ENVIRONMENTAL PROTECTION AGENCY
TECHNOLOGY TRANSFER SEMINAR
LITTLE ROCK, ARKANSAS-JANUARY 16-18, 1973
UPGRADING EXISTING
POULTRY PROCESSING FACILITIES
TO REDUCE POLLUTION
CHOOSING THE OPTIMUM
FINANCIAL STRATEGY FOR POLLUTION CONTROL
J. A. Commins & Associates, Inc. Fort Washington, Pennsylvania 19340
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UPGRADING EXISTING POULTRY PROCESSING FACILITIES
TO REDUCE POLLUTION
CHOOSING THE OPTIMUM FINANCIAL STRATEGY
FOR POLLUTION CONTROL
TECHNOLOGY TRANSFER SEMINAR
LITTLE ROCK, ARKANSAS
JANUARY 16-18, 1973
PREPARED FOR THE
ENVIRONMENTAL PROTECTION AGENCY
by
UDAY M. PATANKAR, Research Associate
and
CHARLES R. MARSHALL, Research Associate
J.A. COMftNS § ASSOCIATES, INC.
506 Bethlehem Pike
Fort Washington, Pa. 19034
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FOREWORD
This report was especially prepared for the EPA Technology
Transfer Seminar for Poultry Processors. The contents of the report have
been designed for managers who contribute to the financial decisions on
pollution control equipment. The quantitative aspects of the report are
intended to provide guideline approaches useful in calculations to develop
comparitive values of the financial alternatives available for pollution
control equipment and expenditures.
The laws and techniques used throughout are applicable to any
air or water pollution situation for any industry. To lend more precise
applicability, the report has been tailored to the poultry processors and
some common attributes of their plants.
The major pollution situation referred to is waste water because
we are considering primarily the processing and not the rendering phase of
the business, although much of what is said here is also applicable to air
pollution control costs. When a waste water system is referred to it will
mean any processing waste water system which could, where feasible, be used
for feedlot or rendering wastes in a vertically integrated company.
The analysis is applicable to processors with their own treat-
ment facilities and to those connecting with the municipal system. Of
all federally inspected processors in the United States in 1970, 631 were
tied into a municipal system while 30% had private treatment facilities.
The remaining 7% had no treatment. In the South Central and South Atlan-
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tic regions the percentage of processors using municipal waste facilities
increases from 63% to 673. The percentage of processors with private
facilities slightly decreases for the south from 30$ to 27%. The data
does not show whether the present mix was derived because of the advantage
of user charges. Nor does it show whether each processor had the physical
choice of both options. Facing higher user charges in the future, brought
about by the Federal Water Pollution Control Act, and new standards for
private treatment, the whole mix is subject to the possibility of major
swings.
The reader should regard the illustrative situations used in
this presentation as necessarily simplified, representative examples that
by no means exhaust the variety of available alternative tax and financing
strategies, particularly those relating to pollution control equipment.
Consultation with the latest tax rulings and legislation is necessary
before undertaking the final decision making process.
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Table of Contents
Page
Introduction i
Management Summary and Guide iii
Organization of the Report v
Chapter I. Depreciation 1-1
Relationship of Depreciation To Taxes and Cash Flow 1-2
Net Present Value 1-3
Water Pollution Control Investment for Poultry Processors 1-5
Rapid Amortization 1-5
Straight Line Depreciation 1-7
Investment Tax Credit 1-7
Double-declining Balance Depreciation 1-8
Depreciation Comparisons ., 1-8
Ability To Use Investment Tax Credit 1-12
Chapter II. Financing Strategies For Pollution Control
Investments 2-1
Methods Used In Analyzing Financing Costs 2-1
Bank Financing 2-4
Small Business Administration-Water Pollution Control
Loans 2-5
Government Aid To Financing (Tax-Free) 2-6
Comparison of Financing Methods 2-7
Chapter III. Optimum Financial Strategy For Pollution Control.... 3-1
Chapter IV. State Financing and Tax Incentives 4-1
Alabama 4-5
Arkansas 4-8
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Table of Contents (Continued)
Page
Georgia 4-2
North Carolina 4-8
Texas 4-9
Review 4-9
Chapter V. Municipal Versus Private Facilities 5-1
Pre-treatment Costs 5-3
By-product Recovery Value 5-3
Operating Cost Differentials 5-4
Municipal Versus Private Waste Water Treatment 5-4
Summary 5-5
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List of Figures and Table
Figure Page
1. Net Present Value of Tax Savings Through
Depreciation 1-9
2. Year-by-Year Tax Savings (Cash Flow Improvements) Through
Different Tax Strategies 1-11
3. Net Present Values of Cash Outflows From Financing 2-8
4. Year-by-Year Cash Outflow from Different Financing
Strategies 2-10
5. Illustrative Financial Characteristics of Pollution
Control Equipment for the Poultry Processing
Industry 3-2
6. Comparisons of Peak Annual Cash Drains From Different
Tax and Financing Strategies 3-4
7. Comparisons of Short-Term Profit Impairment From Dif-
ferent Tax and Financing Strategies 3-5
8. Comparisons of Long-Term Profit Impairment From
Different Tax and Financing Strategies 3-6
9. Long-Term Profit Impairment From Various Financing
and Tax Alternatives 3-8
10. Guide to Management For Choosing The Optimum Financial
Strategy For Pollution Control 5-6
Table
1. Financial Assistance and Tax Incentives For Industry 4-3
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INTRODUCTION
As the 1970fs proceed, environment-related management decisions
will be more complex and frequent. The impact on businesses of non-pro-
ductive environmental expenditures can be significant where by-product
recovery is limited or non-existent. It is clear from the provisions of
the Water Pollution Control Act coupled with the existing Clean Air Act,
that industry must commit sizable capital to meet the environmental stan-
dards the nation has set.
