i-©
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About the AIPP:
The American Institute for Pollution Prevention (AIPP) was founded in June, 1989
under a Cooperative Agreement between the EPA and the University of Cincinnati.
The Institute is composed of a group of volunteer experts selected by the trade
associations, professional societies or other organizations which they represent.
Currently, the Institute has 27 members.
The mission of the Institute is to:
1) Serve as a bridge for communication on the subject of pollution prevention
among regulators, legislators, educators, waste generators and others,
2) Promote the industrial, governmental and educational culture shifts
necessary to catalyze the adoption of the pollution prevention ethic in
environmental protection,
3) Identify and foster driving forces for pollution prevention and work to
eliminate disincentives,
4) Define and communicate the economics of pollution prevention and
5) Identify emerging knowledge, opportunities and issues concerned with
pollution prevention and influence the future directions for this field.
This document was prepared by the Institute under the leadership of Mr, Elliott
Berkihiser with the assistance of Dr. James R. Aldrich. Mr. Berkihiser is with
The Boeing Company and represents the Aerospace Industries Association on the
Institute. Dr. Aldrich was formerly at the University of Cincinnati but is now with
the U.S. Air Force at Wright-Patterson Air Force Base. Other Contributors included:
Richard Conway
Thomas R. Hauser
William J. Mikell
Robert J. Pojesek
David G. Stephan
American Society of
Civil Engineers
AIPP Executive Director
American Chemical Society
American Chemical Society
EPA Liaison to AIPP
Union Carbide Corporation
University of Cincinnati
(ret) E.I. du Pont
de Nemours & Co.
GEI Consultants, Inc.
U.S. Environmental
Protection Agency
"Views contained in this document do not necessarily reflect the views of every member of
the Institute nor every organization represented on the Institute. Mention of commercial
products or specific pollution prevention techniques does not represent an Institute
endorsement nor any assurance that the products or techniques can be successfully and safely
employed without proper attention to all conditions existent at specific individual
locations."
"Although the preparation of this document has been funded in part by the United States
Environmental Protection Agency, it has not been subjected to Agency review and, therefore,
does not necessarily reflect the views of the Agency and no official endorsement should be
inferred."
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EPA/6QO/R-93/059
ApriI1993
A PRIMER FOR FINANCIAL ANALYSIS OF
POLLUTION PREVENTION PROJECTS
by
American Institute for Pollution Prevention
with the assistance of
James R. Aldrich
Department of Civil and Environmental Engineering
University of Cincinnati
Cincinnati, Ohio 45221
EPA Cooperative Agreement No, CR-815932
Project Officer
David G. Stephan
Pollution Prevention Research Branch
Risk Reduction Engineering Laboratory
U.S. Environmental Protection Agency
Cincinnati, Ohio 45268
RISK REDUCTION ENGINEERING LABORATORY
OFFICE OF RESEARCH AND DEVELOPMENT
U.S. ENVIRONMENTAL PROTECTION AGENCY
CINCINNATI, OHIO 45268
Printed on Recycled Paper
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FOREWORD;
This document has been prepared as a guide to pollution prevention
investment. It starts at the point that pollution prevention projects that are
technically equivalent to current practice have already been identified.
Hence, a financial comparison and justification for the investment is the only
consideration. In the case of a small business, the justification may be needed
to negotiate a loan at a bank. Conversely, if the company can fund the
investment itself, justification is needed to compete for funds.
The emphasis of this paper is on the basic analytical techniques needed
to justify pollution prevention investments. The concentration is on
weighing economic and financial aspects of the various project options
instead of the technical factors. In order to receive funding, it is essential that
the project successfully compete in the company's capital funding sequence or
before the bank's loan committee.
Although hazardous material usage generates a number of potential
intangible costs such as future liability for waste cleanup, site remediation,
potential legal action, etc., those issues are not being addressed in this paper
except briefly in appendix 4. As a primer, it is appropriate for this paper to
concentrate on the more definable costs such as utilities, labor, and capital
costs. The intangible costs shall be addressed in future efforts by the
American Institute of Pollution Prevention.
11
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TABLE OF CONTENTS
SUBTECT PAGE
Section I Introduction
The Definition of Pollution Prevention 1
The Pollution Prevention Hierarchy 1
Section n Financial Analysis - Terms and Methods
Life Cycle Costing 3
Present Worth 4
Four Methods of Financial Comparison
Payback Period 5
Internal Rate of Return 5
Benefit Cost Ratio 5
Present Value of Net Benefits 5
Defining the Project's Cost
Cost Categories, 5
Procurement vs. Operating Costs 6
The Starting Point - Baseline Costs
How to Compute Baseline Costs 6
How to Account for the Effects of Interest 8
What to Consider in the Analysis - Revenues and
Expenses
Revenues 9
Expenses
Insurance Expense 10
Depreciation Expense 10
Interest Expense 11
Labor Expenses 11
Training Expense 11
Floor Space Expense 12
Other Factors Which Could Affect the Decision
Cash Flow 12
Opportunity Cost 13
111
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TABLE OF CONTENTS (con't)
Section HI Example Calculations
How to Establish the Baseline 14
Examining Pollution Prevention
Option 1 - Recycle 17
Examining Pollution Prevention
Option 2 - Product Substitution 21
Making the Final Decision 24
Section IV Conclusions 25
APPENDICES
1. The Effects of Interest/Discount Rates 26
2. Methods of Financial Comparison
1. Payback Period 27
2. Internal Rate of Return 27
3. Benefit/Cost Ratio 28
4. Present Value of Net Benefits 28
3. The Effects of Income Tax 29
4, Cost/Benefit Analysis with Uncertainty 31
5. Additional Reading 32
IV
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List of Tables
Page
Table 1: Current costs for Parts Cleaning 7
Table 2: Present Value Calculations for the
Electronics Firm 8
Table 3: Baseline Cost Analysis 15
Table 4: Ten Year Baseline Costs. 16
Table 5: Costs for Solvent Recycling 18
Table 6: Ten Year Costs for the Recycle Option 19-20
Table 7: Annual Costs for the Material Substitution
Alternative 21
TableS: Ten Year Material Substitution Costs 22
Table 9: Annual Cost Comparison 23
Table 10: Present Values of Costs and Benefits 23
List of Figures
Page
Figure 1: Material Balance for the Hazardous Solvent 7
Figure 2: Baseline Material Balance 14
Figure 3: Material Balance for the Recycle System 17
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AIPP Financial Primer
SECTION I
Introduction
The Definition of Pollution Prevention
The scope of actions which constitute pollution prevention has long
been the subject of debate. The major question has been whether or not to
include end-of-pipe treatment in the definition. The Pollution Prevention
Act of 1990 ended the debate by shifting emphasis away from treatment
options and toward waste avoidance. The EPA defines pollution prevention
as any effort to reduce the quantity of industrial, hazardous, or toxic waste
through changes in the waste generating or production process at the source.
Hence, pollution prevention can encompass all actions, taken prior to
the waste being generated, which provide for net reductions in either waste
volume or hazard/toxicity. This is not to imply that end-of-pipe techniques
such as recycling and volume reduction are not desirable. It does, however,
indicate that while these methods can help, there are better approaches.
