Geeky little finance exercise, off the beaten path. I am contemplating replacing my single speed leaking 1 horsepower pump with a Pentair Intelliflo VS-3050 variable speed pump which SDG&E will provide a $200 rebate for (on claims of energy efficiency). Why not apply some discounted cashflow analysis and probability of failure modeling to evaluate the viability of the project? For me, I can have the pump installed for several hundred dollars and don't need any rewiring my existing system. Your assumptions may be different.
One thing worried me of an online review I found: premature failure of pump drive electronics. The electronic drive part costs as much as a new pump. I made up a simple probability model of failure (so we could calculate an expected net present value to the project to take into account the risk of failure). I estimate 100% unsalvageable loss ascending with 10% probability on an annual basis (with a 20% failure rate starting the second year). These estimates are entirely a product of my own creativity based off real-life experience with electronic components. Often intuitive estimates are just as good (and useful) as rigorous statistical models. Maybe someone at Pentair can e-mail me real failure rate models for this component?
This model has everything factored in: warranty, cost of capital, energy savings, and even opportunity cost of replacement (not discounted as my opportunity cost may rise in the future). You can tweak it to your heart's desire. Any expected present value that is positive makes the project a go. With my energy savings and a 2% energy inflation rate, with zero failure the project has a 58% IRR after ten years. Even with a probability of failure being factored in, the IRR comes in at 40%. Not bad. I think I'll do the project.
40% expected return annualized. Maybe spread that with a short Japanese 30 year bond position? Talk about asymmetrical payoffs! If anyone has an idea how to replicate this into a hedge fund structure, let me know.
Download the model here.
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