Choosing the
Optimum Financial
Strategy
Upgrading Meat Packing
Facilities to Reduce Pollution
EPA Technology Transfer Seminar Publication
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CHOOSING THE OPTIMUM
FINANCIAL STRATEGY
Upgrading Meat Packing Facilities
to Reduce Pollution
ENVIRONMENTAL PROTECTION AGENCY* Technology Transfer
October 1973
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ACKNOWLEDGEMENTS
This seminar publication contains materials prepared for the U.S.
Environmental Protection Agency Technology Transfer Program and
presented at industrial pollution-control seminars for the meat pack-
ing industry.
This publication was prepared by Uday M. Patankar and Charles
R. Marshall, Research Associates, of J. A. Commins & Associates, Inc.,
Fort Washington, Pa.
NOTICE
The mention of trade names or commercial products in this publication is
for illustration purposes, and does not constitute endorsement or recommenda-
tion for use by the U.S. Environmental Protection Agency.
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FOREWORD
Much has been written on how to select pollution-control equipment, but relatively little on
how to pay for it. A sound capital investment strategy, however, can mean the difference between
profitable operation and controlled cash flow, on the one hand, and fiscal chaos on the other. This
report is an explanation of how some proven tax and financing strategies, and their use in various
combinations, can help the financial position of three hypothetical meat packing operations, with
differing management goals, facing capital equipment expenditures. For the meat packers who
have a choice between onsite treatment and sending their pretreated wastes to a municipal system,
a method of financial analysis of these alternatives also is presented.
No matter how adept and capable a financial manager may be, it is entirely possible that he
could overlook some important aspect of fiscal management of pollution-control expenditures, be-
cause of the new and unique nature of the legislation, the high degree of complexity, and the one-
shot nature of the decision. This report was prepared especially for the Environmental Protection
Agency Technology Transfer Seminar for meat packers. It shows the small businessman the type
of financial analysis that should be accorded a pollution-control expenditure, because of the possi-
bilities of substantially reducing the funds expended and of smoothing out the cash flow trauma
that otherwise could develop.
The report has been tailored to the meat packing industry engaged in slaughtering and process-
ing, but not in processing alone. The meat packing industry is faced with several Federal regulatory
programs, of which water-pollution control represents the most significant dollar outlay. The finan-
cial laws and analytical techniques, however, have applicability to all air and occupational-safety-
and-health situations for any industry.
This report primarily focuses on areas such as the stunning, bleeding, cutting, eviscerating, and
processing phases of curing; therefore, wastewater is the major pollution situation considered.
Wastewaters from domestic use and boiler and cleaning operations are minor organic sources that,
while included in the definition of wastewaters, are not discussed in the report.
The analysis is applicable to meat packers with their own treatment facilities and to those
whose facilities connect with the municipal system. At present, 60-70 percent of all meat packing
effluent goes to municipal facilities; the remainder, with some form of treatment, goes from the
meat packers to receiving streams. This mix is subject to the possibility of substantial change, owing
to the higher user charges to be faced in the future, brought about by the Federal Water Pollution
Control Act and new standards for private treatment.
The illustrative situations used in this presentation are necessarily simplified; they are represen-
tative examples that by no means exhaust the variety of available alternative tax and financing
strategies, particularly those relating to pollution-control equipment. Much financing—and, to a
lesser extent, tax treatment—varies by jurisdiction. Thus, it is necessary to consult the latest tax
rulings and legislation governing in the particular location before undertaking final decisionmaking.
in
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CONTENTS
Page
Foreword iii
Chapter I. Introduction : 1
Management Summary and Guide 2
Organization of the Report 3
Chapter II. Depreciation 5
Relationship of Depreciation to Taxes and Cash Flow 5
Net Present Value 6
Water-Pollution-Control Investment for Meat Packers 7
Summary 11
Chapter III. Financing Strategies for Pollution-Control Investments 13
Methods Used in Analyzing Financing Costs 13
Bank Financing 15
Small Business Administration—Water Pollution Control Loans 15
Government Aid to Financing (Tax Free) 15
Comparison of Financing Methods 16
Summary 18
Chapter IV. Developing the Optimum Financial Strategy 19
Chapter V. State Financing and Tax Incentives 25
Iowa 27
Illinois 28
Missouri 28
Kansas and Nebraska 28
Review 29
Chapter VI. Financial Decisionmaking Theory for Municipal versus Private Facilities .... 31
Pretreatment Costs 32
Byproduct Recovery Value 32
Operating Cost Differentials 32
Municipal Versus Private Wastewater Treatment 32
Summary 33
Chapter VII. Illustration of Optimum Financial Strategy for Pollution Control for Municipal
versus On-site Treatment 35
On site 35
Municipal 36
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Chapter I
INTRODUCTION
As the 1970's proceed, environment-related management decisions will be more complex and
frequent. The impact on businesses of nonproductive environmental expenditures can be signifi-
cant where byproduct recovery is limited or nonexistent. It is clear from provisions of the 1972
Federal Water Pollution Control Act (FWPCA) amendments (Public Law 92-500), coupled with the
existing Clean Air Act, that industry must commit sizable capital to meet the environmental stand-
ards the Nation has set.
Many governmental institutions have shown compassion for the necessary private equipment
expenditures and public treatment facilities by providing means of reducing or softening the finan-
cial expenditures for pollution control. There exists a mild governmental practice of spreading some
of industry's pollution-control costs over the general public instead of restricting them to the com-
pany and, to some degree, its customers. This spread is accomplished by excusing pollution-control
devices from certain sales, use, and property taxes, by allowing tax-exempt financing by the com-
pany of the expenditures, or through adjustment in company income taxes by the addition of spe-
cial depreciation alternatives. All these programs result in the company's paying lower taxes than
would be the case if the equipment were used for some other manufacturing or service purpose.
Another set of incentives provides for the possibility of government treatment of wastes at lower
costs than self-treatment through Federal Government grant programs.
To put these incentives or cost reduction practices into perspective, it should be pointed out
that they do not pay for the pollution-control investment, nor do they overwhelmingly reduce the
cost; however, they can have a pronounced effect on cash flow and profit positions, depending on
the alternatives selected. Because procurement of control equipment is a relatively unusual business
occurrence, and because of a considerable body of new and involved tax and financing regulations
for such a purpose, it is likely that company financial managers are less familiar with the many possi-
bilities than they would be with the more common business operations.
This report will demonstrate that it is well worth spending time in analyzing the innovative
methods of financing pollution expenditures and their equally innovative tax treatment. The report
will alert decisionmakers as to the availability of and qualifications for some of the financing incen-
tives that Federal, State, and local governments have made available.
Obtaining the optimum financial and tax incentives for a company could save tens of thousands
of dollars over the life of the equipment. For example, a recent article1 demonstrated the cost
savings that tax-exempt pollution-control revenue bonds can provide. "Over the life of a 20 year $10
million issue, the typical interest saving is about $3.6 million." Some revenue bond issues allow for
deferred repayments of principal, and permit the largest payments at the end of a 20-30-year issue.
Meanwhile, the company can take depreciations and use investment tax credits that lower taxes.
Thus, it can build up a cash flow that is used in other areas of the business. On that cash flow, earn-
ings are generated that help to repay the bond principal at the later time.
1 Business Week, pp. 50-51, July 29, 1972.
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On balance, more of this report is devoted to the financial analysis for equipment purchases
than to user charge analysis, for the following reasons:
• First, most industries will face equipment purchases for onsite treatment or municipal treat-
ment since the latter alternative requires pretreatment.
• Second, other regulatory programs, for example, the Clean Air Act, normally show their
impact through required capital equipment expenditures.
The financial techniques used in examining pollution-control expenditures are well established;
however, the future costs to be analyzed are only beginning to become apparent. Under the en-
forcement provisions of the FWPCA's National Pollutant Discharge Elimination System, effluent
guidelines relating to the best practicable technology have been issued specifically for many indus-
tries treating on site. These guidelines give many companies an idea of how they will be required to
control by 1977, but final cost estimates may not be ascertainable until compliance terms of a
given company's specific permit are set and issued.
For costs of discharging to municipal facilities, pretreatment guidelines from EPA are ex-
pected momentarily. The other major cost factor, user charges for those who hook into municipal
facilities that receive Federal grants, will not become accurately known until late 1973. These
costs consist of the equitable cost apportionment of recovering the capital and operating and main-
tenance costs of the company's portion of municipal treatment costs. Once the EPA completes its
process, meat packers and others then will be able to determine whether it would be financially
preferable to make a capital equipment investment for their own private treatment facilities, or
whether being hooked into a municipal treatment system would be better. There may be regula-
tions, however, that would preclude the exercise of the results of such a decision. This report will
indicate how to proceed with an analysis once the permissibility and costs of using municipal facili-
ties are defined more adequately.