The Pollution Prevention Hierarchy:
The variety of waste reduction options available implies that some
methods may be more desirable than others. Section 2 of the Pollution
Prevention Act, Findings and Policy, establishes a Pollution Prevention
hierarchy as a national policy, declaring that:
."- pollution should be prevented or reduced at the source whenever
feasible;
- pollution that cannot be prevented should be recycled in an
environmentally safe manner whenever feasible;
- pollution that cannot be prevented or recycled should be treated in an
environmentally safe manner whenever feasible; and
- disposal or other release into the environment should be employed
only as a last resort and should be conducted in an environmentally
safe manner."
The first option is preferred as a true pollution prevention practice.
However, any change to procedures or processes which would move a firm's
waste management practices up the pollution prevention hierarchy is
assumed to yield environmental benefits and should be evaluated.
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AIPP financial Primer
Section n of this report explains the calculations which are needed to
analyze various options and financially justify a pollution prevention project.
Specific cost and revenue categories which should be considered are also
presented in Section H Section IH introduces a case study of a hypothetical
cleaning operation and demonstrates how to establish a baseline for financial
comparison and to financially analyze recycling and material substitution as
potential pollution prevention options. In examining each option,
calculations are performed to allow a financial comparison to be made
between the three scenarios (do nothing, recycle, or material substitution).
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AIPP Financial Primer
SECTION II
Financial Analysis
In the past, preparing a financial justification for pollution prevention
projects has often been limited to declaring that if funding weren't awarded
there would be an environmental incident and lawsuits would follow.
Unfortunately, this led to many poor decisions. Projects with limited benefit
have been funded and some projects that could have had large impacts on
profit and cash flow were not. Pollution prevention investment must be able
to stand up to every other funding request and effectively compete for monies
on the projects' own merits.
Unfortunately, investment projects, such as pollution prevention,
have often been among the first to be postponed in times of budget shortfalls.
This has been due in a large part to the inadequate support and defense of
environmental projects on an economic basis. Typically, when a production
division requests money, all the necessary documentation, facts, and figures
are ready for presentation. The production project is justified by showing
how the project will increase revenue and how the added revenue will not
only recover costs, but substantially increase the earnings of the company as
well. Pollution prevention project justification requires this same emphasis.
To be competitive, an understanding of the financial system is essential.
Financial tools demonstrate the importance of the pollution prevention
investment on a life cycle or total cost basis; in terms of revenues, expenses,
and profits.
Key concepts and factors:
a. Life Cyde Costing: Sometimes referred to as Total Cost
Accounting, this method analyzes the costs and benefits associated with a
piece of equipment or a procedure over the entire time the equipment or
procedure is to be used. The concept originated in the federal government
and was first applied in procuring weapons systems. Experience showed that
the up-front purchase price was a poor measure of the total cost; costs such as
those associated with maintainability, reliability, disposal/salvage value, and
training/ education had to be given equal weight in making financial
decisions. Similarly, in justifying pollution prevention, all benefits and costs
must be spelled out in the most concrete terms possible over the life of each
option.
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AIFP financial Primer
b. Present Worth; The importance of present worth, or present value,
lies in the fact that time is money. The preference between a dollar now or a
dollar a year from now is driven by the fact that the dollar in-hand can earn
interest. Mathematically, this relationship is as follows:
Present Value = _ Future Value P= F
(1+ interest rate) Dumber or years (l+r)n
where P is the present worth or present value, F is the future value, r is the
interest or discount rate, and n is the number of periods. In the above
example, $1 in one year at 5% interest compounded annually would have a
computed present value of:
P=
Because money can "work," at 5% interest, there is no difference between $.95
now and $1.00 in one year because they both have the same value at the
current time,1 Similarly, if the $1 was to be received in 3 years, the present
value would be:
P= SI. 00 =$.86
(1+.05)3
In considering either multiple payments or cash into and out of a firm,
the present values are additive. For example, at 5% interest, the present
value of receiving both $1 in one year and $1 in 3 years would be $.95 + $.86 =
$1.81. Similarly, if one was to receive $1 in one year, and pay $1 in 3 years the
present value would be $.95 - $.86 = $.09. As a result, present worth
calculations allow both costs and benefits which are expended or earned in
the future to be expressed as a single lump sum at their current or present
value.
c. Comparative Factors for Financial Analysts: The more common
methods for comparing investment options all utilize the present value
equation presented earlier. Generally, one of the following four factors is used
(additional information on all four factors is provided in appendix 2).
* Economically, there is an additional factor at work in present value: Pure time preference
(or impatience) - Pearce and Turner, Economics of I^atura^ Resources and the Environjnen|L
1977, pg. 213. However, this issue is generally ignored in business accounting in that the
firm has no such emotions and opportunities can be measured in terms of per financial return,
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AIPP financial Primer
1. Payback Period; This factor is often used in the research and development
arena and is a measure of how long it takes to return the investment capital.
Conceptually, the project with the quickest return is the best investment.
2. Internal Rate of Return: This factor is also called return on investment
(ROD or rate of return. It is the interest rate that would produce a return on
the invested capital equivalent to the project's return. For example, a project
with an internal rate of return of 23% would indicate that pursuing the
pollution prevention project would be financially equivalent to investing the
resources in a bank and receiving 23% interest
3. Benefits Cost Ratio: This factor is a ratio determined by taking the total
present value of all financial benefits of a pollution prevention project and
dividing by the total present value of all costs of the project. If the ratio is
greater than 1.0, the benefits outweigh the costs and the project is
economically worthwhile to undertake.
4. Present Value of Net Benefits: This factor shows the worth, of a pollution
prevention project as a present value .sum. It is determined by calculating the
present values of all benefits, doing the same for all costs and subtracting the
two totals. The net result would be an amount of money that would
represent the tangible value 6f undertaking the project.
While firms may use any of these factors, the importance of life cycle costing
or total cost analysis makes the Present Value of Net Benefits the preferred
method.
DEFINING THE PROJECT'S COST
The first step in determining thef cost of a project is to establish a
baseline for the analysis. The "do-nothing" or "status quo" alternative is
generally used as a baseline. Then any changes in material use, utility
expense, etc., for other options being considered are measured as either more
or less expensive than the baseline.
Cost Categories: McHugh2 outlines four tiers of potential costs which have
to be examined related to pollution prevention:
Tier 0: Usual costs such as direct labor, materials, equipment, etc.
Tier 1: Hidden costs such as monitoring expenses, reporting and record
keeping and permit requirements.
Tier 2: Future liability costs such as remedial actions, personal injury
under Occupation, Safety, and Health Act (OSHA), property
damage, etc.
2 McHugh, R.T., "The Economics of Waste Minimization," Freeman, Hazardous Waste
Minimization. McGraw-Hill, 1990.
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AIPP Financial Primer
Tier 3: Less tangible costs such as consumer response, employee
relations, and corporate image.
McHugh's Tier 0 and Tier 1 costs can be thought of as direct and indirect costs
which would include the engineering, materials, labor, construction,
contingency, etc., as well as waste collection and transportation services, raw
material consumption (increase or decrease) and production costs.
