Choosing Optimum
Financial Strategies
Pollution Control Systems
EPA Technology Transfer Seminar Publication
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EPA-625-3-76-005
CHOOSING THE OPTIMUM
FINANCIAL STRATEGY
FOR POLLUTION CONTROL
INVESTMENTS
ENVIRONMENTAL PROTECTION AGENCY Technology Transfer
JUNE 1976
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ACKNOWLEDGMENTS
This seminar publication contains materials prepared for the U.S.
Environmental Protection Agency Technology Transfer Program and has
been presented at Technology Transfer design seminars throughout the
United States.
This publication was prepared by C. Marshall and J. Commins of
JACA Corporation, 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 recommendation for use
by the U.S. Environmental Protection Agency.
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CONTENTS
Page
Chapter I. Introduction 1
Organization of This Publication 2
Chapter II. Tax Strategies 3
General Rules for Depreciating Pollution Control Equipment 3
Relationship of Depreciation to Taxes and Cash Flow 4
Net Present Value of Cash Flows As a Decision-Making Tool 4
Sample Analysis of Pollution Control Investment Tax Strategies 6
Comparison of Depreciation Methods 9
Ability to Use Investment Tax Credit (Attention - Small Businesses) 11
Summary 12
Chapter III. Financing Strategies for Pollution Control Investments 13
Bank Financing 15
Small Business Administration Compliance Loans 16
Industrial Development Bonds 18
Leasing 20
Comparison of Financing Methods 20
Chapter IV. Optimum Financial Strategy for Pollution Control 23
Summary 28
Chapter V. State Financing and Tax Incentives 31
Alabama 32
California 32
Missouri 33
New York 33
Wisconsin 34
Summary 35
Chapter VI. Financial Decision-Making Analyses for Municipal Versus Private
Treatment of Water 37
Net Present Value Analysis 40
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Page
Chapter VII. Summary 45
Appendix A. SBA Water Pollution Control Loan Application Procedures 49
Appendix B. Types of Contractual Arrangements Between Governmental Authorities
and Industries Acquiring Tax-Free Financing 55
Appendix C. IRS Definitions and Allocations of Pollution Control Equipment Under
the IDE Program 57
Appendix D. Sources of Information About State Pollution Control Incentives 59
n
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Chapter I
INTRODUCTION
As the 1970's proceed, environment-related management decisions will continue to be
complex and frequent, often requiring the commitment of sizable amounts of capital. The
impact of these nonremunerative environmental expenditures on businesses can be significant,
and cost recovery possibilities are limited or nonexistent.
Several governmental institutions provide means to reduce or soften the effect of these
pollution control expenditures. To a certain extent, the government passes industrial pollution
control costs on to the general public by excusing pollution control devices from certain sales,
use, and property taxes; by allowing companies to use tax-exempt financing for the
expenditures; or by special depreciation allowances. Such programs permit a company to pay
lower taxes or financing costs than it normally would if the equipment being purchased were
for a manufacturing or other business purpose. In addition, through federal construction grants
to municipalities, the cost of treating a company's wastewater can often be reduced if a
municipality treats the wastewater.
To put these incentive or cost-reduction programs into perspective, it should be pointed
out that they do not significantly reduce the cost of the pollution control investment. They
can, nevertheless, affect a company's cash flow and profit position.
Obtaining control equipment is new to most companies, and a considerable body of new
and involved tax and financing regulations exists for such equipment. Consequently, company
financial managers may not be as familiar with incentive possibilities as they would be with
more common business operations.
This publication will alert decision makers to the availability of and qualifications for
some of the financing incentives from federal, state, and local governments, and will
demonstrate that it is well worth spending time analyzing the special methods of financing
pollution control expenditures and the available tax treatments. Obtaining optimum financial
and tax benefits could save a company tens of thousands of dollars over the life of the
equipment. For example, a Business Week article (July 29, 1972, pp. 50-51) calculating the
cost savings that tax-exempt pollution control revenue bonds can provide concluded that "over
the life of a 20-year, $10-million issue, the typical interest saving is about $3.6 million."
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This publication will show the businessman the type of financial analysis that should be
accorded any type of pollution control expenditure in an effort to substantially reduce funds
expended and to smooth out what could develop into a cash flow trauma. This publication
contains a discussion of the tax and financing positions of three hypothetical firms with
different management goals but with similar capital expenditures for pollution control.
A separate financial analysis is presented specifically for firms which have a choice of
wastewater treated onsite or by a municipality.
The net present value financial analysis technique will frequently be used to
quantitatively compare and select alternative tax and financing strategies. This is a very
effective and widely used technique which enables the evaluation of future income and costs
in terms of present dollars. Using this technique, it is possible, for example, to evaluate a
revenue bond issue which might allow for deferred repayments of principal and permit the
largest payments at the end of a 20- or 30-year issue. Meanwhile, the company could lower
taxes immediately by taking depreciation and using investment tax credits, thus building up
cash flow for use in other areas of the business. On that cash flow, earnings could be
generated which would help repay the bond principal later. All of these future incomes, costs,
and resulting cash flows can be analyzed and combined and the results compared to the
results of a similar analysis of an alternate combination of taxing and financing options.
The examples in this publication have been simplified to convey basic problems and
techniques for all industries. They by no means exhaust the variety and combinations of
available tax and financing strategies relating to pollution control equipment. Often, financing
and, to a lesser extent, tax treatment vary by time and by jurisdiction. Consulting the latest
tax rulings and legislation relevant to each location is necessary before undertaking the final
decision-making process.
ORGANIZATION OF THIS PUBLICATION
The remainder of this publication is divided into six chapters. Chapter II analyzes the
standard depreciation tax methods and others which 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 pollution control
equipment to overall company financial strategies in order to select an optimum financial
strategy for the equipment. It is particularly concerned with the effects of each of the
incentives on a company's cash flow strategy or its profit maximization strategy. Chapter V
examines the availability of federal incentives that also require state involvement and examines
examples of additional incentive provided by states. Some financing alternatives are, for
practical purposes, always available, while others are dependent upon the source's budget.
Chapter VI examines the financial benefits of private treatment of industrial wastewater and
the costs and benefits of municipal treatment. Chapter VII is a summary chapter.
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Chapter II
TAX STRATEGIES
Normally, two types of federal tax benefits exist for plant equipment expenditures. The
underlying effects of these benefits are to reduce the taxes payable by a company and to
improve the company's cash flow, thus partially offsetting the original cost of the equipment.
One set of benefits, depreciation, allows a proportion of the equipment cost to be deducted
annually from income as a non-cash expense over a certain guideline period. The period
allowed during which the deductions can be taken changes with different depreciation
techniques. Accelerated techniques allow the cost of the equipment to be deducted early in
the life of the equipment; amortization is the term used to cover depreciation taken over less
than the full life of the equipment. Different proportions can be deducted over the full life
of the equipment using techniques such as straight-line depreciation, double-declining balance,
and sum-of-the-years digits. The depreciation method chosen should conform with a
corporation's financial management strategy.
The second type of tax benefit, an investment tax credit, also exists for all types of
equipment. It was intended as a special incentive to encourage companies to buy capital
equipment and, in effect, reduces the cost of the equipment by providing a permanent tax
reduction.
This chapter will compare selected depreciation techniques, including a technique
specifically provided for pollution control, considering only the major financial aspects of laws
and regulations. The reader should consult specific regulations for more detail.
GENERAL RULES FOR DEPRECIATING POLLUTION CONTROL EQUIPMENT
An analysis of depreciation entails determining the depreciation method to be used and
the useful life of the equipment over which depreciation will be taken.
When choosing a depreciation method for pollution control equipment, the normal
requirement that a company consistently adhere to one depreciation method is waived. For
example, if a company uses the straight-line depreciation method for its other assets, it could
still take double-declining balance depreciation for its pollution control equipment.
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Similarly, when determining the useful life of the equipment, it is possible, with
sufficient justification, to use one asset depreciation range (ADR) for the normal company
assets and a different useful life for pollution control facilities. For example, if a company
customarily uses a guideline useful life of 12 years (permitted in the 9.5- to 14-year ADR),
an 8-year life could be used for the control device if the life of the control equipment were
less than that of the normal ADR. Having a shorter useful life may be advantageous in terms
of the company's financial management objectives.
RELATIONSHIP OF DEPRECIATION TO TAXES AND CASH FLOW
The tax benefits of annual depreciation/amortization values result from their being
accounted for as an expense which does not actually involve any cash outlays in that year by
the taxpayer. (The cash outflows that occur in connection with the equipment purchase are
covered in chapter III). An expense means a tax saving (as well as lower profits). The tax
savings is a net cash inflow to the corporation and is represented by:
NCF = TD
where NCF - net cash flow
T = the tax rate, expressed as a fraction
D = amount of depreciation/amortization
Positive cash flows (cash inflows) can be reinvested in the business on the productive side
of the operation or to reduce the need for obtaining cash from other sources. A short period
of depreciation/amortization means faster deductions, tax savings, and cash flow benefits.
NET PRESENT VALUE OF CASH FLOWS AS A DECISION-MAKING TOOL
Since each tax strategy to be compared in this chapter has a distinct cash flow pattern, a
method of comparing the cash flows has to be employed. One useful method is to compute
the net present value (NPV) of the annual net cash flow (NCF) produced by each strategy
throughout the depreciable life of the equipment. This method of comparison compensates for
differences in cash flow amounts, for differences in the duration of two strategies, and takes
into consideration 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. The dollar saved today has the potential of
yielding a return (r) if used for profit-making company operations, or if saved. Thus, the
present value (PV) of today's dollar that is saved today is
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PV = 1
The present value of a dollar saved a year from now is, on the other hand,
PV =
1 + r
where 1 + r becomes the "discount factor" which yields a present value of less than 1.
The present value of a dollar saved i years from now is obtained by discounting annually
PV = !.