MANAGEMENT SUMMARY AND GUIDE
It has been noted here that there are a number of innovative alternatives that have sizable, dif-
fering financial consequences amounting to tens of thousands of dollars. Many of the alternatives
require, by law, that once a financial decision is made it cannot be changed, or it can be changed in
only one direction. Other decisions are final in that it would be prohibitively costly to change later
on in the program. Therefore, the following five steps should be taken in analyzing financial infor-
mation as a minimum before equipment or charge decisions are made:
1. Determine for all debt financing of pollution-control investments the most effective com-
bination of rate and term of the loan. Calculate the negative cash flows involved and their
net present values.
2. Calculate the year-by-year cash inflows and the present values for each available choice
of depreciation.
3. Select the management objective by which it would be desirable to judge the financial
impact of the investment in equipment; for example, lowest short term profit impairment,
least cash drain, long term profit impairment. Compare the combinations of financing
and depreciation values calculated in steps 1 and 2 against the established management
objective, and select the combination best suited for company needs.
4. Determine what the municipality's user charge will be for processing wastes, and estimate
the capital expenditure necessary for any pretreatment facility. Calculate the present
values for the treatment expense and a present lease value for the user charge payment.
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5. Compare the values and year-by-year effects of step 4 and steps 1-3 against the selected
financial management objective. This comparison will allow a choice between plugging
into municipal waste water or investing in a private treatment facility, from a financial
point of view.
This'analysis presumes that the legal and tax implications of each financial alternative are under-
stood fully by the analyst in order that present values and cash flows can be calculated. The analysis
does not include the legislative and technical matters that may preclude a meat packing plant from
having the freedom of choice.
ORGANIZATION OF THE REPORT
The remainder of the report is divided into six chapters. Chapter II describes the standard
depreciation methods and those that have been established for pollution-control facilities. Chapter
III examines the costs of different methods of financing pollution-control equipment. Chapter IV
relates the financing and tax strategies for equipment to normal company financial strategies. In
other words, how do the incentives correspond to a company's maximum cash flow strategy or its
profit maximization strategy, and so forth? Chapter V looks at the availability of the various
financing alternatives already discussed, both from the Federal Government and from five Mid-
western States in which the greatest amount of meat packing takes place. Some financing alterna-
tives are, for practical purposes, always available, while others are dependent upon the source's
budget. Chapter VI examines the combination of the first four discussions as opposed to the finan-
cial theory of a user charge system. This alternative analysis sets up a basis for decision when the
costs of the FWPCA become predictable, an example of which follows in chapter VII.
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Chapter II
DEPRECIATION
Many pollution-control acquisition incentives are in the form of special depreciation provisions.
Sometimes these provisions are called "rapid amortization," except that the amortization period
bears no relation to useful life as in the case of strict depreciation. The underlying effect of any
type of depreciation is on the taxes payable by a company and its cash flow. Normally, there exist
two general kinds of depreciation incentives for any kind of equipment. One set of depreciation
methods provides an annual deduction from income as a noncash expense over a certain guideline
period. The timing of deduction selection changes with different depreciation techniques. In other
words,-large portions of the cost of the equipment can be deducted early in the life of equipment
by using one technique, or equal proportions are deductible over the life of the equipment using
another technique. This difference in timing gives rise to the familiar terms "straight-line deprecia-
tion," "double-declining balance," "sum of the years digits," and so forth.
Another kind of equipment depreciation factor exists for all types of equipment; that is, an
incentive actually to buy equipment, called an "investment tax credit" (Sees. 46-48, 50, Internal
Revenue Code (IRC)). This provision, in effect, actually reduces the cost of the equipment, be-
cause it gives a permanent tax credit. All the different depreciation methods noted previously
allow a corporation to adjust its depreciation schedule to conform with its financial management
strategies.
To add an incentive for the purchase of pollution-control facilities, the Internal Revenue Serv-
ice permits a pollution-control facility to be amortized over a period of 60 months (Sec. 169, IRC).
Because the 60-month period may have no relationship to the actual life of the equipment, which
could be from 120 to 200 months, the incentive is called "rapid amortization."
Depreciation involves consideration of both method and useful life. The ability to take any
method of depreciation for pollution-control facilities is not precluded because of the method a
company customarily uses. The normal requirement for consistent adherence to class-depreciation
method is waived. For example, if a packer uses a foods-manufacturing asset-depreciation range
(ADR) into which all the assets customarily fall, and he uses the straight-line depreciation method,
he could still take double-declining depreciation for the pollution-control equipment.
Another nuance is that when an asset-class-depreciation range is used, a different useful life
can be used for pollution-control facilities upon sufficient justification. For example, if a packer
customarily uses a guideline useful life of 12 years (permitted in the 9.5-14-year ADR), he could
use 8 years for the control device if he could substantiate this reduced life. This method may be
advantageous if the life of the equipment is less than that of the normal asset range.
RELATIONSHIP OF DEPRECIATION TO TAXES AND CASH FLOW
The financial strategy supporting the rapid amortization plan is a good entry into the methods
of analysis for evaluating which depreciation, amortization, and/or investment tax credit method
to use. The incentive is that depreciation/amortization is an expense that does not actually involve
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any cash outlays by the taxpayer. The lower profits from the expense before taxes mean a tax
savings. The tax savings is a net cash inflow to the corporation and is represented by
NCF = DT
where NCF = net cash flow
D = amount of depreciation/amortization
T = the tax rate, expressed as a fraction
Positive cash flows (cash inflows) can be reinvested in the business for the productive side of
the operation or to reduce the needs for obtaining cash from other sources. A shortened period of
depreciation/amortization means larger deduction, larger tax savings, and more cash flow.
NET PRESENT VALUE
An analysis of this net cash flow through the depreciable life of the equipment will yield a net
present value. The total effect of depreciation on a company's cash flow is determined by using
the present value approach, which makes use of the time value of money. A dollar saved today has
a greater long term effect on the financing situation of an enterprise than a dollar saved a year from
now, because the dollar saved today has the potential of yielding a return if invested or saved. Thus,
at the end of the year, the future value (FV) of today's dollar is
FV = 1 + r
where r = yield (interest earned) on $1.
The present value (PV) of the dollar saved a year from now is, on the other hand,
1 + r
The present value of a dollar saved i years from now is obtained by discounting annually
(1 + r)'
Thus, the present value of the net cash flow during year i, termed discounted cash flow (DCF),
is
NCFf
(1 + r)''
The sum total of all such discounted cash flows over the useful life is the net present value
(NPV) of the tax savings
n n NCFf
NPV= DCF=
Since NPV is the sum of discounted cash inflows (tax savings), the higher the NPV, the more attrac-
tive the depreciation method. The annual discount rate, r, is termed the after-tax return on invest-
ment for the enterprise.
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For meat packing plants, the cost of capital (the same as the return if funds are reinvested) be-
fore tax is estimated to be about 6 percent. After taxes, this figure reduces to about 3 percent.
Therefore,
r = 3%
The effect of the NPV's from each method of depreciation is to reduce the effective cost of
the capital expenditure necessary for the pollution-control facility.
WATER-POLLUTION-CONTROL INVESTMENT FOR MEAT PACKERS
At this time no one can be quite sure what the costs are for the best practicable or the best
available control technology for meat packers or any other industry. For illustrative purposes, an
average investment figure of $400,000 will be used.
For accounting purposes, the ADR of equipment used in the foods-manufacturing industry,
into which category a meat packer usually falls, is 9.5-14.5 years (Sec. 167, IRC). A 12-year life
will be used, based on the guideline useful life of the ADR. Salvage value is assumed to be zero.
Rapid Amortization
The Tax Reform Act of 1969 provides for rapid amortization of certified pollution-control
facilities over a 60-month period, irrespective of the guideline useful life of the equipment. This
amortization is available under certain conditions outlined in Article 169 of the Internal Revenue
Code. The accelerated writeoff was provided to encourage capital investment in pollution con-
trol. Note that a process change, even if it results in lower pollution, does not qualify as a
pollution-control device, and such costs cannot be rapidly amortized.
The rapid amortization applies to the first 15 years of life of the equipment. The asset por-
tion value over 15 years can be depreciated by any method under article 167 and depreciation
can be taken immediately on that portion. The rapid amortization can begin in the month after
installation and continue for a full 60 months, or it can begin in the next fiscal year. For the
intervening months until the next fiscal year begins, a traditional depreciation method can be
used.
An additional first-year depreciation (Sec. 179, IRC) amount of 20 percent of a maximum
asset value of $10,000, or a maximum deduction of $2,000, can be taken in the first year of an
asset purchase. The "bonus" first year depreciation can be taken if a taxpayer elects to take
the rapid amortization or any other method of depreciation. Although this provision is not con-
sidered a pollution-control incentive, its inclusion is needed for accuracy of calculations.
