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.
                                               10

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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.
                                            11

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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.
                                            12

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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.
                                          13

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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


                                             14

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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
                                             16

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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
                                              17

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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
                                            20

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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.
                                             21

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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.
                                      22

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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)
                                              24

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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.
                                             25

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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.
                                             26

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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.
                                             27

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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
                                             28

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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.
                                              29

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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
                                            31

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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.
                                             32

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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.
                                             33

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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.
                                             34

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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.
42

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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.
                                            43

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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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                                   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.
                                          49

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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.
                                             52

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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.
                                             53

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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.
                                          57

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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).
                                              58

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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.
                                         59

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U.S. ENVIRONMENTAL PROTECTION AGENCY • TECHNOLOGY TRANSFER

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