Conversely, his Tier 2 and Tier 3 represent intangible costs. They are much
more difficult to define and include potential corrective actions under the
Resource Conservation and Recovery Act (RCRA), possible site remediation
at third-party sites under Superfund, liabilities that could arise from third
party lawsuits for personal/property damages, and benefits of improved safety
and work environments. Although these intangible costs often cannot be
accurately predicted, they can be most important. To this end, there is a
considerable amount of ongoing research to enhance our understanding and
ability to predict intangibles. Present Value analysis under uncertainty is
addressed in appendix 4. When it is not possible to analyze the intangible
costs and benefits financially, they should be listed as additional factors to
consider when making the pollution prevention investment decision,
Procurement vs. Operating Costs:
In analyzing the financial impact of projects, it is often useful to further
categorize costs as either Procurement costs or Operations Costs to aid in
projecting costs over time. Procurement costs are of shorter duration and
refer to all costs required to bring a new piece of equipment or a new
procedure on line. Conversely, operations costs are long term and represent
all costs of operating the equipment or performing the procedure in the post
procurement phase.
THE STARTING POINT - BASELINE COSTS
To illustrate the concept of the "do-nothing" or "status quo" option, an
example of a small electronics firm will be used to illustrate the computation
of a baseline cost. Presently, the firm cleans metal parts with a chlorinated
solvent. Because the solvent is hazardous, the wastewater from rinsing the
parts must be labeled as hazardous waste. The company is considering ways
to reduce the volume of hazardous waste generated,
To establish the baseline, the current cost of doing business must first
be determined. Once the present costs are known, all potential alternatives
such as substituting a non-hazardous solvent for the current hazardous
material would then be related to this baseline cost.
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AIPP Financial Primer
How to Compute the Baseline Costs:
The simplest way to establish a baseline cost is to add up the relevant
input and output materials for the process and then compute their
appropriate dollar value. This is started by first balancing the material
entering and leaving the operation which contributes to the waste. Figure 1
shows this for a typical tank-line that generates the hazardous waste.
Fugitive
Emissions
Fugitive
Emissions
100 Gal
(Solvent Vapor)
50 Gal
(Solvent Vapor)
New Solvent
1000 Gal
CLEANING
1* AKTV
1 AJ\K
900 Gallons
(dratr hut)
RINSE
TANK
Waste Water
5850 Gal
f
5000 Gal
Water
Figure 1: Annual Material Balance for the Hazardous Solvent
The next step is to ensure the material balance makes sense; i.e., the
volume of solvent purchased must be accounted for in the losses, product,
inventory, and/or waste. In the example, the solvent purchased is equal to
that lost to evaporation, plus that lost in the waste rinsewater. Once
accomplished, determining the baseline cost becomes a simple matter of
pricing each input and output and multiplying their volumes by the
appropriate unit The baseline costs for this example are shown in Table 1.
Table 1 - Current Costs for Parts Cleaning
Item
Solvent
Water
Waste disposal
Cost/Unit
$3.25/gal
$2.10/1000 gal
$2.50/gal
# Units
1000 gal
5,000 gal
5850 gal
Total Annual Cost
Cost/year
$3,250.00
$10.50
$14,625.00
$17,885.50
Although the next step would be to examine expected business changes such
as business expansions, new accounts, rising prices, etc., for simplicity, the
Table 1 costs and volumes will be assumed constant. This means that the
current annual costs will be the same in the out-years except for one very
important aspect, the time value of money.
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ATPP financial Primer
How to Account for the Effects of Interest: Due to the assumptions made
regarding constant cost, the $17,885 annual cost shown in Table 1 will be
repeated each year. The present value calculations shown earlier enable this
annual expenditure to be expressed as a single sum which includes the effects
of interest. The first year's cost, assuming the bills were paid at the end of the
year, would be the amount of money that would have to be banked starting
today, to pay a $17,885 bill in one year. Computationally, using a 10% interest
rate, the computation is as follows:
$17.885 =$16,260
(1-KlO)1
This means that if $16,260 was banked at 10% interest, it would provide
enough monies to pay the $17,885 bill at the end of the year. Similarly, the
second, third, fourth, etc., years expenditures can also be expressed in present
value. This is done in Table 2.
Table 2: Present Value Calculations for the Electronics Finn
Year
I
2
3
4
5
6
7
8
9
10
Expenditure
$17,885
$17,885
$17,885
$17,885
$17,885
$17,885
$17,885
$17,885
$17,885
$17^85
Present Value
$ 16,260
$ 14,781
$ 13,437
$ 12,216
$ 11,105
$ 10,096
$ 9,178
$ 8343
$ 7,585
$ 6,895
TOTAL $109^96
The bottom line to the analysis is that the total cost of the cleaning system
over the next 10 years, given a 10% interest rate, is $109,896 in present value
terms. In other words, $110,0003 invested today at 10% interest would be
sufficient to pay the entire material and disposal costs for the circuit board
cleaning operation for the next 10 years. Hence, any changes to the operation
of the firm can now be compared to this $110,000 baseline. Any change which
would result in a lower 10 year cost would be a benefit in that it would save
money; any option with a higher cost will be more expensive and should not
be adopted from a financial or economic standpoint.
* Given the number of assumptions regarding costs, growth, etc., that must be made in these
calculations, rounding the calculated values to 2 significant figures is generally wise.
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AIPP Financial Primer
WHAT TO CONSIDER IN THE ANALYSIS - REVENUES AND EXPENSES
Simple pollution prevention projects often require little more
financial justification man the savings related to tier 0 or possibly tier 1 costs.
However, as a firm gets more and more sophisticated in its subsequent efforts,
the less tangible tier 2 and 3 costs will become more important. Even if these
costs cannot be accurately predicted, in cases where two investment options
appear to be financially equivalent, if one is a pollution prevention project,
the tier 2 and 3 considerations can favor that option.
With few exceptions, the goal of most business endeavors is to make a
profit. As a result, the costs and benefits cash flows for each option can be
related to the basic profit equation:
Revenues - Expenses = Profit.
The most important aspect is that profits can be increased by either an
increase in revenues or a decrease in expenses. A benefit of pollution
prevention is often lowered expenditures and increased profit. In the
remainder of this section, the different categories of pollution prevention
revenues and expenses will be examined.
Revenues: In its simplest definition, revenue is money coming into
the firm; from sale of goods or services, rental fees, interest income, etc. From
the profit equation, it can be seen that a revenue increase leads to a direct
increase in profit and vice versa if all other revenues and expenses are held
constant.4
It is always possible for a pollution prevention project to either increase
or decrease production rates so revenue impacts must be examined. For
example, often firms can cut wastewater treatment costs if water use (and in
turn the resulting wastewater flows) is regulated to non-peak times at the
wastewater treatment facility. However, this limitation on water use could
hamper production. Consequently, even though the firm's actions to
regulate water use could reduce wastewater charges, unless alternative
methods could be found to maintain total production, revenue could also be
decreased.
Conversely, a change in production procedure as a result of a pollution
prevention project could increase revenue. For example, a process change
such as moving from liquid to dry paint stripping can not only reduce water
consumption/ but also affect production output Since clean up time from dry
paint stripping operations (such as bead blasting) is generally much shorter
than from using a hazardous, liquid based stripper, it could mean not only
the elimination of the liquid waste stream (the direct objective of the
pollution prevention project), but less employee time spent in the cleanup
4 The condition of other expenses/revenues being held constant is assumed throughout this
report.
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AIPP Financial Primer
operation. Hence, production, and in turn revenues could be enhanced
through pollution prevention.
Although less common, one more potential revenue effect is the
generation of marketable byproducts as a result of pollution prevention
efforts. Hence, pollution prevention has the potential to either increase or
decrease revenue and profits.
Expenses.* Expenses are monies leaving the firm to cover the costs of
operations, maintenance, insurance, etc. The following sections review the
major cost categories for pollution prevention investment consideration and
their effects on expenses.