For purposes of simplification, it will be assumed that the effective date of purchase of the
$400,000 waste-treatment facility is the beginning of the fiscal year and that the corporate in-
come tax rate is 48 percent. Computation of the net present value of the $400,000 investment
using rapid amortization results in
Yearly cash flow = TD
= (0.48)($80,000)
NPV= DCFf
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NCFt
DCF = r = 3%
(1 + r)'"
NPV= $175,918
Straight-Line Depreciation
The base or most simple form of depreciation involves taking an equal proportion of 8 1/3
percent for each year of the 12-year life of the depreciable base under the appropriate foods-
manufacturing depreciation class. In this case, the depreciable base could have been reduced to
$398,000 by taking the additional first-year bonus depreciation of $2,000 (maximum), but the
point of emphasis is to have the straight-line method serve as a base. Using the foregoing formula
with the $400,000 base, the NPV of cash inflows is $159,266.
Investment Tax Credit
The Internal Revenue Code (Sees. 46-48, 50) allows an investment tax credit of 7 percent of
the equipment cost to be applied to the reduction of corporate income taxes payable. Investment
tax credit is a special incentive for the business community to purchase capital equipment. This
tax credit is a full and direct tax savings of $28,000 in this example. This figure, adjusted by the
NPV, should be added to the straight-line depreciation NPV, since the investment tax credit is
allowed for that method. The resulting JVPV is $186,596. This calculation also takes into account
the NPV of the after-tax additional first-year depreciation. There is a special caution on invest-
ment tax credit. Rapid amortization and investment tax credit are mutually exclusive; a choice be-
tween the two must be made at the outset.
There are many other details of these amortization and tax credits laws that are too detailed
or peripheral to present here, and that do not change the essence of the calculations.
Double-Declining Balance Depreciation
The double-declining balance method is the quickest method allowable, except for the afore-
mentioned special rapid amortization of depreciating equipment through its useful life. The cal-
culation provides that, in each year, 20 percent of the remaining asset balance can be deducted.
In the example case, the first year's depreciation is $81,600 (0.2 X $398,000 = $79,600 + $2,000).
In the second year, the 20 percent is taken against $398,000 - $79,600, or $318,400, resulting in
a figure of $63,680.
When year-by-year cash flows are discounted using the rate of return, the NPV for the
$400,000 equipment, using double-declining depreciation, becomes $203,000.
There is, of course, another depreciation method, sum of the years digits, that has results
between the straight-line and double-declining methods.
Net Present Value Calculation
Mathematically, table II-l below shows how the NPV is calculated for a $400,000 piece of
equipment depreciated by the straight-line depreciation method over 12 years. The effect of the
investment tax credit plus the additional first year's depreciation is also considered.
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Table 11-1 .-Example of NPV calculation for straight-line depreciation
End of year
1
1 .
2
3
4
5
6
7
8
9
10
11
12 ....
7 percent investment tax credit
discounted back to year zero
Total NPV
Depreciable
base
Dollars
1 400,000
398 000
398 000
398,000
398,000
398,000
398,000
398 000
398,000
398 000
398 000
398 000
398 000
Rate
depreciation
Percent
Maximum
8 1/3
8 1/3
8 1/3
8 1/3
8 1/3
8 1/3
8 1/3
8 1/3
8 1/3
8 1/3
8 1/3
8 1/3
After
tax
depreciation
Dollars
960
15 920
15920
15920
15920
15920
15920
15920
15920
15920
15920
15920
15 920
Rate
of
discount
1 03
1 03
1 0609
1 .0927
1.1255
1 1592
1 1940
1 2298
1.2667
1 3047
1 3438
1.3841
1 4256
NPV
Dollars
2 928
15 456
15006
14,569
14 145
13734
13333
12945
12568
12202
11 847
11 502
11 167
159,402
27 184
1 86 586
The $2,000 maximum additional first year's depreciation must reduce the succeeding year's depreciable base by the same
amount.
Additional first year's depreciation.
Depreciation Comparisons
Figure II-l shows the relationship of the value of each depreciation method to the overall cost
of the equipment. The values are less than the base cost because of the cost-offsetting earnings
from the cash generated by the tax savings from depreciation.
Limiting the consideration to net present value, the optimal strategy in the example case is the
double-declining balance method accompanied by the investment tax credit and additional first
year's depreciation. The fact that this form of depreciation is favored over the special pollution-
control rapid amortization makes one question how the situation arises. When the rapid amortiza-
tion provision was enacted into law, the investment tax credit, which is historically an on-and-off
type of tax incentive, was not in effect. Later the investment tax credit became effective for equip-
ment installed after March 1971. Economic resurgence was the major consideration when the
investment tax credit was reinstated, and not how it would relate to the rapid amortization method.
The investment tax credit plus double-declining preference is accentuated first by the fact that
process changes made to comply with pollution-control regulations do not meet requirements for
rapid amortization (only control devices do), and second by the fact that the investment credit,
per se, never needs to be repaid, whereas rapid amortization really represents only a postponement
of taxes.
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Straight-line depreciation
Straight-line depreciation with investment credit
Double-declining balance depreciation with investment credit
Rapid amortization
150 160
170 180 190 200
THOUSANDS OF DOLLARS
Figure 11-1. Net present value of tax savings
through depreciation.
Figure II-2. Year-by-year savings (cash flow
improvements) through different tax strategies.
=> 35 -
1 = Straight-line depreciation
2 = Straight-line depreciation with investment credit
3= Double-declining balance with investment credit
4 = Rapid amortization
—®—©
©-©—@-@X©-©-©-©-©-©-©-@
\
_L_
234 567 8 9 10 11 12
YEAR AFTER ACQUISITION
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Figure II-2 shows the year-by-year after-tax positive cash flows from the various depreciation
alternatives. The difference between the 1's and 2's is the additional tax investment credit and
additional first-year bonus depreciation taken in the first year of the 2's.
The rapid amortization plan cash flows 4's are practically level because of the installation of
the equipment at the beginning of the fiscal year. The slight hump in the beginning results from
the additional first year's depreciation. A midyear installation with an election to begin the 60-
month amortization period the next fiscal year would have resulted, under optimal conditions, in
a higher hump \r. . first year also, with a level amount over the next 5 years at a very slightly
lower level.
The large hump in the iirst y ear of the double-declining balance method, shown by 3's, re-
sults from taking the investment tax credit and the additional first year's depreciation.
Ability to Use Investment Tax Credit
A company must have a sufficient level of pretax earnings to be able to make full use of the
investment tax credit. An investment tax credit greater than the amount of corporate income
taxes payable would defeat some of the advantage of taking the investment tax credit. Not in this
example, but in actuality, a company has to earn $71,875 before taxes to use the $28,000 available
investment tax credit. This calculation used the corporate tax rates of 22 percent of all income and
26 percent of income over $25,000.
It is true that unused investment tax credits can be carried over into the future under certain
conditions (Sec. 46B, IRC); however, the net present value of an investment tax credit carryover
reduces, and its calculation here would present an unnecessarily complex situation.
SUMMARY
This chapter demonstrated the large magnitude of differences in net present values (NPV's) by
using the various depreciation methods. The purpose of using NPV was to have a common standard
of analysis by which the available depreciation methods for pollution-control facilities could be
compared. The example used for calculations showed the advantage of the double-declining balance
method with investment tax credit over all other methods including rapid amortization. The life
of the equipment has to be very long (over 30 years) before another depreciation method becomes
superior in this illustration.
The next chapter will look at the effect of the special incentives for financing pollution-control
equipment. The determination of the differences in values for these financing methods, coupled
with the analysis just performed, will carry into chapter IV, where the tax and financing strategies
are combined.
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Chapter III
FINANCING STRATEGIES
FOR POLLUTION- CONTROL INVESTMENTS
Before any special pollution-control legislation, a plant manager would make the decision about
a piece of equipment and then, if money was to be borrowed to pay for the equipment, get in touch
with his normal financing source and request arrangements. With the advent of special pollution-
control incentives there are, in general, not only new sources of funds available, but lower rates
than normal for most sources of financing. This situation requires another whole set of analyses be-
fore the best source of funds can be chosen.
Generally, two aspects of the financing strategy are covered in this chapter. The first aspect
is the quantitative analysis using NPV as a tool for valuing each financial source and rate. The
second aspect describes each financial source and, based on rate and terms, calculates and compares
the NPV of each. As in chapter II, the example is based on a $400,000 waste-treatment system.
METHODS USED IN ANALYZING FINANCING COSTS
In order to determine the cost to the company of the various available methods of raising
funds, it is necessary to analyze the effect of fund raising on the company's operating financial
position— its net profits after taxes. The methodology used in the subsequent comparisons is
described below.
A comparison of the after-tax profits with and without the financing for pollution-control
equipment makes it possible to quantify and analyze such an effect. Net annual profit after taxes,
P, and the tax liability, L, can be related to other operating parameters by the equation
T) L=pT
where p = annual taxable income
T - the tax rate, expressed as a fraction
The annual taxable income is related to the interest expense for the year by
P = Q-I
where Q = the operating income
/ = the interest expense
Combining the preceding two equations,
P = (Q - /)(/ - T) L = (Q- I)T
- T)- 1(1- T) = QT-IT
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If there was no interest expense during the year, 1 = 0, and the foregoing equations become
P = Q(l - T) L = Q T
Thus, the effect of the interest expense, /, is to reduce the net profit after taxes by 7(1 - T). The
tax liability is reduced by / T.
