There are two kinds of projects out there: non-mutually exclusive projects and mutually exclusive projects.
Mutually exclusive projects are the ones where equipment fails and you need to replace it. Let’s say you’re evaluating three different replacements that have a good, better and best selection to choose from. You have nine choices in all. But ultimately, you have to take one out and put a new one in, and that means you need to choose the equipment with the best life-cycle cost, which is not necessarily the choice with the lowest first cost.
Non-mutually exclusive projects are even trickier. Let’s say you go into a building and say, “We could replace the HVAC, controls, or lighting, or perhaps add window films, solar panels and so on.” You don't necessarily have to do the solar if you do the lighting and vice versa. This makes proposing improvements to a prospect an entirely different ballgame.
When you do non-mutually exclusive projects there are four rules:
1) You want to consider lowest life-cycle cost alternatives. For example, if you are thinking of replacing the boiler, that's one of the things you could purchase with your available capital for invest in energy efficiency. You want to make sure that it's the lowest life-cycle cost boiler, because otherwise you’ll wind up buying the wrong one.
2) You want to eliminate alternatives with negative net present value. Net present value is basically how many dollars you have left over after earning your discount rate on the dollar you invest. Most people don’t want to invest in things where they have less money at the end of the project than they did when they started when all cash flows are discounted back to their present value.
3) Keep in mind that there are certain exceptions to #2. For example, let's say a school system has a boiler blow up. They have to replace it, but it’s going to have a negative net present value because it's a capital replacement. It's not being done to save energy, but to replace a capital aspect of the building.
4) You have to calculate each potential project’s modified internal rate of return (MIRR) or savings investment ratio (SIR). Modified internal rate of return is the MIRR function within Excel. Savings-to-investment ratio is a formula in which the present value of everything you receive over the course of the analysis term is divided by the present value of everything you invest in that same period. It will give you a finance jock’s version of “bang for your buck.”
Once you’ve figured things out, fund the investments in descending order of MIRR or SIR. This makes sense because if you have 10 things you could invest in, you'd probably want to do the project that would give you $4 back for every dollar you invest before you do one that would give you $1.50 back for every dollar you invest.
Lastly, you may have to choose what is highest priority because the investor doesn't have enough money to do everything. However, if you follow these guidelines you’ll be in an excellent position to justify your recommendations.