When the present value of the net cash flow (NCF) of a future year is calculated using
the discount factor, the resulting cash flow is called discounted cash flow (DCF):
NCFi
DCF} = .
7 (1 + r)1
The sum total of all such discounted cash flows over the useful life is the NPV of the
tax savings:
n n NCF,.
NPV = y DCFj = V
/ _-J I Z^J , ,7
/= 1 /= 1
where n = total years.
Since in this case NPV is the sum of discounted cash inflows (tax savings), the higher
the NPV, the more attractive the depreciation method when the company financial objective
is to minimize cash outflows for the overall pollution control project.
For manufacturing, r, the return on investment, averages about 7.0 percent before taxes.
After taxes, this figure is reduced to about 3.5 percent. Therefore, for our illustrative
purposes,
r = 3.5%
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SAMPLE ANALYSIS OF POLLUTION CONTROL INVESTMENT TAX STRATEGIES
An illustration of the use of NPV in comparing alternative tax strategies is presented
using water pollution control expenditures. As will subsequently be shown, that area of
pollution control involves the greatest variety of financing and tax strategies.
An investment figure of $200,000 will be used and, for accounting purposes, an ADR of
9.5 to 14.5 years. From this range, a useful life of 10 years was selected. Salvage value was
assumed to be zero.
The analysis will include a discussion of the four writeoff strategies: rapid amortization,
straight-line depreciation, straight-line depreciation plus investment tax credit, and double-
declining balance depreciation tax strategies. The analysis will be most fully demonstrated
under the first section, Rapid Amortization, as the analysis techniques for all are similar.
Rapid Amortization
The Tax Reform Act of 1969 provides for the 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 (IRC). The rapid writeoff was provided to encourage capital
investment in pollution control. Significantly, a process change, even if it results in lower
pollution, does not qualify as a pollution control device and cannot be rapidly amortized.
As originally legislated, the eligibility period for rapid amortization would have expired
January 1, 1975. However, additional legislation extended that period for 1 year. Further
extensions are currently being considered.
The rapid amortization applies to the first 15 years of equipment life. The portion of
the asset value with a useful life of 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 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 (Section 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 not
considered a pollution control incentive, the inclusion of this provision is needed for accuracy
of calculations and will be incorporated into all the analyses in this chapter.
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This illustration will assume that the corporate income tax rate is 48 percent and that
the effective date of purchase of the $200,000 waste treatment facility is the beginning of the
fiscal year so that the amortization period will be entirely within the next 5 fiscal years. The
toal useful life of the equipment is 10 years. Computation of the NPV of the $200,000
investment using rapid amortization results in
NCF = TD
= [(.48) (200,000 - 2,000) - 5] + (.48) (2,000)
NPV = £ DCFi
NCF;
(1 + r)1
3.5%
n NCF,
NPV =
i=\ (1 + -035)'
NPV = $86,753
Table 11-1 shows the annual DCF calculations and totals (or NPV) for a $200,000 piece
of equipment written off by the rapid amortization method over 5 years. The effect of the
additional first year depreciation (AFYD) is also considered. Table II-l should be completed
for each of the following tax strategies in order to make comparisons.
Straight-Line Depreciation
The basic or most simple form of depreciation involves reducing taxes by an equal
proportion of the depreciable amount in each year of the life of the equipment. In this case,
the depreciable base reduces to $ 198,000 by taking the additional first year bonus
depreciation of $2,000 (maximum). Using the above formula and table with the $200,000
equipment with a life of 10 years, the NPV of cash inflows or tax savings is $79,969.
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Table II-1.-NPV calculation for rapid amortization
End
of
year
1
1
2
3
4
5
Depreciable
base
$200,000
198,000!
198,000
198,000
198,000
198,000
Depr.
rate
AFYD
20%
20%
20%
20%
20%
Pre-tax
depr.
(D)
$ 2,000
39,600
39,600
39,600
39,600
39,600
After-tax
depr.
(NCF)
$ 960
19,008
19,008
19,008
19,008
19,008
Discount
rate
(1 +r)
1.0350
1.0350
1.0712
1.1087
1.1475
1.1876
DCF
[NCF +
(1 +r)]
$ 928
18,365
17,745
17,144
16,565
16,006
Total DCF = NPV =
$86,753
'The $2000 maximum additional first year's depreciation reduces the depreciable base.
Straight-Line Depreciation Plus Investment Tax Credit
The investment tax credit has been available on an on-again/off-again basis over the last
decade as a special incentive for the business community to purchase capital equipment. The
amount traditionally allowed has been 7 percent, although in 1975 it was temporarily raised
to 10 percent to help produce a turn-around in the national recession. Because of this history
of the investment tax credit, 7 percent will be used for this analysis. In the investment
example being used, this tax credit provides a tax savings of $14,000. This figure, adjusted to
the NPV, should be incorporated into the calculations of the straight-line depreciation NPV,
since the investment tax credit is allowed for the method. It is adjusted to the NPV by
dividing it by the discount rate for the first year and adding the result to the NPV
straight-line depreciation (or $79,969).
By taking the investment tax credit into account, the NPV of the straight-line tax
strategy increases to $93,495.
Accelerated Depreciation (Double-Declining Balance Combined With Sum-of-the-Years Digits)
This is the most accelerated of the traditional ways to depreciate equipment. Although
two methods are used here in combination, they can be used separately and each would be
more accelerated than straight-line depreciation.
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Double-declining balance provides that each year twice the straight-line rate (in this
example that would be 2 X 10 percent) is applied to the declining balance of the equipment
after deducting the AFYD. In this case, the first year's depreciation is $41,600 (0.2 X
$198,000 = $39,600 plus the $2000 AFYD). In the second year, the 20 percent is taken
against the reduced value ($200,000 - $2,000 - $39,600, or $158,400), resulting in $31,680.
The calculation for sum-of-the-years digits is more easily explained by illustration. The
first year of a 10-year life is represented by the 10 in the numerator of a fraction, while 55
in the denominator is the sum-of-the-years digits, 1+2+3+. . .10. The first year's amount in
this case would be computed by multiplying 10/55 times the initial cost minus the AFYD. In
the second year, $198,000 would be multiplied by 9/55.
The quickest method for accelerating depreciation in this case is to use double-declining
balance and the $2000 AFYD in the first year and to switch to the sum-of-the-years digits
method in the second. When these two methods are used in such a combination and the
investment tax credit is included, the NPV> or tax savings, for the $200,000 equipment is
$97,764.
COMPARISON OF DEPRECIATION METHODS
Figure II-l is a bar graph showing how the total value of each depreciation method relates
to the overall cost of the equipment. From this figure, it is clear that, when trying to minimize
cash outflow (by increasing tax savings), the optimum strategy is the double-declining balance
and sum-of-the-years digits methods with the investment tax credit and AFYD.
Curiously, the optimum strategy is not the special pollution control tax strategy, rapid
amortization. This was introduced in 1969 when the national economy was thought to be in
an overheated condition and the investment tax credit was withdrawn. However, because of
the high national priority put on pollution control, its expenditures were accorded special
treatment through rapid amortization. In 1971, in a new effort to stimulate the economy, the
investment tax credit was reinstated and made applicable to all equipment, including pollution
control equipment. The tax credit was especially attractive because it never needed to be
repaid, whereas rapid amortization really represented only a postponement of taxes. In
addition, when the investment tax credit, plus double-declining balance and sum-of-the-years
digits depreciation methods and the AFYD was used, process changes made to comply with
pollution control regulations could be covered, while they do not meet requirements for rapid
amortization (only control devices do). For these reasons, and because rapid amortization and
the investment tax credit were made mutually exclusive, rapid amortization has not been used
extensively.
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$200,000 -
180,000
160,000
140,000
120,000
100,000
80,000
60,000
40,000
20,000
8
00
ft
1
1
EG
UIP
o
o
o
MEN
D
RAPID AMORTIZATION
STRAIGHT-LINE DEPRECIATION
STRAIGHT-LINE DEPRECIATION
WITH INVESTMENT TAX CREDIT
DOUBLE-DECLINING BALANCE PLUS SUM-OF-
THE-YEARS DIGITS DEPRECIATION WITH
INVESTMENT TAX CREDIT
Figure 11-1. Net present value of total tax savings through depreciation.
The line graph in figure II-2 indicates the year-by-year after-tax positive cash flows from
the various depreciation alternatives. The rapid amortization cash flows are practically level
because it was assumed that the equipment was installed at the beginning of the fiscal year.
The slightly higher level in the beginning results from the AFYD. A mid-year installation with
an election to begin the 60-month amortization period the next fiscal year would have
resulted, under optimal conditions, in a higher level in the first year and a level amount over
the next 5 years at a slightly lower level.
The high initial level for the last two methods results from taking the investment tax
credit and the AFYD.
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$30,000
20,000
10,000
RAPID AMORTIZATION
STRAIGHT-LINE DEPRECIATION
STRAIGHT-LINE DEPRECIATION WITH
INVESTMENT TAX CREDIT
DOUBLE-DECLINING BALANCE AND SUM-
OF-THE-YEARS DIGITS WITH INVESTMENT
TAX CREDIT
9 10
Figure II-2. Year-by-year tax savings {cash flow improvements)
through different tax strategies.
ABILITY TO USE INVESTMENT TAX CREDIT (ATTENTION - SMALL BUSINESSES)
A company must have a sufficient level of pre-tax earnings to be able to fully utilize the
investment tax credit. This is particularly important to small businesses at a low income level.
Taking an investment tax credit which would be greater than the amount of corporate income
taxes payable would defeat some of the advantage of investment tax credit. Calculations based
on the new corporate tax rates of 20 percent of all income before taxes up to $25,000, 22
percent of the next $25,000, and 48 percent above $50,000 show that a company has to
have $63,462 in taxable earnings in order to fully benefit from the $14,000 investment tax
credit of our example.