If C is the amount of principal paid back during a year, and / the interest expense incurred as
a result of the loan, the net cash outflow, NCF, is the net of cash outflows and the reduced tax
liability (or tax savings).
NCF = (C + /)-(/ T)
= C + I(l- T)
This equation represents the net effect of the loan on the company's cash balance during a year.
(It must be kept in mind that, in this analysis, the operating costs resulting from the control equip-
ment are not considered. The effect of initial investments in pollution control on the company's
fiscal position is analyzed here.)
The payment of interest and principal payback extends through the term of the loan, which
is defined as more than 1 year for a long term loan. The net cash outflow, NCF{ during year /", is
given by:
where Ct - principal payback during year i
7j- - interest expense during year i
n = term of the loan in years
The total effect of the loan on the company's cash flow is determined by using the present
value approach, which uses the concept of time value of money, described in chapter II.
Thus, the discounted cash flow during year i,
DCF{ -
NCF;
(1 + r)'
The sum total of all such discounted cash flows over the terms of the loan is the net pres-
ent value, NPV, of the loan.
n n NCF{
NPV = % DCF{ = £
Since NPV is the sum of discounted outflows, the lower the NPV, the more attractive the loan.
The annual discount rate, as in chapter II, is the after-tax cost of capital for the meat packer;
r = 3 percent. For domestic corporations, the normal Federal tax rate amounts to 22 percent
on taxable income, plus a 26-percent surtax on income over $25,000. A tax rate of T = 48
percent is assumed throughout this analysis.
14
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BANK FINANCING
Some commercial banks across the country have announced preferential rates and terms for
certified pollution-control facilities. Since these bank programs are quite random, the basis of anal-
ysis used here for financing pollution-control equipment will be the type of normal equipment
borrowing, and not a special bank control loan.
The terms and rate suggested here as normal for this type of financing are 5 years and 6 per-
cent annually, with the effective rate of interest being 11.08 annually. The NPV analysis for
financing the $400,000 packing-treatment system through a bank is $422,353. The cash flows for
this financing alternative are unique because of the bank repayments system. Although the repay-
ment amounts are the same, the proportion of interest in those repayments is higher in the begin-
ning. This interest is tax deductible; therefore, the net cash outflow is approximately halved. Be-
cause the repayments are equal, and the proportions of the earlier payments have more tax-
deductible interest expense and lower principal repayments, the net cash outflow is lower in the
beginning.
SMALL BUSINESS ADMINISTRATION-WATER POLLUTION CONTROL LOANS
Because it could occur that some meat packers might have access to the funds legislated under
the Federal Water Pollution Control Act, the cost of such an alternative will be analyzed. Since this
fund was just recently legislated and is as yet unappropriated, there are many program details yet
to be developed. The fund, however, will be administered through the Small Business Administra-
tion (SBA), and will most likely bear a rate equal to the weighted average of all Federal Government
borrowings. At present that rate is 5 3/8 percent, and with general interest increasing 5.5 percent
has been used here.
According to the FWPCA, those who qualify for the SBA loans are "any small business con-
cern in affecting additions to or alterations in the equipment, facilities (including the construction
of pre-treatment facilities and interceptor sewers) or methods of operation of such concern to meet
water pollution control requirement... if such concern is likely to suffer substantial economic
injury without assistance."
Obviously precarious is any attempt to determine how many companies in the meat packing
industry will sustain substantial economic injury without assistance.
SBA loans are permissible to 30 years; however, a 10-year loan term has been chosen to recog-
nize the guideline useful life of the ADR in which meat packing belongs. Using the 5.5-percent rate
and the 10-year repayment schedule, the NPV calculates to $397,272.
GOVERNMENT AID TO FINANCING (TAX FREE)
As a result of the effort to encourage industrial development in general, and in some cases to
encourage industry to install control equipment on sources of pollution, governmental aid is avail-
able in the following areas:
• Aids to individual borrowers for low-cost capital
• Tax aids to industry through special regulations and procedures
The consequences of the latter aids will not be described at length, as their impact is not large and
varies from State to State. These aids include sales, use, and property tax exemptions.
15
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Many States now have financing programs for the purchase and installation of pollution-control
facilities. These States, via governmental and quasi-governmental agencies, assist in floating attrac-
tive low-interest bond issues and in raising the required funds through industrial mortgages. Such
bonds bear a lower interest rate than any of the aforementioned methods, because the interest pay-
ments are presently free of Federal and State income taxes.
The terms in this example include a 5-percent interest rate, with an initial underwriting cost
of 5 percent. The repayment period is 15 years and the repayment schedule is as follows: 8 percent
of principal annually during years 5-14, and the remaining 20 percent of the principal during year 15.
A word of caution about tax-free status—it is prudent to obtain the advice of counsel. A whole
set of provisions exists on the nature of the facilities qualifying and certified as eligible for tax-
exempt financing.
The NPV of cash outflows for the tax-free financing method for the terms described, and in
our $400,000 example, is $389,137.
Table III-l is an example of how NPV would be calculated for a 5-year bank loan for $400,000
(see also ch. II). The rate of interest is stated at 6 percent and the loan is repaid quarterly.
Table 111-1.— Example of NPV calculation for bank financing
Year
1 . . . .
2
3
4
5
Total 5 years . . .
Total NPV
Repayment
interest
portion
$ 42 286
33,143
24,000
14,857
5,714
120,000
Principal
repayment
$ 61 714
70,857
80,000
89 143
98,286
400 000
Yearly
repayment
$104000
104,000
104,000
104,000
104,000
520,000
I nterest
X
(1- T)
$21,989
17,234
12,480
7,726
2,971
Plus
principal
$ 83 703
88,091
92,480
96,869
101,257
Discount
factor
1 031
1 .0609
1.0927
1.1255
1.1592
NPV
$ 81 265
83034
84,634
86068
87,352
422,353
Note.—Interest rate, 6 percent; loan repaid quarterly.
COMPARISON OF FINANCING METHODS
Figure III-l shows the net present values of the negative cash outflows in financing the
$400,000 cost by the three alternatives. This set of alternatives actually represents a range of maxi-
mum and minimum financial costs into which fall all methods of financing. In other words, more
alternatives exist, but the results would fall between the highest and the lowest bar.
The figure clearly shows the superiority of the tax-free method of financing pollution-control
equipment under net present value considerations. Equally important in emphasis is the magnitude
of the range of values. On a $400,000 piece of equipment alone, the range is approximately $33,000-
a substantial cost if all the financing possibilities had not been fully considered.
16
-------
BASE
I
Ordinary bank loan
SBA water pollution control loan
I
370 380 390 400 410 420 430
THOUSANDS OF DOLLARS
Figure 111-1. Net present values of cash out-
flows from financing.
Figure III-2. Year-by-year cash
outflow from different financing
strategies.
J5>
A - Ordinary bank loan
B = SBA water pollution control loan
C = Tax free loan
-©-
-©-
-©-
20 - ©
©—©-©
i
i i i
3 4 5 6 7 8 9 10 11 12 13 14 15
YEAR AFTER ACQUISITION
17
-------
Figure III-2 shows the great differences in year-by-year cash outflow that result from the
three financing strategies. The conventional bank loan, for example, leads to much higher outflow
during the first 5 years than either of the other strategies. On the other hand, a bond issue has the
lowest cash outflow for an extended period. Depending on the payoff method chosen, however,
full repayment of principal at the end or a sinking fund will be required. In the case of the tax-
free loan thord), high cash outflow is generated owing to the ballooning effect in the final year.
SUMMARY
Now that the ranges of financing and tax strategies have been described and analyzed fully,
tup -.'iK-iees for selection purposes may be related. In order to perform selection, the objectives by
which companies are managed will be explained in chapter IV as they impact possible combinations
of the tax and financing alternatives.
18
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Chapter IV
DEVELOPING THE OPTIMUM FINANCIAL STRATEGY
With the data now available from the calculations discussed in chapters II and III, it is now
possible to develop the appropriate management approach to financing and tax strategies. The
idea is to select the right combination of strategies to meet the management objectives of the com-
pany. To illustrate the pronounced effects involved, a hypothetical plant procurement will be
used.
Table IV-1 contains the key characteristics of three financing strategies, as well as fiscal
characteristics of the hypothetical pollution-control equipment needed. This table will be used
as the common base in developing the three illustrative examples that follow.
Table IV-1.-Illustrative financial characteristics of pollution-control equipment for the meatpacking industry
Equipment characteristics:
I nvestment cost
Salvage value
Useful life . .
Tax status:
Corporate income tax rate . .
Investment credit
Additional first year's depreciation
Effective cost-of-capital rate
Financing terms:
Ordinary bank loan:
Stated interest rate ...
Effective interest rate
Repayment period
SBA-Water Pollution Control Loan:
Interest rate
Present Treasury rate
Payment period
Tax-free loan:
Interest rate
Initial cost of obtaining loan
Repayment period ....