Insurance Expense: Depending upon the pollution prevention
project, insurance expense could either increase or decrease. For example,
OSHA has set limits on worker's exposure to a number of chlorinated
solvents. If one pollution prevention option was to eliminate a hazardous,
chlorinated solvent from production operations, there could be savings in
employee health coverage, liability insurance, etc. Likewise, using a non-
flammable solvent in place of a flammable one could lead to a decrease in the
fire insurance premium.
Conversely, insurance expense could be increased. For example, if a
heat recovery still was added to a process operation, fire insurance premiums
could increase. Depending upon the premium change (if any), expenses, and
in turn profits, could be increased or decreased by pollution prevention.
Depreciation Expense: If the pollution prevention project involves
the purchase of capital equipment with a limited life (such as storage tanks,
recycle or recovery equipment, new solvent bath systems, etc.), the entire cost
is not charged against the current year. Instead, a system of depreciation
spreads that expense over time. Depreciation expense calculations allocate
the equipment's procurement costs (including delivery charges, installation,
start up expenses, etc.) by taking a percentage of the cost each year over the life
of the equipment.
For example, if a piece of equipment was to last 10 years, an accounting
expense of 10% of the procurement cost for the equipment would be charged
each year.5 Even though a firm must use a different depreciation system for
tax purposes, e.g., the Accelerated Cost Recovery System (ACRS), it is
acceptable to use other methods for bookkeeping and analysis. In any event,
any pollution prevention capital equipment must be expensed through
depreciation.
5 This method is straight-line depreciation. Although there are other methods available,
all investment projects under consideration at any given time should use a single depreciation
method to allow for accurate comparisons of expense and revenue impacts between the
alternatives. Since straight-line depreciation is easy to compute, it is the method of choice.
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AJPJP financial Primer
Interest Expense: Pollution prevention investment implies one of
two things must occur; either a firm must pay for the project out of its own
cash, or it must finance the cost by borrowing money from a bank, issuing
bonds, etc. In the case where a firm pays for a pollution prevention project
out of its own cash reserves, the action is sometimes called an opportunity
cost which is discussed later. If cash for the project must be borrowed, there is
an interest charge connected with using someone else's money.
Interest is a true expense and must be treated like insurance expense as
an offset to the project's benefits. The magnitude of the expense will vary
with bank lending rates, returns required on corporate notes issued, etc.,
however, there will be an expense. Example computations are included in the
Section HI example,
Labor Expense: In most cases, the firm's labor requirements will
change due to the pollution prevention project. As pointed out in the dry
paint stripping example, this could be a positive effect which increases
available productive time, or, if extra man hours were required to run new
equipment, perform preventive maintenance, etc., there could be a decrease
in employee's production time.
When computing labor expenses, the tier 1 costs could be significant.
For example, if a material substitution project eliminated a hazardous input
material which eliminated a hazardous waste, there could be a significant
decreases in labor required to complete and track manifests, costs of labeling,
handling and storing hazardous waste drums would be eliminated, etc.
Hence, both direct, tier 0, expenses (e.g., 2 hours per week preventive
maintenance on the pollution prevention equipment) and secondary, tier 1,
expenses can have an effect on manpower costs.
Labor expense calculation can be simplistic or comprehensive. The
most basic approach is to multiply the wage rate times the hours of labor.
More comprehensive calculations include the associated costs of payroll taxes,
administration, and benefits. Many companies routinely track these costs and
establish an internal "burdened" labor rate to be used in financial analysis.
Training Expense: Pollution prevention may also involve the
purchase of equipment or new, non-hazardous input materials which require
additional operator training. In computing the total training costs, both the
direct costs and the man hours spent in training must be considered as an
expense. In addition, any other costs for refresher training or training for new
employees, which is above the level currently needed, must be included in
the analysis.
Computing direct costs is simply a matter of adding the costs of tuition,
travel, per diem, etc, for the employees. Similarly, to compute the labor costs,
simply multiply the employee's wage rate by the number of hours spent away
from the job in training.
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AIPP financial Primer
Floor Space Expense: As with any opportunity costs, the floor space
cost must be based on the value of alternative uses. For example, multiple
rinse tanks have long been used to reduce water use in electroplating. If a
single dip rinse tank of 50 square feet were replaced with a cascade rinse
system of 65 square feet, then the floor space expense would be the financial
worth of the extra 15 square feet and must be included as an expense in the
financial analysis for the pollution prevention project. Unfortunately,
computing this floor space opportunity cost is not always as straightforward as
it was with the case of training costs. In instances where little square footage
is required, there may be no other use for the floor space which implies a zero
cost. In other cases, if the area is currently only being used for storage of extra
parts, bench stock, feed materials, etc., the costs may involve determining the
worth of having a drum of chemical or an extra part closer to the operator.
Alternatively, as square footage increases, calculating floor space costs
becomes more straightforward. For example, if a new building was needed to
house the pollution prevention equipment, it would be easy to compute a
cost. Similarly, if installing the equipment at the production site displaces
enough storage room to require additional sheds be built, the cost would
again be easy to compute.
As a default, the cost of floor space can be estimated from information
available from realtors. The average square foot cost for new or used
warehouse, or administrative, or production space, that would be charged to
procure the space on the local market, is the average market worth of a square
foot of floor space. Unless there is a specific alternative proposal for the floor
space, this market analysis should work as a proxy.
OTHER FACTORS WHICH COULD AFFECT THE DECISION:
Cash Flow: Although cash flow does not have a direct effect on the
firm's revenues or expenses, the concept must be considered with any
pollution prevention project. If the pollution prevention project involves
procurement costs, they often must be paid upon delivery of the equipment.
Conversely, cash recovery could take years. Hence, three things can effect a
firm's available cash. First, cash is used at the time of purchase. Second, it
takes time to realize financial returns from the project through enhanced
revenues or decreased expenses. Finally, depreciation expense is calculated at
a much slower rate than the cash was spent. As a result of the investment, a
firm could find itself cash poor.
Conversely, pollution prevention efforts can have a very positive effect
on cash flow. For example, eliminating a hazardous waste via an input
material substitution could result in a Targe amount of cash available from
not having to pay for hazardous waste disposal every 90 days. Hence, even
though cash flow does not have a direct impact on revenues and expenses, it
may be necessary to consider in analyzing pollution prevention projects.
Opportunity Cost: If in purchasing pollution prevention equipment
a firm pays for the project out of its own cash> some feel this action should
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AIPP Financial Primer
represent a cost to the project because of opportunity costs. Hie basis of the
argument is that if cash is used on pollution prevention, it is unavailable to
use for other opportunities or investments. As a result, revenues which
could have been generated by the cash (e.g., interest from a Certificate of
Deposit at a bank; should be treated as an expense and reduce the value of the
pollution prevention project.
Although the reasoning seems sound, opportunity costs are not
expenses. It is true that the cash will be unavailable for other investments;
however, opportunity cost should be thought of as a comparison criteria and
not an expense. The opportunity forgone by using the cash is considered
when the pollution prevention project competes for the firm's funds and is
expressed by one of the financial analysis factors discussed earlier (e.g., net
value of present worm, pay back period, etc.). It is this competition for the
firm's funds that encompasses opportunity cost and opportunity cost should
not be accounted directly against the project's benefits.