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It is true that unused investment tax credit can be carried over into the future, under
certain conditions (Section 46b, IRC). However, the NPV of an investment tax credit
carryover is less than that of the tax credit itself.
SUMMARY
This chapter has demonstrated the large differences in year-by-year cash flows and NPVs
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 and sum-of-the-years digits method with investment tax credit over all
other methods, including rapid amortization. This advantage is increased if the investment tax
credit percent is 10 percent instead of 7 percent. The life of the equipment must be over 30
years before another depreciation method becomes superior in this illustration.
In chapter III, the special incentives for financing pollution control equipment will be
examined. The differences in values for these financing methods coupled with the results of
the analysis just performed will be carried into chapter IV where the tax and financing
strategies are combined.
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Chapter III
FINANCING STRATEGIES FOR POLLUTION
CONTROL INVESTMENTS
Prior to pollution control legislation, when a plant manager made a decision to buy a
piece of equipment, and if money was to be borrowed to pay for the equipment, he got in
touch with his normal financing source to make arrangements. With the advent of special
pollution control incentives, there are not only new sources of funds available, but also lower
than normal rates for most sources of financing. This situation requires a whole set of
analyses before the best source of funds can be chosen.
In this chapter, each financial source is described and, based on rate and terms, is
quantitatively analyzed using net present value (NPV) as a tool for evaluating the cash flows.
As in chapter II, the example is based on a $200,000 waste treatment system.
In chapter II, the net cash inflow as a result of tax savings was a function of the
amount of depreciation and the tax rate. This chapter deals first with the net cash outflow
resulting from interest costs of the various fund-raising methods, and subsequently with the
loan repayment net cash flow.
A comparison of the net profits with and without the interest costs for pollution control
equipment makes it possible to quantify the cash outflow from interest. Net profit, P, and
the tax liability, £, can be related to operating parameters by the equations:
P = P (1 - T)
and L = pT
where p = annual taxable income
T = the tax rate, expressed as a fraction.
For domestic corporations, the new federal tax rate amounts to 20 percent on taxable income
up to $25,000, 22 percent for the next $25,000, and 48 percent on income over $50,000. A
tax rate of 48 percent is assumed throughout this analysis.
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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 above two equations,
P = (Q - 7) (1 - D
= Q (1 - 71) -7(1 - 7)
and L = (Q - 7) T
= QT - IT
If there was no interest expense during the year, 7=0, the above equations would become
P = Q (1 - T)
L = QT
Thus, the effect of the interest expense, 7, is to reduce the net profit after taxes by 7(1 - T).
The tax liability is reduced by IT.
If C is the amount of principal that is paid back during a year and 7 is 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:
NCF = (C + 7) - (IT)
= C + 7 (1 - T)
The above equation represents the net effect of the load 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 equipment are not considered. Only the effect of initial investments in
pollution control on the company's fiscal position is analyzed here.)
The payment of interest and principal extends through the term of the loan. For long
term loans such as those for pollution control expenditures, the term would be more than 1
year. The net cash outflow, NCFfa during year / is
NCFj = Ct + It (1 - T)
i = 1, 2, - -, n
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where Cf = principal payback during year i
fy = interest expense during year /
n = term of the loan in years.
The total effect of the loan on the company's cash flow over time is determined by
using the net present value approach which incorporates the time-value of money as described
in chapter II.
Thus, the discounted cash flow during year / is
(1 + r)1
The sum total of all such discounted cash flows over the terms of the loan is the NPV
of the loan:
n
NPV = £
/=!
= y NCFi
i=l (1 + ')'*
Since NPV of loans is the sum of discounted outflows, the lower the NPV, the more
attractive the loan. The annual discount rate, 1 + /-, as in chapter II, is the after-tax return on
investment for the manufacturer, averaging 3.5 percent.
BANK FINANCING
Some commercial banks across the country have announced preferential rates and terms
for certified pollution control facilities. However, since these bank programs are quite random,
normal installment bank financing rates and terms were used for this analysis of pollution
control equipment financing.
The terms and rate suggested here as normal for this type of financing are 5 years and 6
percent annually, with the effective rate of interest being 10.84 annually. The NPV for
financing the $200,000 waste treatment system through a bank is $208,100, as shown in table
III-l. The cash outflows for this financing alternative increase each year because of the bank
repayments system. Although the annual payment amounts are the same, the proportion of
15
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interest in those payments is higher in the beginning. Since this interest is tax deductible, thus
reducing the net cash outflow by approximately half, the net cash outflow is lower in the
beginning of the loan.
Table III-l shows the details of NPV calculations for a 5-year bank loan for $200,000,
using a 6 percent interest rate; the loan is repaid quarterly. This type of table should be
completed for each of the following financing strategies in order to make comparisons.
Table 111-1 .NPV calculation for bank financing
Year
1
2
3
4
5
Repayment
interest
/
$21,143
16,571
12,000
7,429
2,857
$60,000
Principal
C
$ 30,857
35,429
40,000
44,571
49,143
$200,000
Total
annual
$ 52,000
52,000
52,000
52,000
52,000
$260,000
Interest
X
{1 - 7-}
$10,994
8,617
6,240
3,863
1,486
Plus
principal
= NCF
$41,851
44,046
46,240
48,434
50,629
Disc.
factor
1 + r
1.0350
1.0712
1.1087
1.1475
1.1877
NCF +
(1 + r)
= DCF
$ 40,436
41,118
41,708
42,209
42,629
Total DCF = NPV = $208,100
SMALL BUSINESS ADMINISTRATION COMPLIANCE LOANS
The Small Business Administration (SBA) has historically provided loans to businesses if
such loans are not available through normal banking channels and if the applicant meets SBA
business size and risk requirements. The funds are provided in three ways: by the SBA
guaranteeing a portion up to 90 percent of a bank loan; by participation, in which case the
SBA provides a part of the funds and the rest is provided by the bank; and by direct loans,
in which case the SBA provides funds on a direct loan basis. All of these so-called regular
business loans, in practice, have typical repayment periods of up to 15 years. Direct loans
have considerably lower rates than the participation rate or the guaranteed rate; however, such
direct loans are frequently not available.
Over the last decade, Congress has passed several significant pieces of consumer and
environmenta! legislation, many of which were expected to significantly impact certain sectors
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of the economy. Those companies which were expected to be most impacted by the
legislation were described as substantially injured. In several instances Congress sought to aid
these companies through special loan and other assistance programs of the SBA. These special
programs come under SBA's general category of disaster loans, rather than regular business
loans. They are similar to regular business loans in that the three types of loans are used by
SBA, but they differ in that the repayment period is longer and the direct loans with their
lower interest rates are somewhat more available. Therefore, such loan programs should be
carefully examined by a substantially injured firm.
Water Pollution Control Loans
The Federal Water Pollution Control Act (FWPCA) legislated that $800 million be made
available under the disaster loan category of SBA to small businesses for water pollution
control capital expenditures providing the company is substantially injured. The program has
been operating since August 1974. An important part of the law is that it is necessary for an
applicant to obtain a certification from the appropriate regional office of EPA stating that the
equipment is "necessary and adequate" to meet FWPCA regulations.
A company qualifies for SBA water pollution control loans if it is a "small business
concern . . . affecting additions to or alterations in the equipment, facilities (including the
construction of pretreatment 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." Appendix A describes loan application
procedures.
Compliance Loans for Other Regulations
In January 1974, the President approved legislation permitting SBA to make loans to any
small business concern required to "meet requirements imposed on such a concern pursuant to
any Federal law," or any state law enacted in conformity with the federal law. This
legislation unified several earlier enactments (except for water pollution control) which had
established specific loan programs for each regulatory program. Under the new legislation, SBA
can now provide a loan to any eligible company for compliance to any federally-imposed
standards (except for water pollution control) which require alterations in its plant, facilities,
or methods of operation.
Because the compliance loans are relatively new, it should be made clear to SBA and
other financial officials at all steps in the inquiry and application process that inquiries are
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being made for compliance loans under the disaster fund, rather than for regular business
loans.
To be eligible for either of these loan programs, companies must satisfy the SBA
definition of small business and be companies which would sustain substantial injury from
compliance requirements without the benefit of the loan. Substantial injury has not been
defined for either of .these loan programs; SBA relies on evidence supplied by the applicant,
including proof of the unavailability of loans from commercial sources.
The interest rate for SBA's direct loan bears an interest rate equivalent to the
government rate of borrowing. The 1975 rate was 6.5 percent and is used in this illustration.
Interest rates for guaranteed loans are generally several percentage points higher than direct
SBA loans.
Equal annual repayments were chosen as the principal payback method, and the interest
rate was applied to the declining outstanding principal balance of the loan. SBA loans can
extend up to 30 years. However, in the example being illustrated here, a 10-year loan term
was chosen. Using the 6.5-percent direct loan rate and the 10-year repayment schedule, the
NPVis $198,846.
INDUSTRIAL DEVELOPMENT BONDS
Government aid is also available to corporate borrowers as a result of the effort to
encourage industrial development in general and in some cases to encourage industry to install
control equipment on pollution sources.
Federal tax provisions make it possible to finance pollution control equipment at interest
rates that are generally lower than usual. Once a state declares that pollution control, or
industrial development, serves a public purpose, equipment can be financed with the proceeds
of industrial development bonds (IDBs) issued by a municipality or quasi-governmental
agency1; there is a limit on the amount that can be funded by IDBs for industrial
development, but no limit when pollution control equipment is being funded.
Because the interest paid on these bonds is exempt from federal income taxes, IDB
buyers are willing to accept an interest rate that may be as much as 25 percent lower than
prevailing interest rates on corporate bond issues of comparable quality. The advantages to the
company of this alternative are reduced by the added fixed costs of issuing the bonds,
resulting in an effective lower limit on the size of issues that can be financed by such means.
1 Appendix B contains various contractual arrangements a company may have with the government authority through which
tax-free financing was obtained.
