specific context of solar energy projects, the savings on electricity bills expected in the future are valued less than the same amount of savings realized today. To accurately account for this, you need to enter an appropriate discount rate into the "discount rate" field.
If unsure about the discount rate, consult your financing partner or financial advisor for tailored guidance. Using no or an incorrect discount rate can misrepresent your client’s expected cash flows and financial outlook.
Where = Savings in year n
= Savings in year one
= Discount Rate
= Year of evaluation