A minimum rate of return or hurdle rate is often used to express this
opportunity cost competition between investments. For example, if a firm
can draw 10% interest on cash in the bank, then 10% would be a valid choice
for the hurdle rate as it represents the firm's cash opportunity cost. Then in
analyzing investment options under a return on investment criteria, not
only would the highest returns be selected, but any project which pays the
firm a return less than the 10% hurdle rate would not be considered.
Pollution prevention has good investment potential. In reducing or
eliminating waste generation and the related disposal/treatment expenses,
pollution prevention can have a significant impact on the firm's bottom line.
Even in cases where revenues are not generated, reducing the expenses and
liabilities that are connected with generating hazardous waste represent a
substantial reduction in overall expenses and an increase in profit. The next
section illustrates how to analyze the worth of a pollution prevention
investment.
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AIPP Financial Primer
SECTION III
Example Calculations
This section provides a step by step outline of the process of analyzing a
pollution prevention project. The hypothetical firm under review takes in
used parts, deans them in a dip tank using a hazardous solvent, and applies a
new finish. The financial analysis will be between the current solvent
cleaning operation and two pollution prevention alternatives: a solvent
recycle system and non-hazardous material substitution.
How to Establish the Baseline.
As indicated before, the first step is to define the baseline cost of the
process. Once accomplished, the financial effects of any change to business as
usual can be judged as either equal to, more expensive, or cheaper than the
baseline case. To do this, the expenses resulting from the baseline, the recycle
system and the non-hazardous solvent must be computed and compared.
Figure 2 shows the material balance for the current system.
Fugitive
Emissions
SO Gal
New Solvent
4000 Gal
3950 Gal
Waste
"
SOLVENT
CLEANING . _. .
PROCESS to Dl8p°Sal
Figure 2. Baseline Material Balance
With the mass balance complete, annual costs can be assigned for the
process. The resulting cash flow would be as shown in Table 3.
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Table 3. Baseline Cost Analysis
Element
Procurement Expenses
Operations Expenses
Utilities
Operating Expense
Maintenance /Spare Parts
Input Solvent
Waste Disposal
Rate
$3.50/gal
$2.50/gal
Annualized Costs
None
N/A<>
N/A
N/A "'
$14,000
$9,875
None of the other expenses previously discussed in Section 2 need be
addressed at this point as they will be computed, as applicable, as changes
from this baseline.
To express these annual costs in present value terms, a time reference
must be selected so that each option can be considered over the same length
of time. Since me recycle equipment has an expected life of 10 years, the
baseline and both options will be examined over this time period.
For the purpose of illustration, the firm's discount rate (the firm's
internal interest or "hurdle" rate) shall be taken as 15% and the inflation rate
is assumed at a constant 5% per year. Since the discount rate and inflation
work in opposite directions (i.e. interest makes your money more valuable
over time and inflation makes it less valuable over time), they can be
combined. However, for simplicity, they shall be treated separately. All
present value computations shall be made using 15% interest and all
expenses shall be increased at an inflationary rate of 5% per year.
To account for prices which rise faster than inflation, annual real price
increases (in excess of inflation) of 1% of the cost of solvent and 4% of the cost
of disposal shall be assumed. In these cases, the cost of solvent shall increase
6% per year (5% inflation + 1% real price increase) and waste disposal shall
increase 9% per year. Given these assumptions, the baseline expenses for the
next decade are as shown in Table 4.
6 These expenses are not applicable for the baseline because we need only consider
increases/decreases when analyzing the options
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AIPP Financial Primer
Table 4. Ten Year Baseline Costs
Year
--:-: ' ;< i .. ;
2
3
4
5
6
7
8
9
10
Annual Cost
Item
New Solvent
Waste Disposal
New Solvent
Waste Disposal
New Solvent
Waste Disposal
New Solvent
Waste Disposal
New Solvent
Waste Disposal
New Solvent
Waste Disposal
New Solvent
Waste Disposal
New Solvent
Waste Disposal
New Solvent
Waste Disposal
New Solvent
Waste Disposal
w/o Recycle
$14,000
$9^75
$14,840
$10,764
$15,730
$11,732
$16,674
$12,788
$17,674
$13,939
$18,734
$15,194
$19,859
$16,561
$21,050
$18,051
$22,313
$19,676
$23,652
$21,447
Annual Total
$23,875
$25,604
$27,462
$29,462
$31,613
$ 33,928
$36,420
$39,101
$ 41,989
$45,099
In many cases firms simplify the calculations by assuming costs will be
constant over the life of the project. If this is the case, then all outyear costs
would be the same as was done with the Table 1 example.
The intermediate step in the financial analysis will be to compare the
annual costs of the two pollution prevention options with the annual costs of
the baseline process. (This will be illustrated in Table 9) Then the present
value of the annual cost savings (or cost increase) of the options will be
calculated. This will be done for the base line and both options
simultaneously at the end of the analysis.
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AIPP financial Primer
The final step will be to sum the present values from each year to obtain the
net present value. The net present value represents the quantifiable worth of
the project
Examining Pollution Prevention Option 1 - Recycle.
As before, the first step is to establish the mass balance diagram for this
option. This is shown in Figure 3.
Fugitive
Emissions
New Solvent
360 Gal ^
1
50 Gal
SOLVENT
CLEANING
PROCESS
Waste
to Disposal
310 Gal
3640 Gal
Figure 3. Material Balance for the Recycle System
As is the case with many recycle options, a salable by- product is
generated (the recycled solvent), but instead of offering the solvent for sale,
the firm is using it as an input to offset the cost of new solvent so there is no
revenue impact. Further, since the actual cleaning operation has not changed,
there should be no change in production rate as a result of this option. As a
result, there are no revenue impacts to consider.
This material balance in Figure 3 can be readily converted to a cash
flow. As discussed earlier, the recovery equipment has a life of 10 years.
Further, there is no salvage value; the solvent must be chemically treated at
the end of year 5 to retain it's effectiveness at a cost of $1000;7 and no
additional permits, such as RCRA treatment permits or air permits, are
required to operate or install the equipment Given these assumptions, the
annual costs are as shown in Table 5.
^ Even though the solvent has to be treated at year 5, the time scale is a full ten years.
This is because the life of the recycle equipment is the key (10 years), not the life of the
solvent (5 years)
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Table 5, Costs for Solvent Recycling
Element
Procurement Expenses
Recycle Equipment:
Tanks, Pumps, Mixers, etc.
Installation: Design^iping, Labor, etc.
Contingency (@10%)
Operations Expenses
Recovery System
Utilities
Operating Expense
Maintenance/Spare Parts
Input Solvent
Waste Disposal'
Rate
Total;
1 hr/day @$20/hr
5% of Capital Cost
$3.50/gal
$2,50/gal
Base Year
Costs8
$40,500
$20,000
$6,000
$66,500
$240
$5,000
$3,325
$1,260
$775
Other Expenses to Consider:
Insurance: The recycle operation involves a drum evaporator which
could significantly increase insurance expense. However, for simplicity, it is
assumed there is no increase in insurance expense.
Depreciation: Straight line depreciation shall be used with the
procurement costs being expensed at 10% each year for 10 years.
Interest: The firm borrowed the capital costs, will make annual
payments for 3 years, and must pay 12% interest annually. Note: the
principle ($66,500) will be repaid in three equal installments. The interest
expense is calculated for each year based upon the current balance. (The
actual monies borrowed, or repaid, are neither revenues nor expenses and do
not appear in the financial analysis)
Labor: The equipment requires 1 hour of maintenance per day. This
expense (@ $20/hr) has been included in the operations expenses listed above.