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IDBs are either sold to an institutional investor or a commercial bank and referred to as
private placements, or they are sold to the public and referred to as public placements. The
costs of issuing public placements are greater than those for private placements because of the
high costs of the legal work, advertising, and printing, as well as the fees charged by
investment bankers. Consequently, publicly placed IDBs are generally utilized only in
multi-million dollar financings; $500,000 is the generally acknowledged floor, or trade-off
point.
In many states there have been a considerable number of privately placed IDBs issued for
amounts less than $500,000. In the case of privately placed IDBs, there are also costs
resulting from the fees for bond counsel, application fees for the industrial development
agencies, and other administrative expenses. However, they are frequently considerably below
these of publicly placed issues. The trade-off point or minimum practical size varies from state
to state, and even within a state.
IDE financing is available in all but a very few states. Most states require a municipal,
county, or regional development authority or corporation to serve as the actual issuer of the
bonds. While such authorities do not exist in all locations, it is generally possible to create
one. However, the expenses involved in such an effort would be prohibitive for a single
relatively small borrowing.
There have recently been efforts by the Connecticut Development Authority, the New
York State Job Development Authority, and other governmental agencies to eliminate the
handling costs that preclude the use of such revenue bonds for small borrowings. In some
instances, the borrowing power of state authorities was used for large offerings undertaken on
behalf of several companies; the economies of scale yielded reduced financing costs for the
individual companies.
For our example of IDB financing, the terms include a 6-percent interest rate with an
initial underwriting cost of 2 percent. The repayment period is 15 years and the repayment
schedule is as follows: 8 percent of principal annually during years 5 through 14, and the
remaining 20 percent of the principal during year 15. In order to enter the 2-percent
underwriting expense into the NPV calculations, the amount is added to the repayment
interest amount for year 1.
As a word of caution about tax-free status, it is prudent to obtain the advice of counsel.
There are a number of stipulations about the type of facilities qualifying for tax-exempt
financing (see appendix C).
The NPV of cash outflows for the tax-free financing method using the terms described in
the $200,000 example is $195,600.
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LEASING
Leasing involves outside ownership of the equipment but permits the company to use the
equipment for regular fees, which are expensed. In terms of cost comparisons, leasing fees
should be compared to the depreciation and tax credits the company would have had if it
purchased the equipment.
Leasing is attractive when companies cannot benefit from the tax credits and deductions
of the equipment, or when companies prefer not to show long-term debt on their balance
sheets. The latter becomes a preference when a bank limits company debt, or when the
company prefers to show a low debt structure. Whether this form of accounting will be
allowed to continue will depend on accounting standards boards. It is currently being studied
by the Financial Accounting Standards Board.
However, the Internal Revenue Service (IRS) has issued many rules which must be
adhered to for a leasing financing arrangement to be a true lease and not a disguised sale.
Two rules are most critical for pollution control. At the termination of the lease, it must not
be impossible or impractical for the lessor to remove the property. Secondly, where property
is acquired specifically for the lessee, the IRS may contend that the property has no value to
anyone other than the lessee at the end of the term, thus encouraging the lessor to abandon
the property to the lessee. These are severely limiting restrictions as far as pollution control
leasing is concerned since the equipment is often tailored to a source and not transferable to
other sources and since both air and water pollution control equipment often become so
interwoven with real estate that removal is impractical.
In addition to the difficulties in qualifying for a lease, leasing is more costly over the long
run than any of the other alternatives discussed here. For these reasons, less than 10 percent
of all pollution control equipment is leased, and a detailed analysis is therefore not included
in this manual.
COMPARISON OF FINANCING METHODS
Figure III-l is a bar graph of the net present values of the negative cash outflows in
financing the $200,000 cost by the three alternatives. The graph indicates the superiority of
the tax-free method of financing pollution control equipment under the parameters selected
for the illustration. There is a 10-percent difference between the best and worst selection.
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. Conversely, a bond issue
has the lowest cash outflow for an extended period. However, depending on the payoff
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method chosen for the bond, full repayment of principal at the end or a sinking fund will be
required. In the first instance (illustrated), high cash outflow is generated in the final year due
to the ballooning effect.
Now that the financing and tax strategies have been described and analyzed, we are
prepared to compare the alternatives for selection purposes. In order to make a selection, the
objectives by which companies are managed must be analyzed, as they impact possible
combinations of the tax and financing alternatives. These will be discussed in chapter IV.
$200,000 --
180,000
160,000
140,000
120,000
100,000
80,000
60,000
40,000
20,000
D
ORDINARY BANK LOAN
SBA LOAN
TAX-FREE BOND
Figure 111-1. Net present values of cash outflows from financing alternatives.
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$50,000
40,000
30,000
20,000
10,000
A. ORDINARY BANK LOAN
B. SBA WATER POLLUTION CONTROL LOAN
C. TAX-FREE BOND
J L
1 - 1 - 1
8
1 - 1 - 1 - 1 _ ' ' J
10 11 12 13 14 15
YEAR AFTER ACQUISITION
Figure 111-2. Year-by-year cash outflow from different financing strategies.
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Chapter IV
OPTIMUM FINANCIAL STRATEGY FOR
POLLUTION CONTROL
No two manufacturers face the same financial problems, nor exactly the same
management objectives. However, to demonstrate the effects of combining the various tax and
financing strategies, we have selected three business situations involving different management
objectives that might exist in a manufacturing operation. We will show how different
combinations of tax and financing affect each situation.
The data from the calculations discussed in chapters II and III will be used here to
determine the appropriate financing and tax strategies for a given set of company management
objectives. The data is capsulized in table IV-1, which contains the price and life of the
hypothetical pollution control equipment and the tax status of the companies, as well as the
key characteristics of three financing strategies.
First let us look at the manufacturer who has enough resources and stability to
concentrate on maximizing long-term profit. For him, a financial management decision
regarding tax and financing strategies would be based on finding the combination with the
lowest net present value (NPV}. The computation of NPV for each of the 12 combinations (4
tax and 3 financing strategies) will be necessary. The combination illustrated in table IV-2 is
rapid amortization and commercial bank financing. This combination was chosen since the
illustrations in chapters II and III contained those strategies. The figures in table IV-2 are
identical to the last columns in the earlier NPV illustrations for each separate strategy. Note
that the term cash inflows is used to represent the tax savings of rapid amortization, and the
term cash outflows is used for the financing costs of the commercial bank loan strategy.
Table IV-3 shows the net NPVs for all 12 combinations of tax and financing strategies.
Since the financial strategy in this case is to minimize the long-term profit impairments of the
strategies, the optimum financial strategy is to choose the tax and financing strategy
associated with the lowest NPV, indicated by the boxed figure. In this instance, optimality
($97,800) is achieved by using the double-declining and sum-of-the-years digits depreciation
method along with a tax-free bond (strategies 3 and C).
The numbers for all combinations of strategies, as shown in table IV-4, were computed
for those managers who are concerned about short-term profit impairment (STPF) because, for
example, they may have a short-term need to demonstrate the strongest net income statement
to lenders or stockholders.
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Table IV-1.-Illustrative financial characteristics of pollution control equipment for manufacturers
1, Equipment Characteristics
Investment cost
Salvage value
Useful life
2. Tax Status
Corporate income tax rate
Investment credit
Additional first year's depreciation
Effective cost-of-capital rate
3. Financing Terms
(a) Ordinary bank loan
Stated interest rate
Effective interest rate
Repayment period
(b) SBA water pollution control
loan or compliance loan
Interest rate
Present treasury rate
Payment period
(c) Tax-free bond
Interest rate
Initial cost of obtaining loan
Repayment period
Repayment schedule
$200,000
0
10 years
48 percent
7 percent
$2,000
3.5 percent annually
6 percent annually
10.84 percent annually
5 years
Weighted average treasury rate
6.5 percent
10 years {could be as long as 30 years, but
practically may not be more than life of
equipment)
6 percent
2 percent of capital
15 years
8 percent of principal annually during years 5
through 14; 20 percent of principal during year
15 (balloon)
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Table \\l-2.-Net NPV after combining cash inflows and outflows
using rapid amortization and bank financing
Year
1
2
3
4
5
NPV of
year-by-year cash inflows
$19,293
17,745
17,144
16,565
16,006
$86,753
NPV ot
year-by-year cash outflows
$ 40,436
41,118
41,708
42,209
42,629
$208,100
NPV cash outflows $208,100
Less NPV cash inflows 86,753
Net NPV $121,347
Table \V-3.-Comparison of long-term profit impairment resulting from
different tax and financing strategies
Useful life = 10 years
Investment cost: $200,000
Financing strategy
Tax strategy1
1.
2.
3.
4.
Straight-line depreciation
Straight-line depreciation
with investment credit
Double-declining balance depreciation
plus sum-of-the-years digits
with investment credit
Rapid amortization for
pollution control equipment
A.
Conventional
bank loan
$128,100
114,600
110,300
121,300
B.
SBA loan
$118,800
105,300
101,000
111,200
C.
Tax-free
bond
$115,600
102,100
|97,800
108,800
'Also includes effect of additional first year depreciation. Section 179, Internal Revenue Code.
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Table IV-4.Comparisons of short-term profit impairment resulting from
different tax and financing strategies
Useful life = 10 years
Investment cost: $200,000
Tax strategy1
1.
2.
3.
4.
Straight-line depreciation
Straight-line depreciation
with investment credit
Double-declining balance depreciation
plus sum -of -the- years digits
with investment credit
Rapid amortization for
pollution control equipment
Financing strategy
A.
Conventional
bank loan
$57,700
43,700
64,600
75,700
B.
SBA loan
$47,700
33,700]
56,900
68,000
C.
Tax-free
bond
$53,400
39,400
62,600
73,700
'Also includes effect of additional first year depreciation. Section 179, Internal Revenue Code.
