Sometimes we may want to compare two investment opportunities and figure out which is a better one. Say for example should we rent or buy a house? One way go about it is by using the return on investment method. Basically we calculate how much return we might get going with each opportunity and pick the one with better returns. It is usually not as cut and dry especially if we are dealing with different risks. Yet, it is a good practice to at least find the numbers and later decide if the difference in returns is worth the risk. So in this post, I will discuss how I go about calculating the return on investment. You may have other metrics or different way to look at things, so don’t consider this to be the only option.
Since I have already tackled the question of “rent vs buy” conundrum in another post, I will use a different example. Say for example you are trying to decide if buying a solar panel is better than investing in a mutual fund or fixed deposit. Supposed you have Rs, 1 lakh to invest. How do you go about it?
Lets go with solar panel setup first. Suppose Rs. 1L would buy you 1.5 KW worth of solar power generation which includes everything like solar panels, cables, stands, circuit breakers, fuses, net metering, labour charges for installation etc. Suppose the setup can generate about 2500 units per year. Assuming cost of 1 unit of electricity is Rs. 8 then you could be saving Rs. 20K per year. Now you might think the annualized return on investment is 20% but the real rate of return is calculated using IRR (internal rate of return).
The annualized rate of return you are thinking about is actually only true if your investment of Rs. 1L gives you Rs. 20K for infinity. Otherwise the real annualized return as calculated by IRR will be different. Without being too pedantic, I will try to explain. Remember the Rs. 1L that you invested in buying the solar setup? That money is gone and you will never get back that principle. What you are saving, Rs. 20K is sort of the interest on the investment. If you invested the money in FD, you will get the interest as well as the principle at the end of the investment period. Where as at the end of investment period of solar setup you have nothing.
So what is the end of investment period in the case of solar panels? Sources on internet say that they last about 25 years. Assuming that you don’t have to do any kind of repairs on the panels or cables or any other part of the solar setup and you get Rs. 0 if you sell everything after 25 years, your returns per year as calculated by IRR is 19.78%. That is very close to the 20% simple returns calculation we made earlier. The reason is that the number of years is long enough compared to how much you are saving every year that IRR approaches 20%. Suppose the life of solar setup is only 15 years, then IRR will be 15% and not 20% as we would normally think.
Now you might say – what is the big deal? The IRR is so close to the simple returns calculations if the duration is long enough. Well, not always. If the investment returns on the solar setup is low compared to investment, then that would make a huge difference too. For example, if the solar panels were saving you only Rs. 5,000 per year instead of Rs. 20,000. You might think that is 5% return on investment. But it actually is just 1.80% per year for 25 years! So always use IRR. An easy way to calculate IRR if the yearly savings are exactly the same every year, then you can use the RATE formula in a spreadsheet like so
RATE(periods, payment per period, present value) In our example periods = 25 payment per period = 5,000 present value = -1,00,000 RATE(25, 5000, -100000) = 1.80%
If the yearly or monthly savings are non-uniform then you can list out the savings for each period and use the
IRR formula on the list of values. Anyway, going back to our example, if we assume 25 years life on our investment, and Rs. 20K savings every year, we arrive at an IRR of 19.78%. Now is that really the annualized return on investment? Not really. You started year 0 with Rs. 1L and at the end of 25 years what are you left with? That will tell you how much annualized return you got on your Rs. 1L investment.
Going by the example, once you have the solar panels you can reinvest the savings that you would have otherwise paid as electric bill. Say you invest your savings in an investment netting 12% return, then you will end up with a net annualized return of 14% and not the 20% you initially assumed. The reason is that after 25 years all the savings and the investment returns of the savings will give you Rs. 27L. Since you started with Rs. 1L, and your solar panel investment is worth zero now, the returns are 14%. See the following table for a better understanding.
|0||Solar panel setup||-1,00,000||0|
So in this case, unless you can find an investment that can give you better than 14% rate of return, you are better off installing the solar panel setup. Solar panel is the clear winner.
However, that only works if you already have the money upfront. What if you have to borrow money to build a solar setup. Would it still make sense? Lets say you took a loan of Rs. 1L at an interest rate of 10% to build the solar panel setup. Then you need to pay the bank Rs. 11,017 as EMI every year. So the savings of Rs. 20,000 will come down to Rs. 8,983 (after paying EMI). Further, suppose you invest this savings into an investment vehicle (say equity mutual fund) that gives you returns of 12% on average over the 25 years. Then your savings will grow to almost Rs. 12L by the end of 25 years.
Now the alternative investment opportunity is to not take a loan and not setup a solar panel setup. Instead, use the money that you would have spent on paying EMIs into an investment vehicle that gives 12% rate of return. Then your money would grow to almost Rs. 15 lakhs. In this scenario, it is better to not go with solar panel installation. See how quickly things changed?
You can apply the same principle to any other investment opportunities that come your way. However, it is not simple as it sounds. There are a lot of nuances and assumptions that can change the numbers quite a bit depending on your exact situation. For example
- the solar panel setup will not stop giving you returns after 25 years right? The output may be less, but it still works.
- the savings due to solar panel might increase every year due to inflation of electricity
- you may not want to invest your savings in equity mutual funds and may want to go for some safer investment with less return
- may be you already have Rs. 70K and only want to take a loan of Rs. 30K
There are still a lot more assumptions baked into the calculations based on one hypothetical person and situation. It will certainly be very different for you as would be for me. Hence, personal finance is really always personal :). Hopefully now you have some idea on how to think about your investment options.