For simplicity, the wage rate will be assumed constant except for cost of living
increases due to inflation.
Training: The training was supplied by the recycle equipment supplier
with training on site so there are no direct costs. Three operators must spend
2 hours each learning the operations. Their wage cost will also be taken as
$20/hour.
^ Costs shown are typical for drum evaporator recycle equipment; however, individual
estimates must be made. This analysis is meant only to show the method of calculation,
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AIPP Financial Primer
Floor Space Considerations: The equipment is relatively compact/
will be installed integral to the process, and will carry a zero floor space
expense.
As done with the baseline, annual costs for the recycling option must
also be spread over time as they will actually occur. Given our assumptions
the costs, by year, for the 10 year life are shown in Table 6.
Table 6. Ten Year Costs for Recycle Option
Year
I
2
3
4
Item
Interest Expense ($66,500 x 12%)
Depreciation Expense
Initial Training
Operating Expenses
(Labor, Utilities, Maint)
New Solvent
Waste Disposal
Interest Expense ($44,333 x 12%)
Depreciation Expense
Operating Expenses (5%/yr. increase)
New Solvent (6%/yr. increase) (360 gallons)
Waste Disposal (9%/yr. increase)
Interest Expense ($22,166 x 12%)
Depreciation Expense
Operating Expenses
New Solvent
Waste Disposal
Depreciation Expense
Operating Expenses
New Solvent
Waste Disposal
w/ Recycle
$7,980
$6,600
$ 120
$8,565
$1,260
$775
$5,320
$6,600
$8,993
$1,336
$845
$2,660
$6,600
$9,442
$1,416
$921
$6,600
$9,915
$1,501
$1,004
Total
$25,300
$23,094
$21,039
$19,020
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AIPP Financial Primer
Table 6. Ten Year Costs for Recycle Option (con't)
Year,
5
6
7
8
9
10
Item
Depreciation Expense
Operating Expenses
New Solvent
Waste Disposal
Depreciation Expense
Operating Expenses
New Solvent
Waste Disposal
Depreciation Expense
Operating Expenses
New Solvent
Waste Disposal
Depreciation Expense
Operating Expenses
New Solvent
Waste Disposal
Depreciation Expense
Operating Expenses
New Solvent
Waste Disposal
Depreciation Expense
Operating^ Expenses
New Solvent
Waste Disposal
wl Recycle
$6,600
$11,4109
$1,591
$1,094
$6,600
$10,931
$1,686
$1492
$6,600
$11,477 '
$1,787
$1,300
$6,600
$12,051
$1,895
$1,417
$6,600
$12,654
$2,008
$1,544
$6,600
$13,287
$2,129
$1,683
Total
$20,695
$20,409
$21,164
$21,963
$23,806
$23,699
Again, these annual costs will be compared to the baseline after all cash
flows for the options have been computed.
9 This figure reflects the 5 year solvent reconditioning that was required at a cost of $1,000,
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AIPP financial Primer
Examining Pollution Prevention Option 2 - Material Substitution.
This option consists of replacing the hazardous solvent used for
cleaning in the baseline case with a non-hazardous cleaner which is used in
the same manner. The firm has been fortunate to find a cleaning solution
which is sewerable and does not require disposal as a hazardous waste. The
cost of sewering the 3950 gallons is assumed to be negligible.
In pollution prevention projects which involve substituting a non-
hazardous material for a hazardous material, part of the analysis must
consider how well the new product or process works in relation to the current
practice. In this example, it is assumed no operational changes are required so
production levels can be maintained. However, the cost of the cleaner is
nearly 25-percent higher: $4.60/gal. The first year costs for implementing this
option are shown in Table 7.
Table 7. First Year Costs for the Material Substitution Alternative
Element
Procurement Expenses
Rate
Annualized Costs
None
Operations Expenses:
Operating Expense
Maintenance/Spare Parts
Input Solvent
Waste Disposal
Training
$4.60/gal
N/A
N/A
$18,400
$ 00
$120
Insurance: Since the material substitution operation involves less risk
to the employees, there could be an insurance reduction; however, because
insurance cost is very site/circumstance specific, and to not bias the analysis, it
will again be assumed to be a constant cost.
Depreciation: Since there is no capital expenditure, there is no
equipment to depreciate.
Interest: The company has the cash reserve to absorb the additional
cleaner cost without borrowing any additional capital. Hence, there is no
interest expense.
Labor: There is no additional equipment maintenance requirement
and the wage rate is again constant except for cost of living increases due to
inflation.
Training: As before, we will assume the training needed to use the
new cleaner was supplied by the vender and 3 operators spent 2 hours
learning how to handle, test, and maintain the cleaner. Their wage rate will
be taken as $20/hour (from the previous example).
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Floor Space Considerations: The current solvent storage capacity for
the firm is adequate for the new material.
With the same assumptions regarding cost increases, the annual costs for
switching to the non-hazardous cleaner, over the ten year period, are shown
in Table 8.
Table 8. Ten Year Material Substitution Costs (5% / yr. increases)
Year
I
2
3
4
5
6
7
8
9
10
Item
New Cleaner
New Cleaner
New Cleaner
New Cleaner
New Cleaner
New Cleaner
New Cleaner
New Cleaner
New Cleaner
New Cleaner
Annual Cost
$ 18,520
$ 19320
$20,286
$21,300
$22,365
$23,484
$24,658
$25,891
$27,185
$28,544
Making the Financial Comparison:
With all annual costs computed, the final comparisons can be made.
Table 9 shows the annual baseline costs (from Table 4) in the first column;
columns 2 and 3 show the annual costs for recycle (from Table 6) and the
increase or decrease from the baseline; and finally, columns 4 and 5 show the
annual costs for material substitution (from Table 8) and their associated
change from the baseline.
10
The $120 training costs have been included in the first year's, annual cost
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Table 9: Annual Cost Comparison
Year
1
2
3
4
5
6
7
8
9
10
Baseline
23,875
25,604
27,462
29,462
31,613
33,928
36,420
39,101
41,989
45,099
Recycle
25,300
23,094
21,039
19,020
20,695
20,409
21,164
21/963
23,806
23,699
Savings
(1,425)
2,510
6,423
10,442
10,916
13,519
15,256
17,138
18,183
21,400
Material
Substitution
18^20
19320
20,286
21300
22365
23,484
24,658
25391
27,185
28,544
Savings
5355
6,284
7,176
8,162
9,248
10,444
11,762
13,210
14,804
16,555
If an option's annual costs are less than the baseline, the difference is
considered a benefit. Conversely, if the option's annual costs are higher than
the baseline (indicated by parenthesis), the difference is considered a cost.
So that the two options can be compared, the final steps are to bring each
option's costs and benefits back to present value, compute the net difference,
and make the financial decision. These calculations are shown in Table 10.
The present value calculation uses the formula from page 4 with the interest
rate set at 15%. (Recall that 15% was set as the example firm's "hurdle" rate
the acceptable internal interest rate)
P= .... F
Table 10: Present Values of the Costs and Benefits n
Year
1
2
3
4
5
6
7
8
9
10
NET PR]
Recycle Option
Difference
(1,425)
2310
6,423
10,442
10,916
13,519
15,256
17,138
18,183
21,400
ESENT VALUE
Present Value
(1,239),
1398
4,223
5,970
5,427
5,844
5,735
5,602
5,169
5,290
$43,919
Material Substitution
Difference
5355
6,284
7,176
8,162
9,248
10,444
11,762
13,210
14,804
16,555
Present Value
4,657
4,752
4,718
4,666
4,598
4,515
4,422
4,318
4,208
4,092
$44,946
Costs are again indicated by parenthesis.