The figures were derived by adding each year's depreciation amount (D) to the interest
expense (/) and multiplying the result by (1 - T). These computations were performed for the
first 3 years of each combination. Thus the formula for STPI of one of the combinations is
STPI = (Z>! + /j) (1 - T) + 0>2 + /2) (1 - T) + (D3 + /3) (1 - T)
The boxed figure in table IV-4 is the optimal strategy for STPI and results in the use of
straight-line depreciation plus the investment tax credit and a Small Business Administration
(SBA) loan.
For table IV-5, the financial management situation is that of a manufacturer with weak
working capital. He needs pollution control equipment, but cannot "afford" it, either 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 strategy analysis for this situation is
accomplished by determining the year-by-year net cash outflows for each combination of tax
and financing strategy and choosing that combination which maintains the lowest profile with
the lowest peak outflow in any one year.
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Table IV-5.Comparisons of peak cash drains in any one year resulting
from different tax and financing strategies
Useful life = 10 years
Investment cost: $200,000
Tax strategy1
1.
2.
3.
4.
Straight-line depreciation
Straight-line depreciation
with investment credit
Double-declining balance depreciation
plus sum-of-the-years digits
with investment credit
Rapid amortization for
pollution control equipment
Financing strategy
A.
Conventional
bank loan
$41,100(5)2
41,100(5)
40,500(5)
31,400(5)
B.
SBA loan
$17,300(1)
16,600(2)
19,000(10)
23,400(6)
C.
Tax-free
bond
$41,200(15)
41,200(15)
41,200(15)
41,200(15)
'Also includes effect of additional first year depreciation. Section 179, Internal Revenue Code.
2 Indicates year after acquisition during which stated peak cash drain is reached.
The boxed figure $16,600(2) in table IV-5 means that the peak net cash outflow in any
one year was $16,600 and occurred in the second year. This was accomplished using
straight-line depreciation plus investment tax credit tax strategy, and an SBA loan. To arrive
at the figures, table IV-2 was used, and a column was added to the right to indicate the net
cash outflow for each year.
Of course, few business financial decisions are ever made on the basis of only one
objective; a number of objectives are usually sought with varying degrees of intensity, and
compromises are reached. For example, a manager may be particularly concerned with having
the least STPI but also be concerned with the long-term profit picture. In that case, he might
choose straight-line depreciation with investment tax credit, plus tax-free bond financing.
Although this was not the most advantageous combination under either management objective,
it was second under both and by a fairly small margin in each case, as shown in table IV-6.
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Table \\f-6.-The five most advantageous strategy combinations
by management objective ranked in order
Least long-term
profit impairment
3 + C = $ 97,800
3 + B = 101,000
2 + C = 102,100
2 + B = 105,300
4 + C = 108,800
Least short-term
profit impairment
2 + B = $33,700
2 + C = 39,400
2 + A = 43,700
1 + B = 47,700
1 + C = 53,400
Least cash drain
in any one year
2 + B = $16,600
1 + B = 17,300
3 + B = 19,000
4 + B = 23,400
4 + A = 31,400
CODE:
Tax Strategies
1, Straight-line depreciation
2. Straight-line depreciation with investment credit
3. Double-declining balance depreciation plus sum-of-the-years digits with investment
credit
4. Rapid amortization for pollution control equipment
Financing Strategies
A. Conventional bank loan
B. SBA loan
C. Tax-free bond
SUMMARY
Figure IV-1 clearly demonstrates why this analysis is so important. It shows the results
of an NPV analysis for one of the management objectives, minimizing long-term profit
impairment. If the pollution control facility in our example were financed by an ordinary
bank loan (a fairly traditional choice) and rapid amortization taken, the effective cost of a
$200,000 investment would have been $121,300. A tax-free bond with an investment tax
credit and double-declining balance and sum-of-the-years digits depreciation resulted in an
effective cost of $97,800, a savings over the former plan of $23,500. Therefore, it is well
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worth devoting considerable cost in order to explore the various alternatives available for
making the optimum financial decision.
Caution
The conclusions derived in this chapter are based on assumptions about costs, and about
each of the tax strategies and financing strategies discussed in the previous chapters. All
assumptions should be checked against prevailing conditions when a final analysis is made, and
new figures should be determined when those conditions change assumptions.
$130,000 -
120,000 -
110,000 -
100,000
90,000 -
80,000 -
D
DOUBLE DECLINING BALANCE
+ SUM-OF-THE-YEARS DIGITS + IN-
VESTMENT TAX CREDIT
WITH RAPID AMORTIZATION
Figure IV-1. Long-term profit impairment from
various financing and tax alternatives.
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Chapter V
STATE FINANCING AND TAX INCENTIVES
In the preceding chapters, nationally-available federal incentive programs were discussed;
these included the federal tax programs and the Small Business Administration (SBA)
programs, the availability of which is limited only by funding levels.
Although industrial development bonds (IDBs) are federally allowed and regulated
programs, each state must pass enabling legislation so that IDBs can become available to
companies within the state. Nearly all 50 states have passed such legislation or have other
programs which accomplish a similar objective. Therefore, when a choice analysis such as has
been outlined is performed, it is the relevant state laws as well as federal law that determines
certain costs and conditions of industrial development financing.
In addition to IDBs, there are a number of other state programs which permit additional
costs savings for pollution control equipment. State financing programs other than IDBs
include state-backed loan guarantees and state support of municipal waste treatment facilities
through bonds or state grants.
State tax regulations offering incentives for pollution control include real and personal
property tax exemptions, tax exemptions on the purchase of pollution control equipment, tax
credits, accelerated depreciation, and other programs. If choices are necessary, an analysis
similar to that described above should be done.
Although state support of municipal waste treatment facilities may not be considered
directly relevant to industries, it will be shown in chapter VI that it becomes an important
aspect of analysis for those companies with industrial water pollution. Under the 1972 Federal
Water Pollution Control Act, the federal government will grant 75 percent of construction
costs to eligible municipal waste treatment projects. It is the financing of the remaining 25
percent that creates differences in costs between, and even within, states for industrial and
residential treatment plant users.
A particular financing program of the state in which the company is located should be
included in a choice analysis among the financing alternatives.
Since this chapter is intended to alert a company's financial decision-maker to nonfederal
incentive programs, five states have been chosen to demonstrate the variety and similarities to
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be found from state to state. It should be noted that most incentives of all states must be
applied for and are not automatically provided.
ALABAMA
Alabama has enabling legislation to permit municipalities and local nonprofit development
corporations to issue IDBs, thus permitting tax-free financing of the pollution control capital
programs of a corporation.
Alabama provides a wide variety of tax exemptions for pollution control equipment. It
allows a deduction, for purposes of computing state corporate income taxes, on "all amounts
invested in devices, parts of devices, systems or facilities used or placed in operation in the
State of Alabama . . . primarily for the protection of the public and the public interest
through the control, reduction, or elimination of air and water pollution." This law results in
a 1-year depreciation writeoff of pollution control facilities or the election of a customary
depreciation method for state tax purposes.
The same types of pollution control facilities described above are also exempt from the
ad valorem tax. All equipment and materials to be used in the control of air and water
pollution are exempt from sales taxes, and the storage, use, or consumption of all equipment
and materials for air and water pollution control purposes is exempt from the Alabama use
tax. In addition, the assessed value of pollution control equipment can be deducted from the
assessed corporate shares, thus reducing the base on which the ad valorem tax is computed.
CALIFORNIA
California has an IDE program, supports municipal water treatment facilities, has rapid
amortization tax provisions, and has sales or use tax exemptions for all new pollution control
equipment.
The rapid amortization provision closely follows the federal tax provisions for rapid
amortization, which are described in chapter II of this manual. The equipment's value (less
the value of recovered materials and excluding land, or buildings not related to pollution
control) can be deducted from state corporate income tax over 60 months. The equipment
must be for plants in operation before January 1, 1971 and must be installed before January
1, 1976 or as extended; information about the installation date can be obtained from the
California Franchise Tax Board. The facilities must also be certified by the appropriate state
pollution control agency.
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As will be explained later, wastewater treatment projects qualifying for federal funds can
receive 75 percent of the funding from the federal government. The remaining 25 percent
must be derived from local or state bonds or grants. The California Water Bond Law of 1974
raised funds from which grants can be made for the next 12-1/2 percent. California will also
make loans with liberal repayment conditions to municipalities that have difficulty floating
their own issues for the last 12-1/2 percent of construction cost. Thus, one municipality could
assess lower costs to an industry than another municipality where the local loan or bond has
less liberal repayment terms.
As with the federal share of construction grants, industry in California must repay their
proportionate share of the state-financed portion of the construction costs. The state also has
regulations guiding the municipality in recouping annual operating and maintenance costs.
MISSOURI
Missouri provides for the use of municipal general obligation or revenue bonds for
industrial development purposes, namely to expand or upgrade industrial plants and therefore
to finance pollution control equipment.
Tax incentives include a sales and use tax exemption for pollution control facilities. A
general property tax exemption for pollution control equipment is not provided by legislation;
however, control equipment financed by IDBs is municipally owned and consequently requires
no property tax.
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 which also qualify for federal aid. The state requires a cost recovery system from the
users whereby all costs are recovered, including interest, depreciation for future replacement,
and maintenance and operation.
NEW YORK
New York State has several tax incentives and financing programs for pollution control
facilities, including two of the largest public bond issues in the United States for municipal
sewage treatment plants. The tax incentives involve sales, property, and corporate income
taxes for qualified pollution control equipment. A revenue bond financing capability for
corporations also exists.
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Pollution control equipment and utilities are exempt from state and local sales taxes
except for those of New York City.
Local municipalities are given the power by the state to excuse pollution control facilities
from real estate taxation and special ad valorem levies.
An unusual feature of New York State's tax incentives is its 1-year depreciation
provision. Corporations can deduct the full cost of pollution control facilities in 1 year against
their state corporate income taxes. For those who decide against the 1-year depreciation, a
1-percent tax credit is allowed on state corporate income taxes payable.