Repayment schedule
$400,000
0
12 years
48 percent
7 percent subject to a
certain maximum
$2000
3 percent annually
6 percent annually
1 1.08 percent annually
5 years
Weighted average Treasury rate
5 3/8 percent ~ 5.5 percent
As long as 30 years, not more
than life of equipment,
1 0 years
5 percent
5 percent of capital
1 5 years
8 percent of principal annually
during years 5-14, 20 per-
cent of principal during
year 15 (balloon)
19
-------
Table IV'-2. —Example of N PV calculations for combined cash inflows and outflows
[Dollars]
Year
1
2
3
4
5 ...
6
7
8 ...
9
10
11
12 ...
Total
Less NPV cash inflows
Total NPV
NPV of
year-by-year
cash inflows
43 568
15 006
14569
14 145
13 734
13333
12 945
12 568
12202
11 847
11 502
11 167
186 586
/VPVof
year-by-year
cash outflows
81 265
83 034
84 634
86 068
87 352
422 353
186586
235 767
No two meat packers face the same financial problems. And no two share exactly the same
management objectives. To demonstrate the cumulative effects of the various tax and financing
strategies covered so far, three typical business situations have been selected, involving different
management objectives that might exist in a meat packing operation. How different strategy combi-
nations affect each situation will be shown.
Table IV-2 gives the calculations for another simplified example. The objective is to show how
the NPV of the combination of tax and financing strategies was obtained. As will be seen later, the
term NPV becomes synonymous with the lowest long term profit impairment a project has on a
company. The figures used are those developed in chapters II and III for a $400,000 capital invest-
ment. Note that the equipment was depreciated in 12 years and financed in 5 years.
First, a look at a meat packer with a weak working capital. He needs pollution-control equip-
ment, but cannot "afford" it, now or in the foreseeable future. Clearly, the situation calls for the
lowest possible cash outflow, year by year, over the life of the investment.
The lowest cash outflow, and the strategy combinations that permit it, are shown in table IV-3.
This value, shown boxed, is $35,300—the result of following a combination of tax strategy 2 and
financing strategy B. It is the best choice for a meat packer with weak working capital acquiring
pollution-control equipment.
Using a 3-year period as the near term, table IV-4 shows the cumulative profit impacts of the
different strategies in their various possible combinations, resulting in the best near term profit. The
boxed value, $51,900, represents the lowest possible cash outflow under the circumstances. It is
derived from a combination of strategies 2 and B.
Finally, there is the meat packer with enough resources and stability to concentrate on maxi-
mizing his long-term profit. Table IV-5 shows that the strategies producing the lowest long term
20
-------
Table \\f-3.-Comparisons of peak annual cash drain from different tax and financing strategies
[Dollars]
Tax strategy
1. Straight-line depreciation
2 Straight-line depreciation
with investment credit1
3. Double-declining-balance
depreciation with invest-
ment credit1
4. Special amortization for
pollution-control equipment1
A. Conventional
bank loan
87,500 (5)
87,500 (5)
87,800 (5)
68,300 (5)
Financing strategy
B. SBA-Water- Pollution
Control Loan
35,900(1)
35,300 (2)
36,400 (6)
45,700 (6)
C. Tax-free loan
52200(15)
52200(15)
52200(15)
52200(15)
1 Also includes effect of additional first year's depreciation (Sec. 179, Internal Revenue Code).
Note.—Useful life = 12 years; investment cost = $400,000. Figures in parentheses indicate year after acquisition during which
stated peak cash drain is reached.
Table IV-4.— Comparisons of short term profit impairment from different tax and financing strategies
[Dollars]
Financing strategy
Tax strategy
1 Straight-line depreciation
2. Straight-line depreciation
with investment credit1
3. Double-declining balance
depreciation with investment
credit1 ... . . . . . . ...
4. Special amortization for
pollution-control equipment1
A. Conventional
bank loan
98,000
71 700
90,600
168,000
B. SBA-Water Pollution
Control Loan
78200
51 900
70800
148,200
C. Tax-free loan
•88,500
62200
81,100
158,500
1 Also includes effect of additional first year's depreciation (Sec. 179, Internal Revenue Code).
Note.—Useful life =12 years; investment cost = $400,000.
profit impairment ($186,100) are double-declining-balance depreciation with investment credit com-
bined with a tax-free loan (strategies 3 and C).
The hypothetical examples of tables IV-3 to IV-5 do not represent straightforward totals of
year-by-year values, but rather the totals of present values, attributable at the start of the period to
the future events portrayed in the examples. This replacement is necessary because a meaningful
comparison between financial effects occurring at varying times in the future can be obtained only
by relating them all to a common point in time, such as the present.
21
-------
Table IV-5.—Comparison of long term profit impairment from different tax and financing strategies
[Dollars]
Tax strategy
1. Straight-line depreciation
2. Straight-line depreciation
with investment credit1
3. Double-declining balance
depreciation with
investment credit1
4, Special amortization for
pollution-control equipment1
A. Conventional
bank loan
263 100
235 800
219400
246,400
Financing strategy
B. SBA-Water Pollution
Control Loan
238 000
210 700
194300
221 400
C. Tax-free loan
229 900
202 500
186 100
213 200
Also includes effect of additional first year's depreciation (Sec. 179, Internal Revenue Code).
Note.-Useful life = 12 years; investment cost = $400,000.
Wuh investment credit
With rapid amortization
Ordinary bank loan
200 210 220
THOUSANDS OF DOLLARS
240
Figure IV-1. Long term profit impairment from various financing and tax
alternatives.
Having chosen a combination of tax and financing strategies based on analyses such as those
presented in tables IV-3 to IV-5, it is good practice to refer to separate year-by-year projections like
those in figures II-2 and III-2. Doing so determines year-by-year effects and makes them fall within
acceptable limits.
In all three cases discussed, the rapid amortization plan for pollution-control equipment was
not the optimal choice. By the very fact that tax incentive exists it is logical to be drawn to its use.
22
-------
As demonstrated, however, the management objective carries the deciding weight in determining
whether or not rapid amortization is the optimal choice.
Figure IV-1 clearly demonstrates why all this analysis is so important. From the considera-
tion of long term profit impairment, the magnitude of the difference in costs to a company is the
height of the difference in the maximum and minimum costs. If a pollution-control facility in the
example were financed by an ordinary bank loan and rapid amortization were taken (a fairly tradi-
tional choice), the effective cost would have been $246,400. A tax-free loan and investment tax
credit with double-declining balance depreciation results in an effective cost of $186,100, a savings
over the former plan of $60,300. It is well worth devoting whatever cost is necessary to explore
the various alternatives available to arrive at the optimal choice.
To determine how optimal the choice can be for an equipment investment, chapter V will
explore the degree of availability for all of these alternatives. Limitations in the availability may
possibly reduce the optimum savings; however, the savings will still be substantial.
23
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Chapter V
STATE FINANCING AND TAX INCENTIVES
The tax and financing strategies discussed in chapters II and III and the simplified examples of
how they relate to management objectives (ch. IV) were based on an assumption that all companies
would have access to each alternative. Whether this assumption holds true for a company depends
considerably on size and location. The depreciation methods for tax strategies are available for any
size company in any location.
Financial strategy availability is a much more complex matter requiring expert legal and tax
advice. For example, although the tax-exempt financing is generally more attractive than regular
bank borrowing, smaller companies generally do not have access to this source throughout the
United States, except for a very few States.
A general statement cannot be made concerning tax-free financing that conveys obvious ad-
vantages to the borrower because of the many variations from State to State, but generally the
borrower must qualify for the credit from either the public or a private source of capital. Enabling
legislation also must have been passed in the State to permit revenue bond-industrial development
financing for pollution-control facilities. The ultimate tax-free eligibility ruler is the Internal
Revenue Service (IRS). Specific attention therefore must be paid to what each meat packer's State
has passed into law regarding availability of antipollution revenue bonds.
Size also is an important factor because there is usually a fixed portion of any bond-underwriting
expense. Thus, a bond issue must be large enough to make those initial fixed costs effectively mini-
mal. This limitation cuts off many potential users, or requires that a State have a form of private
placement system for loans of less than nominally a million dollars.
The possible financing via States varies widely, as can be seen from table V-l. The tax regula-
tions are usually fairly lengthy and considerably involved, so that they generally defy any attempt to
condense and simplify. They are also time varying, and the reader is cautioned to obtain a current
reading before selecting a course of action.
The foregoing relates to the alternative involving equipment purchases; also of concern are
State and Federal programs for financing the municipal treatment plants into which individual com-
panies connect themselves. As for the Federal portion of construction grants, the monies contained
in the 1972 Federal Water Pollution Control Act (FWPCA) were based on a survey of municipal
areas planning to upgrade. Thus, the authorization was designed to satisfy all plants. The munici-
palities then in question, however, were not necessarily relating their estimates to secondary treat-
ment, defined as best practicable, nor to any advanced treatment. A new survey will be taken to
determine just how suitable was the FWPCA authorization. Presumably, construction grant money
over time will be available for the vast majority of plants. A major appeal of this money is that
interest is not included in any repayments.