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MAKING THE FINAL DECISION
In this example,, both options display a positive effect on profitability.
The two proposals each generate a net benefit compared to the baseline, status
quo, option. Likewise, the proposals also meet the firm's internal hurdle rate
(15%), because their present values are positive when calculated using a 15%
discount rate.
The final task is to select between the two options. In that they have
the same present worth of net benefits, they are equivalent under the
financial criteria. However, as previously discussed, when projects appear
financially equivalent, consideration of other tier costs can swing favor
toward an option. In the above analysis, only tier 0 costs were included. If one
considers the labor savings due to not having to manifest waste shipments,
label drums, and so on., because the material substitution option eliminates
hazardous waste generation, there is a substantial savings. Additionally, the
elimination of hazardous waste limits the potential intangible tier 2 and 3
costs for remedial actions, lawsuits, etc.. Given these considerations, and the
fact that material substitution was higher on the pollution prevention
hierarchy, the material substitution option is clearly the most beneficial
option.
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SECTION IV
CONCLUSIONS
The key point to remember is that firms are in business to make a
profit and pollution prevention can be critical to profitability. In the past,
environmental expenditures were seen as pure cost sinks with no payback
potential. It is becoming apparent that in the realm of pollution prevention
there are a number of areas where expenditures can be cut significantly. One
EPA study12 of waste reduction projects showed that in 29 cases that included
data on payback period, over 80% had payback periods of less than 3 years.
There is no doubt that environmental management can make a
difference in reducing a company's expenses. The task becomes one of selling
improvements in the expense side of the profit equation. Reducing an
expense is as effective as increasing, revenues when it comes to profit.
The final considerations in justifying pollution prevention
investments are the tier 2 and 3 potential liability costs. Many types of
projects can effect revenues, expenses, and/or cash flow, but pollution
prevention projects are relatively unique in their additional positive effects.
Although difficult to express in concrete financial terms, both environmental
compliance and pollution prevention can have far ranging benefits in terms
of reduced long term liability, customer relations, public goodwill, and
employee morale. While these factors may not serve to justify the
investment in a project by themselves, they must enter into the analysis.
This primer has provided a working definition of pollution
prevention and presented the hierarchy of waste management methods.
Basic financial tools were described and a preference was put forth for the use
of Net Present Value as an appropriate method of financial comparison.
Suggestions were made on what types of costs should be considered in
evaluation of a pollution prevention project, and how those costs should be
calculated over the project lifetime. An example case study of an industrial
process and two pollution prevention options was illustrated. Finally, the
financial results of the case study were evaluated and the meaning of those
results was discussed.
In conclusion, this primer presents financial tools and a suggestion of
other less tangible benefits which can be used to justify pollution prevention
projects on an equal basis with all other funding requests.
12 iky, Butler, Timm, and Fromm.
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APPENDICES
Appendix 1
The Effects of Interest/Discount Rates
In determining the value of a pollution prevention project, the
discount rate used becomes critical. H pollution prevention project benefits
are accrued far into the future, or if a larger discount rate is used, the effect on
the present value (and hence the apparent value of the pollution prevention
project) could be dramatic. Figure Al shows the relationship between percent
of future worth regained over time at varying interest rates.
Present Value Compared to Future Value
100%-,
80%-
60%-
40%-
20%-
0%
0 24 6
Years
15% Rate 12% Rate * 8% Rate
10
4% Rate
Figure Al. The Effect of Time on Present Value.
Most companies prefer an return on investment (ROI) or hurdle rate
in the range of 10-15% (the federal government uses a 10% standard). At 10%
over half of a future benefit stream can be lost due to the time value of
money within the first 10 years. This factor works against the acceptability of
projects which provide benefits far in the future. Hence, to justify pollution
prevention projects with long term benefit cash flows it is often necessary to
move to tier 2 or 3 criteria (See Section IV, Financial Criteria).
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Appendix 2
Methods of Financial Comparison
1: Payback Period: The technique for determining payback period again lies
within present value; however, instead of solving the present value equation
for the present value (P), the cost and benefit cash flows are kept separate over
time. First, the projecf s anticipated benefit and cost is tabulated for each year
of the project lifetime. Then these values are converted to present values by
using the present value equation with the firm's discount rate plugged in as
the discount factor. Finally the cumulative total of the benefits (at present
value) and the cumulative total of the costs (at present value) are compared
year by year. At the point in time when the cumulative present value of the
benefits start to exceed the cumulative present value of the costs, the project
has reached the payback period. Ranking projects then becomes a matter of
selecting the projects with the shortest payback period.
While some firms have gone to the point of establishing a minimum
payback time standard, this method is not recommended for comparing
investment options dealing with pollution prevention because of two factors.
First, because the pollution prevention benefit stream generally extends far
into the future, discounting makes its payoff period very long. Second, the
highest costs and benefits associated with most environmental projects are
generally due to catastrophic failure, also a far future event. Since the payback
period analysis stops when the benefits and costs are equal, the projects with
the quickest positive cash flow will dominate. Hence, for a pollution
prevention project, with a high discount rate, the long term costs/benefits
may be so far into the future that they do not even enter into the analysis. In
essence, the importance of life-cycle costing is lost in using this method
because it only considers costs and benefits to the point where they balance
instead of considering them over the entire life of the project.
2: Internal Rate of Return: Again, this method is based in the net present
value of benefits and costs; however, it does not use a predetermined
discount rate. Instead, the present value equation is solved for the discount
rate (r). The discount rate that satisfies the zero benefit is the rate of return on
the investment and project selection is based on the highest rate.
Computationally, the present value equation is solved for (r) after setting the
net present value to zero and plugging in the future value obtained by
subtracting the future costs from the future benefits over the lifetime of the
project. Although this method is frequently used in business, the net benefits
and costs must be determined for. each time period and brought back to
present value separately. Computationally, this could mean dealing with a
large number of simultaneous equations.
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3: Benefit/Cost Ratio: Again, the present values of the benefits and costs are
kept separate and expressed in one of two ways. First, there is the pure
benefit/cost ratio which implies that if the ratio is greater than 1, the benefits
outweigh the costs and the project is acceptable. Second, there is the net ratio
which is the net benefit (i.e. benefits less costs) divided by the costs. In this
latter case, the decision criteria is that the benefits must outweigh the costs
which means the net ratio must be greater titan zero (e,g. if the benefits
exactly equaled the costs, the net B/C ratio would be zero). In both cases, the
highest B/C ratios are considered as the best projects.
There is a potential for altering the actual ratios using this method. Take for
example, if the present value of a project's benefits were $100 and costs were
$60, the B/C ratio would be $100/$60 or 1.67. If however the proponent of the
project were to reassess the project and declare that some of the costs were not
"true" costs, but instead simply offsets to benefits, then the ratio could be
changed considerably. In our above example, if $50 of the $60 total cost was
for waste disposal, and $70 of the $100 in benefits due to waste minimization,
then one could use them to offset each other. Under this line of thinking
both the numerator and denominator of the ratio could be reduced by $50
with the following effect: ($100 - $50) / ($60 - $50) = 5.0. Hence, without
changing the project, the new B/C ratio would make the project seem to be
considerably better.