Large corporations can finance their pollution control facilities located in New York
State by means of industrial development (revenue) bonds. Small corporations can request
financing for pollution control facilities from the New York Job Development Authority. A
1973 bond issue by the Authority is currently serving as a source of funds to make low
interest, long-term loans for up to 90 percent of the value of the pollution control
equipment. Future funding levels have not yet been determined.
Municipalities in New York can obtain a considerable amount of grant assistance from
the state government for construction and for operating and maintenance costs of water
treatment facilities. Under a $1.15 billion 1972 Environmental Quality Bond Act, $750
million was designated for municipal construction grants to provide 12.5 percent of construction
costs on top of a 75-percent federal grant. However, eligible construction costs, by state
definition, disallow collection systems. Thus the local government can obtain 75 percent for
collection system (since the federal government does fund collection systems) and 87.5
percent for the remainder of the entire waste treatment facility. New York has another fund
from which grants are made to municipalities for one-third the costs of eligible operating and
maintenance costs.
WISCONSIN
Wisconsin has several tax incentives. Statute 70.11 (21) of Wisconsin exempts the air and
water pollution control equipment of income producing properties from general property
taxation. In addition, pollution control equipment was exempted from sales taxes as of 1973.
Companies may deduct from the Wisconsin corporate income tax all of the cost of
depreciable air and water pollution control equipment in 1 year. Or, if a company so desires,
the cost of pollution control equipment can be amortized over a period of 5 years. The
election of either method of depreciation cannot be changed once one is selected.
Wisconsin also allows that the cost of depreciable pollution control equipment, less any
federal depreciation taken, can be deducted from gross personal adjusted income.
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In addition to having an IDE program for corporations as a financing incentive,
state-assisted financing and grant programs are available for municipalities in Wisconsin. The
percent the state will grant varies, but the municipality cannot receive more than a total of
80 percent from all grant sources.
SUMMARY
From these examples, it is clear that states influence the terms of IDBs in the optimal
choice analysis in the earlier chapters. The states also add incentive programs of their own
which further lower pollution control costs. The reader is cautioned to obtain a current copy
or interpretation of a state law or regulation, and to discover the funding levels and priorities
of a loan program before selecting a course of action. Some sources for this information are
included in appendix D.
The emphasis in the analysis thus far has been on a firm's capital costs. In chapter VI,
municipal charges imposed by municipalities for treatment of industrial wastewater will be
discussed and optimization of financial strategies for water pollution control costs will be
analyzed. This requires an analysis of the costs of both municipal waste treatment and private
treatment.
35
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Chapter VI
FINANCIAL DECISION-MAKING ANALYSES FOR
MUNICIPAL VERSUS PRIVATE TREATMENT OF WATER
The analyses completed in the earlier chapters were for the capital costs of air and water
waste treatment systems. Companies needing to control air pollution emissions must undertake
the full responsibility of control themselves. In many instances, companies with waterborne
wastes have the choice of treating their process, sanitary, and cooling wastes themselves
(on-site treatment) or turning the chore over to the municipality, after any prescribed
pretreatment, by sewering their wastes. Economics play an integral part in this decision and
the economics of the past are changing considerably.
Tying into municipal treatment facilities will have to be carefully analyzed for each new
discharge source, and many established companies may find it necessary to reconsider their
options in the near future. Costs for most companies for municipal or for on-site treatment
will be higher than they may have experienced in the past because:
Municipal
Industry will now have to pay pro-rated costs of the treatment performed by
municipalities, which in most cases is more than previously paid to the
municipalities.
Pretreatment costs for municipal discharges will be higher due to pretreatment
requirements.
On-Site
Effluent limitation requirements are more stringent than before.
The decision about tying into municipal treatment facilities is largely guided by the types
of pollutants a company would be discharging into the facility. Incompatible wastes have the
potential to pass through without adequate treatment or they might interfere with municipal
treatment facilities. The federal regulations now require that incompatible wastes be pretreated
by companies before discharging to a municipal facility. Each pollutant must be pretreated to
the same level as the effluent limitation set for the stream discharging of that pollutant.
Therefore, pretreatment costs for an incompatible pollutant are equal to full private treatment
costs for that pollutant.
37
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Compatible wastes are those which the municipal plant is designed to treat and
substantially remove from the waste stream. For most organic or suspended solids,
pretreatment of compatible wastes is not required before the wastes are discharged to a
municipality unless there are surges in flow or pollutant concentrations which upset or reduce
the efficiency of the municipal plant.
Under the Federal Water Pollution Control Act (FWPCA), all recipients of wastewater
treatment plant construction grants must charge industry its proportionate share of initial
capital and annual operating costs for the treatment and/or conveyance of discharged wastes.
These costs may be determined on the basis of strength or volume characteristics of the
wastes. Incompatible wastes which have already been adequately treated by a company may
be charged, for example, on a volume basis, while the costs for treating compatible wastes
may be charged according to their strength (concentration) characteristics. The charges on
industry for proportionate capital costs are referred to as industrial cost recovery charges,
while the charges for operating costs are referred to as user charges. Both of these costs
together are referred to here as municipal costs.
Before the 1972 amendments to the FWPCA, there had been an outright, but
comparatively small, construction costs grant system through which Federal funds were
apportioned to municipalities. The 1972 amendments continued the grant concept at a
significantly increased dollar level and increased to 75 percent the eligible fraction of total
municipal treatment construction cost. The amendments also required municipalities to
recover, through charges, the capital costs in addition to the formerly required operational
costs attributable to the industrial proportion of the Federal grant.
To implement industrial cost recovery, a general wastewater rate is established by the
municipalities. The rate is computed by dividing the applicable construction costs by the
design waste volume and dividing that figure by the repayment period (municipal plant
life-maximum 30 years). Once the wastewater rate is established for industrial cost recovery,
each industry can decide whether to be charged a variable amount each year on the basis of
maximum flow, or a fixed amount each year on the basis of a reserved capacity. A charge for
maximum flow (typically a 4-week peak period) entails amounts in direct proportion to each
year's maximum discharge, whereas a charge for reserved capacity will be constant even if
there is no discharge for a given year.
In addition, since the 1972 amendments:
Industry's share of these capital costs must be recovered in 30 years, or less if the
facility's intended useful life is less.
No interest is charged on the federal portion of the capital costs.
Municipal costs for large users (typically industry) no longer include quantity
discounts. Savings from economics of scale must be shared by all users.
38
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Companies and industries with similar waste characteristics can be classed together
and the class assessed at a single rate to facilitate administration of the program.
Each user of more than 10 percent of the municipal volume must sign a letter of
agreement with the municipality saying that the user agrees to pay that portion of
the grant allotable to the treatment of its wastes.
Should another industrial user leave the municipal system, the remaining industries
are not responsible for that industry's Federal industrial cost share.
CAUTION: The 0- to 25-percent construction cost portion raised by the municipality need
not conform to the above regulations.
Municipal costs should theoretically be lower than the company costs to treat the same
wastes because of two factors:
The economics of scale that should be available from the large size of the municipal
treatment system.
Municipal treatment standards which are slightly less stringent than those which
private dischargers face.
On the other hand, the actual costs for municipal treatment could be higher where the source
has substantial quantities of incompatible wastes or has to extend sewers a considerable
distance to join the municipal system.
The waste discharge decisions open to management can readily be comprehended by table
VI-1, which shows the type of waste and the control possibilities from which the choice can
be made.
Table V1-1.Control strategy vs. type of wastewater
Type of waste
Total on-site treatment
and discharge to
surface water
Pretreat and discharge
to sewer
Direct discharge
to sewer
Compatible
Incompatible
Mixed
Not allowed
Not allowed
'A comparison between these technical alternatives will always show a preference for on-site treatment and discharge to
surface water -(assuming one time sewer connection charges and piping to stream are equal) because, for incompatible wastes,
on-site and pretreatment costs are identical.
39
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The economic choice to be examined in the following illustration is between (1) the
pretreatment and discharge to sewers of mixed wastes and (2) total on-site treatment of
mixed wastes.
NET PRESENT VALUE ANALYSIS
In order to compare the costs of private and municipal treatment, and continuing to use
the earlier illustration, operating and maintenance costs have to be added to the effective
equipment costs computed at the end of chapter IV:
effective equipment cost (NPV)
plus NPV of operating costs
equals Total Effective Equipment Cost for a Private Treatment Facility.
The municipal cost elements to include in the financial analysis are as follows:
effective municipal industrial cost recovery and user charges (NPV)
plus NPV of pretreatment capital and operating costs for incompatible pollutants
equals Total Effective Pollution Control Cost for Using a Municipal Facility.
Because of the complexity of this analysis and to avoid repetition of the preceding
portions of this publication, we will limit this discussion to one of the three financial
management strategies discussed in chapter IV. Of the three, we have chosen the management
objective of maximizing long-term profit, the analysis of which is primarily a net present value
(NPV) analysis. This method, incidentally, is the one used most frequently by EPA in
economic impact studies.
In developing an NPV for the two treatment alternatives, i.e. pretreatment versus total
on-site treatment, we must take into account the differing useful lives of the technical
alternatives. The industrial cost recovery guidelines issued by EPA specify municipal plant cost
recovery from industrial clients for the shorter of 30 years or the life of the municipal
equipment. We have chosen a life of 20 years in the following example. Because the preceding
discussion of treatment cost used a life of 10 years for the equipment, it will be necessary in
the computation to show the effect of buying new treatment equipment after 10 years. At
the end of 20 years, both the municipal equipment and the second treatment will be fully
depreciated.
(In comparing NPVs for varying depreciation range equipments, it is necessary to extend
the analysis to the point where both depreciated values are zero. This is accomplished by
40
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renewing the shorter-lived equipment enough times so that its depreciated value and that of
the longer lived equipment are equal. An NPV comparison can then be made.)