Of a quite varying nature will be the cost and source of the monies to finance the remaining
minimum 25 percent. Further complicating the situation is the degree to which these funds have to
be repaid. Obviously, if a bond issue is floated to raise the local portion, the full cost plus interest
25
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Table V-1 —Financial assistance and tax incentives for industry
State
Alabama
Alaska
Arizona
Arkansas
California
Colorado
Connecticut
Delaware
Florida
Georgia
Hawaii
Idaho
Illinois
Indiana
Iowa
Kansas
Kentucky
Louisiana
Maine
Maryland
Massachusetts
Michigan
Minnesota
Mississippi
Missouri
Montana
Nebraska
Nevada
New Hampshire
New Jersey
New Mexico
New York
North Carolina
North Dakota
Ohio
Oklahoma
Oregon
Pennsylvania
Rhode Island
South Carolina
South Dakota
Tennessee
Texas
Utah
Vermont
Virginia
Washington
West Virginia
Wisconsin
Wyoming
1
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
2
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
3
X
X
X
X
X
X
X-
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
4
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
5
X
X
X
X
X
X
X
X
X
6
X
X
X
X
X
X
X
X
X
7
X .
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
8
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
g
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
10
X
X
X
X
X
X
X
X
X
X
Note.—1 = State-sponsored industrial development authority. 2 = privately sponsored development credit corporation. 3 - State
authority or agency revenue bond financing. 4 = city and/or county revenue bond financing. 5 = State loans for equipment,
machinery. 6 = excise tax exemption. 7 = tax exemption or moratorium on land, capital improvements. 8 = tax exemption or
moratorium on equipment, machinery. 9 = sales-use tax exemption on new equipment. 10 = sales-use tax exemption applicable to
lease of pollution-control facilities.
26
-------
requires repayment. Funds appropriated from a State public works budget will have different repay-
ment schemes and degrees, depending on the State.
There follows a brief and simplified overview of several States that are expected to be of special
interest to meat packers.
According to statistics from the last Census of Manufacturers,1 the following States had the
highest value of shipments:
• Iowa, $2,497.7 million
• Nebraska, $1,382.9 million
• Minnesota, $1,119.6 million
• California, $1,116.1 million
• Texas, $732.8 million
• Illinois, $726.4 million
• Ohio, $692.6 million
• Missouri, $682.4 million
• Kansas, $601.3 million
The total for these nine States is $9.552 billion, or 63 percent of the 1967 sales for the entire
meat packing industry, $15.248 billion. Five of these States germane to the immediate audience of
this report will be selected to alert the meat packers about provisions in their States. The volume
for these five States represents well over one-third that of the entire industry. Therefore, the legis-
lation of Iowa, Nebraska, Illinois, Missouri, and Kansas has a very important financial as well as
technical impact on pollution-control efforts of the meat packing industry.
There are two categories of State tax incentives, as mentioned before. One category comprises
exemptions from certain State taxes whose consideration would not enter the calculations per-
formed in previous chapters. Examples include franchise taxes, property taxes, use taxes, and sales
taxes. Equipment purchases in the States with these kinds of incentives are straightforward in the
sense that a purchaser receives those benefits or he does not. There are no other alternatives to
analyze. The second category pertains to the cost of financing involving low-cost pollution-control
loans.
IOWA
The State legislature of Iowa has not yet provided any pollution-control incentives that permit
exemptions or special deductions from any form of taxation. The tax-free status, as mentioned
earlier, is not for any State legislature to grant, since that privilege belongs to the IRS. Iowa does
have the legislation for allowing pollution-control facilities to be financed with industrial develop-
ment bonds.
1 U.S. Department of Commerce, Bureau of the Census, Washington, D.C., 1967.
27
-------
Under the Iowa Department of Environmental Quality Act, there are provisions for the State
to fund up to 50 percent of the portion of a municipal water-pollution-control construction project,
but at least 25 percent of total cost of construction. The fund is called the "sewage works con-
struction fund." The projects that qualify are also those that qualify for Federal construction grants
under the FWPCA.
ILLINOIS
Under the Revenue Act of 1939 (Rev. Stat., chs. 120, 482 et seq.) of Illinois, certified pollution-
control facilities are exempt from real and personal property taxes. The assessment of property on
which the real or personal property tax is levied takes into account the economic value of productiv-
ity to the owner, which for pollution-control facilities is little, if anything, unless costs are partially
recovered.
Also, under the Illinois Retailers' Occupation Tax, Article 2, Section 6, sales of pollution-
control equipment are exempt from the sales tax. Certification need not be acquired for this
exemption.
As with Iowa and the States to follow, Illinois also permits pollution-control facilities to be
financed via industrial development bonds.
MISSOURI
The State of Missouri provides a sales and use tax exemption for pollution-control facilities
under section 144.030 (13) and (14) of the appropriate law.
A general property tax exemption for pollution-control equipment is riot provided by legisla-
tion; however, control equipment financed by industrial development bonds is actually municipally
owned, and consequently requires no property tax.
In a few States, and Missouri is one, the specific enabling legislation for pollution-control
financing via industrial development bonds has not been passed. Interpretations of the existing
legislation have been sufficient, however, to allow this method of financing.
Under various chapters of the Missouri Water Pollution Law, grants can be made for municipal
treatment works. The State can grant up to 25 percent of the construction cost for projects that
also qualify for Federal aid (ch. 204.210). Also, chapter 204.230 indicates that the Missouri Water
Pollution Board's "determination of relative need, priority of projects, and standards of construction
shall be consistent with the FWPCA." This same chapter also requires a cost recovery system from
the users, whereby all costs are recovered including interest, depreciation for future replacement, and
maintenance and operation.
KANSAS AND NEBRASKA
Records of J.A. Commins & Associates, Inc., indicate that Kansas and Nebraska do not have
tax-exemption programs for pollution control. These States do have industrial development bond
programs through which tax-free loans are used for pollution-control financing.
28
-------
The foregoing description of incentives in various States should strongly demonstrate two
aspects.
• It would be unusual to find the exact same condition in two States, especially where the
incentive legislation is time varying.
• It is worth the effort to study the tax and financing schemes available in the pertinent State.
REVIEW
From the preceding explanation, it becomes clear that the ability to achieve an optimum finan-
cial strategy is highly dependent upon the size of the firm and its location. Parameters used in
chapters III and IV in the optimal choice analysis may have to be altered to reflect a firm's real
spectrum of choices. The stress in the analysis thus far has been a firm's capital costs. In the next
chapter, the realm of user charges and their possible modifications in the future will be discussed.
Complete optimization under long-range management objectives then can be made by weighing
the ramifications of being a part of a municipal wastewater-treatment system versus constructing
private treatment facilities.
29
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Chapter VI
FINANCIAL DECISION/MAKING THEORY
FOR MUNICIPAL VERSUS PRIVATE FACILITIES
Assuming that each alternative is available, many meat packing plants have the ability to
choose whether they should have private or municipal wastewater treatment. The present mix of
meat packing plants, as stated in the foreword, favors municipal tie-ins. Such a mix is not unex-
pected considering the fact that user charges generally have not been assessed based on any cost-
accounting system for allocating the entire costs of operations and replacements. Likewise, many
rural and developing areas over the years have been able to attract plant locations by purposely
keeping user charges low.
This user charge system, as we know it today, is headed for abrupt change due to the 1972
Federal Water Pollution Control Act (FWPCA) amendments. As generally known, all wastewater
control standards for private and public wastewater treatment will become highly stringent as a
result of the aforementioned legislation. Unless existing private or public plants happen to have
advanced wastewater treatment, all will be expected to make significant investments in the best
practicable or best available technology.
It is fairly safe to say that a major decisionmaking process in water-pollution control will take
place in the United States owing to the large number of companies expected to need change. A
major part of the decisionmaking scope includes the financial implications of equipment buying
versus yearly municipal waste-treatment rates.
Under previous amendments to the FWPCA there has always been a grant system, although
comparatively small, through which Federal funds were apportioned to the States. The 1972
FWPCA amendments continue the grant concept, but at a tremendously bolstered dollar level.
The fraction of total municipal treatment construction costs that can be funded by the Federal
grants has also been increased. At least $21 billion in future and repayment construction grants
eventually will be funneled to municipalities; provisions of the FWPCA will permit up to 75 percent
of the construction costs to be derived from the Federal grant.
It also appears that a significantly higher user charge rate structure is in the offing as the FWPCA
requires the municipality to recover, through charges, the operational costs and replacement value
attributable to the industrial proportion of the Federal grant. For certain replacement equipment
based on flow only, a municipal plant devoting 60 percent of its capacity to the general population
and 40 percent to industry must recover at least 40 percent of the 75-percent Federal portion if the
maximum grant contribution was used. Other replacement costs might be charged by the user's
waste strength.