4: Present Value of Met Benefits: This comparison evaluates all benefits and
costs at their current or present values. If the net benefit (i,e., the benefits less
costs) is greater than zero, the project is worth undertaking; if the net is less
than zero, the project should be abandoned on a financial basis.
This technique is firmly grounded in microeconomic theory and is
ideal for total cost analysis (TCA) and pollution prevention financial analysis.
Even though it requires a preselected discount rate which can greatly discount
long term benefits, it assures all costs/benefits over the entire life of the
project are included in the analysis. Once the present value of all options
with positive net values are known, the actual ranking of projects using this
method is straight forward; those with the highest Present Value of Net
Benefits are funded first.
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Appendix 3
The Effects of Income Tax
Although many firms use only revenue and expense figures in
comparing investment projects, income tax effects can enter into each
calculation if either revenues or expenses are changed from the baseline
values; more expenses mean lower profits and less taxes, and vice versa. If
the effect of income taxes on profit is needed, the computations are simple
and can be done during or after the analysis.
As with expenses and revenues, the total tax liability for each option
does not need to be computed. Instead, only the difference in tax liability
resulting the changes in revenues and/or expenses from the baseline due to
the options being considered is required.
The profit equation shown in Section n reflects gross or pre- tax profits.
Income tax is based on the gross profit figure from this equation and cannot
be computed until the changes in revenues/ expenses are known. For the
purposes of illustration, the income tax rate shall be taken as constant at 40%
of gross profit.
Taxes act to soften the impact on net profit due to changes in
revenue/expenses as follows. If revenues increase by $100 with no other
changes, pre-tax profits would also increase $100. Since income taxes take $40
of this increase, the effect on net profit would be to soften the $100 revenue
increase to a $60 net profit increase. Similarly, if expenses increase $100, pre-
tax income would decrease $100. The tax liability would be $40 less, so in this
latter case, the -$100 pre-tax impact would be softened to a $60 net-profit
decrease. This is shown in Table A3-1.
Table A3-1
The effect of changes in revenues and expenses on pre-tax and net profits.
Revenue Increase;
Initial Condition;
Beginning pre-tax profit: $100
Tax liability: $40
Net Profit without pollution prevention project: $ 60
Post Pollution Prevention:
Revenue increase subsequent to project: $100
New pre-tax profit:. $200
New tax Liability: $80
New net Profit: $120
Increase in net profit due to +$100 in revenues +$ 60
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AIPP Financial Primer
Table A3-1 (cont.)
Expense Increase
Initial condition
Beginning pre-tax profit: $100
Tax liability: ' $40
Net Profit without pollution prevention project: $ 60
Post Pollution Prevention:
Expense increase subsequent to project $100
New pre-tax profit: $ 00
New tax liability: $00
New net profit: $ 00
Decrease in net profit due to +$100 in expenses: -$ 60
As the table shows, the profit impact of an increase or decrease in
revenues or expenses is limited by 1 minus the tax rate (1-t). If the tax rate is
different from 40%, it can be inserted into (1-t) and used in calculating the
impact. For example, for a 33% tax rate, a $100 increase in revenue would
increase profit by (1-.33) or $67.
Tax credits are a special case allowed by the IRS at various times. For
example, during the energy crunch of the seventies, certain capital expenses
which reduced energy consumption (such as solar energy projects) were given
special treatment as tax credits. Unlike the more familiar personal tax
deductions, tax credits could be deducted directly from the tax obligation of a
firm. As a result, in this special tax credit case, capital expenses which would
otherwise lower pre-tax income can be subtracted directly from the tax liability
and increase profit. While there are currently no tax credit projects available,
given the political emphasis on pollution prevention, it is a possibility for the
future that cannot be overlooked.
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AIPP Financial Primer
Appendix 4
Present Value Computation Under Uneer tainty
Tier 2 and 3 costs are by their nature very difficult to quantify or predict.
For example, a typical tier 3 cost would be cost of lost sales due to adverse
public reaction to a pollution incident. The variables would include the types
of incidents tihat could occur, the severity of each incident, the ability of the
firm to control or respond to the emergency, the public's reaction tctthe
incident, the firm's ability to sate the public's concerns, etc. At the very least,
a complex situation.
In many cases, there is a probability that can be connected with the
event. This enters into the calculation of expected value. The expected value
of an event is the probability of an event occurring times the cost or benefit of
the event. Once all expected values are determined, they are totaled and
brought back to present value as done with any other benefit or expense.
Hence, the expected value measures the central tendency or the value that an
outcome would have on the average.
For example, there are a number of games at county fairs that involve
betting on numbers or colors much like roulette. If the required bet is $1, and
the prize is worth $5, and there are 10 selections (e.g., the numbers 0-9) the
expected value of the game can be computed as:
(benefit of success)x(probability of success)
(cost of failure)x(probability of failure)
)- ($l)x(.9)=-$.40.
Hence, on the average, the player will lose (i.e., the game operator will
win) $.40 on every $1 wagered.
For tier 2 and 3 expenses, the analysis is the same. For example, there is
a great deal of data available from Occupational Safety and Health
Administration (OSHA) studies regarding employee injury in the workplace.
In justifying a material substitution pollution prevention project, if the
probability of injury and a cost could be found, the benefit of project could be
computed.
The concept of expected value is not complicated although the
calculations can become somewhat involved. For example, even though
each individual's chance of injury may be small, given the number of
employees, their individual opportunity costs, the various probabilities for
each task, etc., could mean a number of calculations. However, if one
considers the effect of the sum of these small costs, or the large potential costs
of environmental lawsuits or site remediation under either the Resource
Conservation and Recovery Act (RCRA) or the Comprehensive
Environmental Response, Compensation, and Liability Act (CERCLA), the
expected value computations can be quite important in the financial analysis.
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Appendix 5
Additional Reading
Managerial Finance
By: Joe K. Shim & Joel G. Siegel
Published by: Schaum's Outline Series (067306-9)
This instructional text describes financial analysis and includes sections on
the time value of money and capital budgeting.
Managerial Accounting
By: Joe K. Shim & Joel G. Siegel
Published by: Schaum's Outline Series (067303-0)
This instructional text describes management accounting and includes
sections on cost concepts, terms and classifications, cost allocation, and capital
budgeting.
Hazardous and Solid Waste Minimization
By: A. H, Purceil
Published by: Government Institutes, Inc.
ISBN/ISSN: 0865871361
This document describes waste minimization and resource recovery. It
includes the whys and wherefores of waste minimization, considers the
economics of waste management decisions, and covers waste minimization
planning, auditing, and implementation.
Waste Minimization Manual
Published by: Government Institutes, Inc.
ISBN/ISSN: 0865877319
This document discusses waste minimization, economic imperatives, legal
and regulatory incentives, and how to conduct waste minimization audits. It
also contains waste minimization case histories for Dow, DuPont, Chevron,
Hewlett Packard, and the Navy.
Costing & Financial Analysis of Pollution Prevention Projects
By: Marlene R. Wittman
Published by: Massachusetts Office of Technical Assistance
This text provides a curriculum which is intended to familiarize
environmental professionals with basic business terms, and to increase their
awareness of the factors that influence an investment in pollution
prevention options.
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