The following analysis assumes that both sets of on-site equipment will be depreciated
and financed by the same methods which were superior in the long-term profit analysis of
chapter IV; i.e. double-declining balance and sum-of-the-years digits depreciation with
investment tax credit and a tax-free pollution control bond. The terms of the two tax-free
bonds will be repayments of 10 percent of the principal in 1 through 10 years and again in
years 11 through 19 for the second on-site system.
Table VI-2 shows how the NPV for the on-site treatment plant alternative was derived.
Table VI-2.NPV of 20-year on-site treatment plant
Year
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
A
O&M
$20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
B
Yearly
depreciation
$41,6003
31,680
28,160
24,640
21,119
17,599
14,080
10,560
7,040
3,520
41,6003
31,680
28,160
24,640
21,119
17,599
14,080
10,560
7,040
3,520
C
I nterest
payments
$22,0004
10,800
9,600
8,400
7,200
6,000
4,800
3,600
2,400
1,200
22,0004
10,800
9,600
8,400
7,200
6,000
4,800
3,600
2,400
1,200
D
Principal
payments
$ 20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
$400,000
E1
After-tax
negative
cash flow
$41,840
36,016
35,392
34,768
34,144
33,520
32,896
32,272
31,648
31,024
41,840
36,016
35,392
34,768
34,144
33,520
32,896
32,272
31,648
31,024
F2
After-tax
positive
cash flow
$33,968
15,206
13,517
11,827
10,137
8,448
6,758
5,069
3,379
1,690
33,968
15,206
13,517
11,827
10,137
8,448
6,758
5,069
3,379
1,690
G
Discounted
cash flow
(E-F}-Hl+r}'
$ 7,606
19,427
19,730
19,992
20,213
20,395
20,544
20,658
20,742
20,795
5,315
13,679
13,892
14,077
14,233
14,362
14,466
14,547
14,606
14,645
Total DCF = NPV = $323,924
'(A + CK1 - T) + D.
2BT + 10 percent investment tax credit ($20,000) for year 1 and for year 11.
3 Includes additional first year's depreciation of $2,000.
4 Includes 5-percent underwriting expense for bond issue.
41
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issue
The analysis of the municipal treatment plant alternative includes the pretreatment costs
plus the municipal costs to be paid by the manufacturer. The size, capital, and operating
characteristics of the municipal treatment plant directly influence the fee charged for
treatment. The type and volume of incompatible wastes influence the pretreatment costs. This
analysis assumes a municipal treatment plant capable of handling 16 million gallons per day
(MGD). At an approximate capital cost of $1.2 million per MGD, the total plant cost would
be approximately $19 million. For illustrative purposes, it is assumed that the manufacturer
contributes 2 percent of this total flow or 0.32 MGD.
In addition, it is assumed that:
Seventy-five percent of the construction cost is provided by federal grant at no
interest and requires industrial cost recovery.
Twenty-five percent (the local/state share) is raised through a tax-exempt bond
at 6 percent and also requires industrial cost recovery.
The municipal plant requires the manufacturer to have pretreatment equipment,
which is $100,000 over the 20-year period and is financed by a 6-percent tax-free
loan and depreciated by the double-declining balance and sum-of-the-years digits plus
investment credit method.
The operating and maintenance costs (O&M) incurred by the plant for the
pretreatment facility is 10 percent, or $10,000 per year.
The municipal costs for the plant thus consist of the following costs:
Two percent (percentage contribution to the total municipal flow) of 75 percent of
$19 million over 20 years, which equals $14,250 per year (to repay the federal
capital proportion, i.e., industrial cost recovery).
Two percent of 25 percent of $19 million plus yearly interest of 6 percent on the
unpaid balance to repay the local/state capital proportion, which equals $10,450 in
year 1 and decreases to $5,035 by the 20th year,
Yearly municipal O&M (2 percent of $760,000) which equals $15,200.
In order to make a comparison with on-site treatment costs, the following must be added
to the municipal costs;
The NPV of the pretreatment capital costs after cash flow considerations from
depreciation and financing costs.
Pretreatment O&M of $10,000.
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This example of the costs resulting from using. a munipical treatment system with
required pretreatment is further illustrated in table VI-3.
When comparisons are made between table VI-2 (the NPV of 20-year on-site treatment
plant) and table VI-3 (the NPV of charges for 20-year municipal treatment cost recovery
system), the financial choice is to treat wastewater on site. Obviously this is an illustrative
finding based on the parameters of our hypothetical plant. It would not be prudent to extend
the implications of this simplified example to industry in general.
A number of cost elements could not be quantified and incorporated into the analysis,
such as costs to extend sewers to a stream or to the public treatment system. A number of
assumptions were made in the illustrated case that can change from situation to situation. For
example, the 25-percent state/local portion of the construction cost portion could be raised
through a local or state bond issue, or a state grant, or a combination of the two. Generally,
local or state loans or bond issues must be repaid over the years with an interest payment as
was assumed in this analysis. However, grants for treatment plant construction costs do not
usually require repayment. Thus, the peculiarities of each state's program for financially
assisting municipal waste treatment systems must be incorporated into the financial analysis.
With appropriate adjustments as needed, the analysis in this chapter can serve as a
management guide to completing a more definitive analysis based on specific plant situations
and company financial posture and goals.
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44
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Chapter VII
SUMMARY
In this era of special financing and tax programs associated with a multiplicity of
environmental, health, and welfare regulatory laws, it is important to perform a financial
analysis of the costs associated with these regulations with as much zeal as goes into the
technological analysis of the needed equipment.
There are a number of new financing and tax alternatives specially designed for pollution
control expenditures that can have financial consequences amounting to tens of thousands of
dollars. Many of the laws covering these alternatives require that once a financial decision is
made it cannot be changed, or can be changed in only one direction. Even if it can be
changed, the cost of change would be prohibitive later in the program. Some alternatives are
exclusively for pollution control capital costs or for process changes which also reduce
pollution, while others indirectly affect costs for operating and maintenance.
The following financial information should be analyzed as a minimum before pollution
control expenditure decisions are made:
1. Calculate the year-by-year cash inflows and the present values for each available
choice of depreciation.
2. Determine the most effective combination of rate and term of loan for all debt
financing of pollution control investments. Calculate the negative cash flows involved
and their net present values.
3. Select the management objective by which you would want to judge the financial
impact of the investment in equipment; for example, lowest short-term profit
impairment, least cash drain, least long-term profit impairment, etc. Compare the
results of combining the various financing and depreciation alternatives considered in
steps 1 and 2 against the management objectives and select the combination best
suited to your company needs.
4. For those with industrial wastewater, determine what the municipality's charge will
be for processing wastes, estimate the capital expenditure and operating costs
necessary for any pretreatment expense, and determine a present value for the
municipal and pretreatment costs.
45
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5. Compare the present values and year-by-year effects of step 4 against the selected
financial management objectives and compare the results to on-site treatment capital
and operating costs. This will provide a financial basis for choosing between using a
municipality's wastewater system or investing in a private treatment facility.
This analysis presumes that the legal and tax restrictions of each financial alternative are
fully understood by the analyst before the present values and cash flows are calculated. In
addition, any state and local technical restrictions which may preclude a manufacturer from
having freedom of choice must have been determined.
Figure VII-1 is a flow chart for the analysis needed in choosing the optimum financial
strategy for pollution control. The factors entering the municipal versus private treatment
decision process are shown at the right of the broken line.
46
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47
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Appendix A
SBA WATER POLLUTION CONTROL
LOAN APPLICATION PROCEDURES
WHO IS ELIGIBLE
Section 8 of the Federal Water Pollution Control Act (FWPCA) authorizes the Small
Business Administration (SBA) to make loans to assist any small business concern in effecting
additions to or alterations in the equipment, facilities, or methods of operation of such
concern to meet water pollution control requirements under the FWPCA, if the concern is
likely to suffer substantial economic injury without assistance. SBA has defined a small
business in standards that are available at any SBA field office. In essence, the applicant must
be an independently owned and operated small business, not dominant in its field, and must
meet employment or sales size standards established by SBA. In addition, a small concern
may be eligible for a loan if its requirement for a loan is a result of engaging in one of the
following activities:
The business has an effluent discharge requiring a National Pollution Discharge
Elimination System (NPDES) permit under Section 402 of the FWPCA.
The business emits discharges through a sewer line into a publicly owned treatment
works, and the city or town requires the treatment of waste discharge.
The business plans to discharge into a municipal sewer system through the
construction of a lateral or interceptor sewer.
The business is subject to the requirements of a state or regional authority for
controlling the disposal of pollutants that may affect groundwater.
The business is subject to Corps of Engineers permit for disposal of dredged or fill
material.
The business is subject to Coast Guard or state requirements regarding the standard
of performance or marine sanitation devices controlling sewage from vessels.
The business is implementing a plan to control or prevent the discharge or spill of
oil or other hazardous substances.
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SMALL BUSINESS SIZE
Note that only small businesses are eligible for relief under the provisions of the FWPCA.
Before you go to the time, trouble, and expense of preparing applications, be very sure of
your size classification. If there is any doubt about the classification of your business, see
Part 121.3-10 of the Small Business Administration Rules and Regulations or contact your
local SBA office to determine the applicable employee or sales standard.
WHAT COLLATERAL IS NECESSARY
The applicant must be in sound financial condition and give reasonable assurance that the
loan will be repaid. The applicant must pledge whatever collateral or give such guarantees as
he can. When the SBA loan is used to acquire fixed assets, these must be pledged as security.
Personal and/or business assets should be used to the greatest extent possible, but it is
not expected that they will be needed to the point of curtailing working capital or reserve
requirements.
ERA'S TECHNICAL REVIEW
Before the SBA will review your eligibility for these loans, your credit information, or
your ability to repay the loan, EPA must perform a technical review of the application to
determine that the proposed additions or alterations are necessary and adequate to comply
with one or more applicable standards.