The rest of this chapter will construct a type of analysis for use in making the user-charge-versus
private-facility decision. The FWPCA is recent, and its effects on the rate structure are yet to unfold.
It would, therefore, be premature to portray accurate cost estimates. One major reason why it is
difficult at this stage to estimate user costs is the lack of EPA or other guidelines as to the number of
years over which the replacement value is to be recovered from industrial users of a municipal facility.
There are at least three major factors—pretreatment costs, byproduct recovery value, and two
sets of operating costs—that must be calculated separately before the final decision phase is consummated.
31
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PRETREATMENT COSTS
The first factor is pretreatment costs for the conditioning or pretreating of its own wastewater
by a company before the wastes reach the municipal system. The costs of pretreatment depend on
the nature and volume of the wastes, and will vary widely from industry to industry. It is con-
ceivable that very little in the way of expensive equipment may be needed for some industries
where pretreatment costs would consist of chemicals and other consumable supplies. Certain other
industries will require capital investments for pretreatment, but not quite as large as would be needed
for complete private treatment.
The net present value (NPV) method of analysis again will be used to calculate a cost for pre-
treatment. The financial and tax strategy calculations for this equipment are the same as those used
in chapters II and III. Further analysis would have to take into account the expected difference in
useful life of a private pretreatment facility from that of a municipality.
BYPRODUCT RECOVERY VALUE
It is reasonable that pretreatment will produce byproduct recovery in a meat packing plant;
however, the subject is relevant here for its value in a complete private facility. For purposes of this
report, the value of annual byproduct recoveries will be described as an offset to the equipment
costs.
Byproduct considerations purposely were not examined earlier in the equipment decision phase.
The discussion here takes note that before the 1972 FWPCA, byproduct recovery of some degree
did exist in the meat packing industry. The emphasis here is owing to the very likely increase in
extent of byproduct recovery as events proceed in the meat packing industry.
OPERATING COST DIFFERENTIALS
It is intuitively understood that the annual operating costs for a pretreatment and municipal
use system will be less than the costs to operate a private facility. This yearly difference must be
assigned an NPV to be added to the NPV of the private treatment facility. The analytical method is
the same as that described in chapter III for a negative cash flow.
MUNICIPAL VERSUS PRIVATE WASTEWATER TREATMENT
To complete the sequence necessary for constructing a municipal-versus-private-treatment
analysis, the remaining step is the calculation of an NPV for user charges. Using the formula in chap-
ter III, the yearly cash flows for the longest predictable horizon of the user charge system should be
valued at NPV (as that horizon lengthens, the NPV approaches the value that would have resulted
if the present value of an annuity had been used where the payments are infinite in duration). The
sets of costs now to be compared in the decision process have been adjusted as follows:
• Effective equipment cost - NPV of byproduct recovery + NPV of greater operations cost
= adjusted effective equipment cost for a private treatment facility.
• Effective use charge value + NPV of pretreatment costs = adjusted effective user charge
value for using a municipal facility.
The basis for a financial decision between the two alternatives is outlined in the foregoing. The
financial data can be added to the technical factors that enter into the final decision.
32
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SUMMARY
Figure VI-1 is a flowchart of the analytical guides suggested for choosing the optimum finan-
cial strategy for pollution control. The chart summarizes the entire flow of this report. Under the
previously defined pollution-control laws it is possible, as was done in chapters II, III, and IV, to use
quantifiable examples to optimize tax and financial strategies for equipment decisions (see the area
of the chart to the left of the dashed line). Chapter V, while not in the flow, showed how these
alternatives may be limited due to specific State programs.
The tradeoffs and factors entering the municipal-versus-private-treatment decision process are
shown on the right of the dashed line. They are not quantifiable at this time, and are intended as a
guideline at the time when these costs become firmly known.
Analysis of
all possible
combinations
of tax and
financial
strategies
under the
management
objective
Adjustment by
incremental
NPV of.
• byproduct
recovery
• operating
costs for
private
facility
I—
EQUIPMENT CHOICE ONLY
PRIVATE TREATMENT VERSUS
'MUNICIPAL TIE-IN
Figure VI-1. Guide to management for choosing the optimum financial strategy for pollution
control.
33
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Chapter VII
ILLUSTRATION OF OPTIMUM FINANCIAL STRATEGY
FOR POLLUTION CONTROL
FOR MUNICIPAL VERSUS ON-SITE TREATMENT
Chapter IV developed various financial decisionmaking processes for management use where
pollution-control equipment is bought. These processes took into consideration cash flow and long
and short term profit management objectives, and compared various strategies in buying and writing
off the equipment. This chapter presents an example of the application of this financial theory
where the comparison is between buying equipment for treating plant wastes on site versus munici-
pal treatment costs. This example assumes that the pertinent regulations permit such choice.
Each of the three financial management strategies discussed in chapter VI is complex enough
to make it desirable to limit the illustration to one strategy; therefore, theory for all three will not
be repeated. For illustration of the analysis for economically choosing municipal versus on-site treat-
ment, the financial strategy analysis of long term profit, which is primarily net present value con-
sideration, will be used. This method, incidentally, is the one used most frequently by EPA in their
economic impact studies.
Recalling the costs from chapter VI that were to be used in the comparison, there are for on-
site treatment the capital costs that include financing and depreciation, the operating costs, and
byproduct values. For municipal treatment, the costs are pretreatment plus the associated operating
and maintenance costs and the user charge assessed by the municipality. For the costs of each
option to be comparable, the number of years or length of analysis over which the calculations are
performed must be the same.
ON SITE
In choosing the length of analysis, the lives of the two alternatives must be relatable for proper
costs matching. The user charge cost recovery guidelines to be issued by EPA will have an impact
on the length of analysis. One of the guidelines will determine the number of years in which in-
dustry's portion of the capital construction cost granted by the Federal Government must be repaid.
It is estimated here that the guidelines will specify cost recovery for the shorter of 20 years or the
life of the equipment. A 20-year analysis will be used, therefore, for the two alternatives. The
meat packing investment used earlier in the report was for 12 years at a cost of $400,000. It is
speculated that, even though that equipment could last longer than 12 years, regulatory obsolescence
will require updating that will leave an $800,000 cost of on-site treatment over 20 years.
It will be assumed that the on-site equipment will be depreciated and financed by the same
methods that were superior in the long term profit analysis of chapter IV; that is to say, double-
declining balance depreciation with investment tax credit, and a tax-free pollution-control loan.
The terms of the tax-free loan will be repayment of 8 percent of the principal in years 10 through 19,
and a 20-percent balloon payment in the 20th year. The tax-free loan rate will be 5 percent.
Because the meat packing plant has to perform all maintenance and operation, those costs must
be included, as well as any sludge-handling and disposal costs. Operation and maintenance costs will
be considered to be 8 percent of the total facilities investment cost, or $64,000 per year.
35
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Table VII-1 shows how the NPV for this example was derived.
Table VII-1.-NPV of 20-year on-site treatment plant
[Dollars]
Year
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15 ..
16
17
18 ..
19
20
Total NPV
Operation
and
management
64,000
64,000
64,000
64,000
64000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
Yearly
depreciation
1 161,600
127,680
102,144
81,715
65372
52,298
41,838
33,471
11,157
11,157
11,157
11,157
11,157
11,157
11,157
11,157
11,157
11,157
11,157
11,157
I nterest
payments
2 80,000
40,000
40,000
40,000
40000
40,000
40,000
40,000
40,000
40,000
36,800
33,600
30,400
27,200
24,000
20,800
17,600
14,400
1 1 ,200
8,000
Principal
payments
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64000
64,000
160,000
After tax
negative
cash flow
74,160
54 080
54,080
54,080
54 080
54 080
54,080
54,080
54,080
118,080
116,416
114,752
113,088
111,424
109760
108,096
106,432
104768
103,104
197,440
After tax
positive
cash flow
133,568
61 286
49,029
39,223
31 379
27,195
21,756
16,066
5,355
5,355
5,355
5,355
5,355
5,355
5,355
5,355
5,355
5,355
5,355
5,355
Net cash
flow
NPV
3 57 678
3 6 792
4,622
13200
19583
22517
26,284
30,010
37346
83,885
80,241
76,738
73,373
70,133
67 021
64,033
61,162
58403
55,755
106,371
886,207
1 Includes additional first year's depreciation of $2,000.
Includes 5 percent underwriting expense for bond issue.
Positive cash flows, the remaining 18 years being negative.
MUNICIPAL TREATMENT
The size, capital, and operating characteristics of the municipal treatment plant directly in-
fluence the fee it charges for treatment. Assume a municipal treatment plant capable of handling
16 mgd. At an approximate capital cost of $1.2 million per million gallons per day, the total plant
cost would round out to $19 million. Assume further, for illustrative purposes, that a meat packing
plant contributes to 5 percent of this total flow. The flow of the on-site treatment plant for the costs
assumed would be for a medium-size meat packing plant with an assumed flow of 0.8 mgd.
Taking the above assumed costs, the following additional assumptions will be made:
• 75 percent of the cost of the construction is provided by Federal grant at no interest.
• 25 percent, or the local-State share, is raised through a tax-exempt bond issue at 5 percent.
36
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• The yearly operation and maintenance of the municipal plant is 3 percent of total investment
cost, or $570,000.
• The meat packing plant requires pretreatment equipment that, for the 20-year cost, is
$100,000, and is financed via a 5-percent tax-free loan and depreciated via the double-
declining balance plus investment credit method.
• The operation and maintenance for the pretreatment facility incurred by the meat packing
plant is 8 percent, or $8,000 per year.
The user charge for the meat packing plant thus consists of the following costs:
• 5 percent (percentage flow) of 75 percent of $19,000,000 over 20 years, which equals
$35,625 (Federal capital appointment)
• 5 percent of 25 percent of $19,000,000, plus yearly interest of 5 percent on the unpaid
balance (local-State capital appointment)
• The NPV of the pretreatment capital costs after cash flow considerations from deprecia-
tion and financing costs
• Yearly principal and pretreatment operation and maintenance of $28,500 and $8,000
In tables VII-1 and VII-2, the financial choice between buying and treatment on site versus pre-
treatment and use of municipal facilities results in the pretreatment and municipal facility choice by
Table VI1-2.—NPV of user charges for 20-year cost recovery system
[Dollars]
Year
1 . .
2
3
4
5 . .
6
7
8
9
10 . .
11 ..
12
13 . .
14 ..
15
16 . .
17 ..
18 . .
19
20 . .
Total NPV
Federal
portion
user charge
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
Local1
State
portion
23,750
23,156
22,562
21,968
21,374
20,781
20,188
19,594
19,000
18,407
17,814
17,220
16,626
16,032
1 5,438
14,845
14,251
13,658
13,064
12,470
Pretreatment
operation and
management
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
Pretreatment capital costs
Depreciation
21,600
1 5,680
12,544
10,035
8,028
6,423
5,138
1,581
1,581
1,581
1,581
1,581
1,581
1,581
1,581
1,581
1,581
1,581
1,581
1,580
Interest
10,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
4,600
4,200
3,800
3,400
3,000
2,600
2,200
1,800
1,400
1,000
Principal
8,000
8,000
8,000
8,000
8,000
8,000
8,000
8,000
8,000
8,000
20,000
After tax
positive
cash flow
17,368
7,526
6,021
4.817
3,853
3,083
2,466
759
759
759
759
759
759
759
759
759
759
759
759
758
After tax
negative
cash flow
55,055
52,146
51,837
51,528
51,219
50,910
50,601
50,292
49,983
57,674
57,160
56,643
56,127
55,609
55,093
54,576
54,060
53,543
53,026
64,509
Net cash
flow
NPV
36,589
42,058
41,929
41,503
40,859
40,056
39,140
39,104
37,728
42,353
40,749
39,200
37,708
36,267
34,878
33,541
32,253
31,009
29,812
35,304
752,040
Precalculated.
37
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a sizable margin of $134,167. It would not be prudent to extend the implications of this simpli-
fied example to a general meat packing industry preference for municipal treatment. One reason is
that the value of byproduct recovery was excluded from the on-site and pretreatment facilities.
Should the yearly byproduct recovery from on site be greater than that from pretreatment by $17,000
in this example, the two alternatives become equal in value. In addition, note that this chapter is
rife with assumptions, since many pertinent regulations are not available at this time. Nevertheless,
the chapter can serve as a general guide to completing a more definitive analysis for the plant when
appropriate data are available.
Completed now are the analytical financial guides necessary for making the proper choices of
treatment alternatives and pollution-control incentives as soon as they are available. In this era of
regulatory programs for health and welfare, it is, as demonstrated herein, important to perform the
financial analysis with as much zeal as goes into the choice of proper equipment.
38
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METRIC CONVERSION TABLES
Recommended Units
Description
Length
Area
Volume
Mass
Time
Force
Moment or
torque
Stress
Unit
metre
kilometre
millimetre
micrometre
square metre
square kilometre
square millimetre
hectare
cubic metre
litre
kilogram
gram
milligram
tonne or
megagram
second
day
year
newton
newton metre
pascal
kilopascal
Symbol
m
km
mm
|jm.
m2
km2
mm2
ha
m3
1
kg
9
mg
t
Mg
s
d
year
N
N-m
Pa
kPa
Application
Description
Precipitation,
run-off,
evaporation
River flow
Flow in pipes,
conduits, chan-
nels, over weirs.
pumping
Discharges or
abstractions,
Yields
Usage of water
Density
Unit
millimetre
cubic metre
per second
cubic metre per
second
litre per second
cubic metre
per day
cubic metre
per year
litre per person
per day
kilogram per
cubic metre
Symbol
mm
m3/s
m3/s
l/s
m3/d
m3/year
I/person
day
kg/m3
Comments
Basic SI unit
The hectare (10 000
m2) is a recognized
multiple unit and
will remain in inter-
national use.
The litre is now
recognized as the
special name for
the cubic decimetre.
Basic SI unit
1 tonne = 1 000 kg
1 Mg = 1 000 kg
Basic SI unit
Neither the day nor
the year is an SI unit
but both are impor-
tant.
The newton is that
force that produces
an acceleration of
1 m/s2 in a mass
of 1 kg.
The metre is
measured perpendicu-
lar to the line of
action of the force
N. Nota |oule
of Units
Comments
For meteorological
purposes it may be
convenient to meas-
ure precipitation in
terms of mass/unit
area (kg/m3).
1 mm of rain =
1 kg/m*
Commonly called
the cumec
1 l/s = 86.4 m3/d
The density of
water under stand-
ard conditions is
1 000 kg/m3 or
1 000 g/i or
1g/ml
Customary
Equivalents
39.37 m.=3.28 ft=
109yd
062 mi
0.03937 in.
3937 X 103=103A
10.764 sq ft
= 1 196sqyd
6,384 sq mi =
247 acres
0.00155 sq in.
2.471 acres
35.314 cu ft =
1.3079cuyd
1. 057 qt = 0.264 gal
= 0.81 X 10 " acre-
ft
2.205 Ib
0.035 02 = 1 5.43 gr
0.01543 gr
0.984 ton (long) =
1.1023 ton (short)
0.2248) Ib (weight)
= 7.233 poundals
0.7375 ft-lbf
0.02089 Ibf /sq ft
0.14465 Ibf/sq in
Description
Velocity
linear
angular
Flow (volumetric)
Viscosity
Pressure
Temperature
Work, energy,
quantity of heat
Power
Recommended Units
Unit
metre per
second
millimetre
per second
kilometres
per second
radians per
second
cubic metre
per second
litre per second
pascal second
newton per
square metre
or pascal
kilometre per
square metre
or kilopascal
bar
Kelvin
deqree Celsius
joule
kilojoule
watt
kilowatt
joule per second
Symbol
m/s
mm/s
km/s
rad/s
m3/s
l/s
Pa-s
N/m2
Pa
kN/m2
kPa
bar
K
C
J
kJ
W
kW
J/s
Comments
Commonly called
the cumec
Basic SJ unit
The Kelvin and
Celsius degrees
are identical.
The use of the
Celsius scale is
recommended as
it is the former
centigrade scale.
1 joule - 1 N-m
where metres are
measured along
the line of
action of
force N.
1 watt = 1 J/s
Customary
Equivalents
3.28 f ps
0.00328 tps
2.230 mph
15,850 gpm
= 2.120cfm
15.85 gpm
0.00672
poundals/sq ft
0.000145 Ib/sq in
0.145lb/sqin.
14.5 b/sq in.
5F
T -17.77
3
2.778 X 10 7
kwhr =
3.725 X 10 7
hp-hr = 0.73756
ft-lb = 9.48 X
JO 4 Btu
2.778 kw-hr
Application of Units
Customary
Equivalents
35.314 cfs
15.85 gpm
1.83X 10'3gpm
0.264 gcpd
0.0624 Ib/cu ft
Description
Concentration
BOD loading
Hydraulic load
per unit area,
e.g. filtration
rates
Hydraulic load
per unit volume;
e.g., biological
filters, lagoons
Air supply
Pipes
diameter
length
Optical units
Unit
milligram per
litre
kilogram per
cubic metre
per day
cubic metre
per square metre
per day
cubic metre
per cubic metre
per day
cubic metre or
litre of free air
per second
millimetre
metre
lumen per
square metre
Symbol
mg/t
kg/m3d
m3/m2d
m3/m3d
m3/s
l/s
mm
m
lumen/m2
Comments
If this is con-
verted to a
velocity, it
should be ex-
pressed in mm/s
(1 mm/s = 86.4
m3/m2 day).
Customary
Equivalents
1 ppm
0.0624 Ib/cu-ft
day
3.28 cu fl/sq ft
0.03937 in.
39.37 in. =
3.28ft
0.092 ft
candle/sq ft
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U.S. ENVIRONMENTAL PROTECTION AGENCY • TECHNOLOGY TRANSFER
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