You can obtain this review by submitting two copies of the application for Statement of
Compliance to the EPA Regional SBA Coordinator. Processing time at EPA should generally
not exceed 45 working days from the time a complete application is received.
The review by EPA may result in one of three distinct determinations:
Approval: A written statement will be provided to you attesting to this, with a
copy sent directly to the appropriate SBA office.
Conditional Approval: Some of the items were acceptable and some were not. A
copy of the conditional approval will be sent to the appropriate SBA office. Appeal
of the rejected portion may be made without prejudice to the approved portion.
You may use a conditional approval to secure a loan.
50
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Disapproval: You may make an appeal within 60 days directly to the EPA Deputy
Administrator in Washington, D.C.
The EPA review is for technical purposes. Do not send detailed company financial and
credit data to EPA. EPA may empower states to conduct this review and to issue statements.
WHEN TO APPLY TO EPA
Applications to EPA should be made after a permit or other official notification
containing requirements is issued to or placed upon you by EPA, Corps of Engineers, Coast
Guard, state, municipal, or regional management authority. These requirements will specify
certain conditions or schedules to be met; only after these requirements are known can the
determination of necessity and adequacy be considered.
WHAT MUST AIM APPLICATION INCLUDE
An application to EPA need not be in any particular form but it must include the
following:
Name of applicant
Mailing address
(Address of affected facility, if different, from above)
Signature of owner, partner, or principal executive officer requesting the Statement
of Compliance
Standard Industrial Classification (SIC) number for business for which an application
is being submitted (see Standard Industrial Classification Manual, 1972 edition, or
describe the type of business activity if SIC is not known)
Description of process or activity generating the pollution to be abated by additions,
alterations, or methods of operation covered by application
Specific description of additions, alterations, or methods of operation covered by the
application. This would include, where appropriate:
Summary of construction to be undertaken
Listing of major equipment to be purchased or utilized in operation
51
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- Purchase of any land or easements necessary to operation of facility
- Other items deemed pertinent (information considered as a trade secret shall be
identified as such)
Declaration or requirement(s) for compliance for which alterations, additions, or
methods of operations are claimed to be necessary and adequate
If you have received a permit from a State Water Pollution Control Agency within
the preceding 2 years, and the permit was not an NPDES permit issued under the
federal act, and where the permit relates directly to abatement of discharge for
which statement is sought, a copy of the permit should be included.
Any written information from a manufacturer, supplier, or consulting engineer, or
similar independent source, concerning design capabilities of the additions or
alterations covered by the applications. This would include warranties or
certifications obtained from or provided by such sources which would bear upon
design or performance capabilities. (Requirement may be waived if there is no
independent source for the information described).
Estimated schedule for construction or implementation of alterations or methods of
operation
Estimated cost of alterations, additions, or methods of operation and, where
practicable, individual costs of major elements of construction to be undertaken
Information on previously received SBA loan assistance for a facility or method of
operation; description and dates of activity funded
NPDES permit number, if applicable
SBA'S FINANCIAL REVIEW
The EPA approval or conditional approval should be submitted to the appropriate SBA
office with the completed SBA loan application. Once SBA has received your complete
application package, you should plan for a review time of about 4 weeks.
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FURTHER INFORMATION
For further information, contact either the EPA regional or SBA district office. The EPA
regional office will also be able to provide you with a copy of the regulations that were
developed for this program, which should help you in preparing your application for technical
review.
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Appendix B
TYPES OF CONTRACTUAL ARRANGEMENTS BETWEEN
GOVERNMENTAL AUTHORITIES AND INDUSTRIES
ACQUIRING TAX-FREE FINANCING
Depending on the state, a borrower utilizing the industrial development bond program
may deal with a township, city, town, county, village, or borough; a quasi-governmental
authority; or a state. Also, the sources which loan the funds to the authority to be lent to
the borrower may be a bank, the public at large, or some other institutional investor who can
benefit from the tax-free income. Just as variable are the agreements between the authority
and the company installing pollution control equipment, particularly in the manner of interest
and principal repayments.
The interest and principal repayment schedule utilized by the borrower in the example in
this manual is essentially similar to many bond indentures. That is, equal interest payments
are paid each year, but the borrower pays different amounts of principal into a type of
sinking fund during the life of the financing. The sinking fund plus earned interest is used as
the repayment source at the end of the term of the financing. As is typical in most
situations, there is a lien on the property being financed and/or a guarantee by the borrower.
At the end of the financing period, the borrower purchases the facility from the authority at
nominal consideration, which must be less than fair market value. The borrower is treated as
the owner for tax purposes during the financing period, even though legal title is in the
authority. The borrower can take depreciation and investment tax credits.
It is also possible for the relationship between the governmental authority and the
industry to be structured as an ordinary financing lease, with lease payments deducted by the
business as rental payments. In this case, the lessee does not have the privilege of taking
depreciation and the investment tax credit. The payments would be even over the lease life.
The authority retains title at the end of the financing. This relationship does not occur often
because of difficulty in meeting the same lease tests described in chapter III.
Another possibility is to establish the relationship as an installment sale with title going
to the buyer at the end of the installment period. This system would have equal payments
and allow the purchaser to take depreciation and the investment tax credit.
The last method is for the government agency to issue a bond, the proceeds of which
are reloaned to several companies. Each company negotiates its own terms and signs a loan
agreement or note. The borrower is entitled to depreciation and the investment tax credit.
55
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Appendix C
IRS DEFINITIONS AND ALLOCATIONS OF POLLUTION
CONTROL EQUIPMENT UNDER THE IDB PROGRAM
For the financing of equipment to be tax exempt under the industrial development
program, it must meet many tests [Treasury Regulations Section 1.103-8 (a) and (g)].
In mid-1975, the Internal Revenue Service (IRS) promulgated regulations which define
pollution control equipment for industrial development bond (IDB) financing and which
allocate its costs where the equipment also performs a function other than pollution control.
Since the regulations were not finalized at the date of this printing, the reader should refer to
the regulations as they are adopted after public comment has been considered, particularly for
the more controversial regulations.
The regulations are listed below and several are followed by examples:
"The property must in whole, or in part, abate or control water or atmospheric
pollution or contamination by removing, altering, disposing or storing pollutants,
contaminants, wastes or heat." The term pollutant only applies to materials or heat
discharges which definitely result in water or atmospheric contamination. This
definition excludes "the release of materials or heat which would endanger the
employees ... in which such property is used," for example, as determined under
the OSHA program.
The property must be "of a character subject to allowance for depreciation ... or
land."
"The jurisdictional agency must certify that the facility, as designed, is in
furtherance of the purpose of abating or controlling pollutants, or the facility will
meet or exceed the appropriate regulations in effect at the time of issuance."
Property does not qualify if used to avoid the creation of pollutants. For example,
the installation of a new boiler which reduces pollution by more efficient
combustion than the replaced boiler does not qualify. Likewise, equipment that
removes potentially polluting sulfur from fuel does not qualify. However, equipment
which handles or treats the removed sulfur does qualify. This is one of the more
controversial regulations.
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Property does not qualify if it processes material or heat that was a pollutant, but
is not upon reaching the process in question. The property must be "a unit which is
discrete and which performs . . . one or more of the (pollution control)
functions . . . and which cannot be further reduced in size without losing one of
such characteristics." For example, consider pollutants converted in a first step to a
nonpollutant chemical which is subsequently processed to make it saleable. The
equipment of the first step qualifies; equipment in the subsequent steps does not
qualify. The equipment in the first step is the smallest unit of property which
functions to control pollution. In addition, by the time the material reaches
subsequent steps it is no longer a pollutant.
Property also does not qualify if the polluting materials were customarily controlled
for other reasons. For example, a water system which discharges heat from cooling a
turbine does not qualify since turbines require cooling to operate at peak
efficiencies.
In addition to the above tests, an exempt issue requires that 90 percent or more of the
proceeds must be used for pollution control equipment. Therefore, up to 111 percent of the
pollution control costs, if exactly known, may be borrowed.
The second major component of the regulations concerns the allocation of property costs
which controls pollution and serves a purpose other than the control of pollution. Allocations
are necessary since it is only the cost of the pollution control portion which qualifies for the
financing. The following ratio should be applied to the property cost to determine what costs
do not qualify:
Y
C + E
where Y - present value of estimated economic benefits to be realized over the life of the
equipment, such as "gross income or cost savings resulting from any increase in
productivity or capacity, production efficiencies, the production of a byproduct,
the extension of the useful life of other property . . . (and) savings resulting
from the use, reuse, or recycling of items recovered."
C = present value of payments (excluding interest and minus salvage value) for
acquiring the property, i.e., capital costs
E = present value of all expenses, including interest, incurred during the operation of
property.
Present values are computed using a 12-1/2 percent discount rate (r).
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Appendix D
SOURCES OF INFORMATION ABOUT STATE
POLLUTION CONTROL INCENTIVES
The Industrial Development Research Council (Conway Research Inc., Peachtree Air
Terminal, 1954 Airport Road, Atlanta, Georgia) publishes a list of pollution control incentives
available by state.
The National Association of State Development Agencies (Suite 203, 1925 K Street,
N.W., Washington, D.C.) maintains a list of the directors of state development agencies. These
directors can provide details about state financing programs relevant to pollution control, as
well as some tax information.
State departments of revenue and taxation should be consulted for details about state tax
exemption and credit programs specifically for pollution control.
Information about state municipal wastewater construction grants (including eligibility,
funding level, and priorities for grant approval) can be found in the water quality office in
either a state health department or a state environmental department.
In addition to requesting a copy of the laws and any helpful supporting information, the
names of other authorities who will need to be contacted should be requested. This is
especially true for those seeking information on how to proceed when interested in industrial
development bonds, also referred to as pollution control or municipal revenue bonds.
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U.S. ENVIRONMENTAL PROTECTION AGENCY TECHNOLOGY TRANSFER
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