Many governmental institutions have shown a form of compassion
for these necessary expenditures by providing means of reducing or soften-
ing the financial expenditures for pollution control. There exists a mild
governmental practice of spreading some of industries' pollution control
costs over the general public in place of just the company, and, to some
degree, its customers. This is accomplished by excusing pollution control
devices from certain sales, use and property taxes, by allowing tax-exempt
financing by the company of the expenditures, or through adjustment in
company income taxes by the addition of special depreciation alternatives.
All of these programs involve a company paying lower taxes than they nor-
mally would have to pay if that equipment was for some other manufacturing
or service purpose.
To put these incentives or cost reduction practices into per-
spective, it should be pointed out that these incentives do not pay for
the pollution control investment nor do they overwhelmingly reduce the cost.
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They can, however, have a pronounced effect on cash flow and profit posi-
tions depending on what alternatives are selected. Because procurement
of control equipment is a relative unique business occurrence, and because
of a considerable body of new and involved tax and financing regulations
for such purposes, it is likely that company financial managers are not
as familiar with the many possibilities as they would be with the more
common business operations.
This report will demonstrate that it is well worth spending
time in analyzing the unique added methods of financing pollution expen-
ditures and their equally unique tax treatment. It will alert decision
makers as to the availability of, and qualifications for some of the fi-
nancing incentives that federal, state and local governments have made
available.
Obtaining the optimum financial and tax incentives for your com-
pany could save tens of thousands of dollars over the life of the equip-
ment. For example, a recent Business Week article (July 29, 1972 pp. 50-
51) demonstrated the cost savings that tax exempt pollution control reve-
nue bonds can provide. "Over the life of a 20 year $10 million issue, the
typical interest saving is about $3.6 million." Some revenue bond issues
allow for deferred repayments of principal and permit the largest payments
at the end of a 20-30 year issue. Meanwhile, the company can take depre-
ciations and use investment tax credits which lower taxes. Thus, it can
build up a cash flow which is used in other areas of the business. On
that cash flow, earnings are generated which help to repay the bond prin-
11
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cipal at the later time.
The emphasis of the report thus far has centered on equipment
purchases. Poultry processors with their own waste treatment facilities,
and any processor-Tenderer with air pollution control equipment, will
find the equipment emphasis appropriate. Those poultry processors whose
waste becomes part of the municipal system will find the equipment analy-
sis pertinent only if pre-treatment of wastes requires capital expenditures,
The municipal treatment users, who already pay charges, are expected to
face increased user charges under the 1972 Federal Water Pollution Con-
trol Act, where federal funds are used for construction of the municipal
treatment facility.
Once the EPA publishes its system of user charges (April, 1973),
poultry processors and others will then be able to analyse whether it
would be financially preferable to make a capital equipment investment
for their own private treatment facilities, or whether being hooked into
municipal treatments system is better. There may be regulations, however,
that might preclude the exercise of the results of such a decision. Pres-
ently, there is little that can be said quantitatively with respect to the
preference of a user charge versus private treatment decision because of
the anticipated changes in rates. This report will indicate, however, how
to proceed with an analysis once the permissibility and costs of using mu-
nicipal facilities are more adequately defined.
Management Summary and Guide
We have noted that there are a number of new unique alternatives
that have sizable differing financial consequences amounting to tens of
iii
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thousands of dollars. Many of the alternatives require, by law, that once
a financial decision is made it can't be changed, or changed in only one
direction. Others are final in that it would be prohibitively costly to
change later on in the program. Therefore, the following financial infor-
mation should be analyzed as a minimum before an equipment decision is
made.
1. Determine for all debt financing of pollution
control investments, the most effective combination
of rate and term of the loan. Calculate the nega-
tive cash flows involved and their net present
values.
2. Calculate the year-by-year cash inflows and the
present values for each available choice of depre-
ciation.
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, long-term profit im-
pairment, etc. Compare the combinations of financ-
ing and depreciation values calculated in steps 1
and 2 against the established management objective,
and select the combination best suited for your
company needs.
4. Determine what the municipality's user charge will
be for processing wastes and estimate the capital
IV
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expenditure necessary for any pre-treatment facility.
Calculate the present values for the treatment ex-
pense and a present lease value for the user charge
payment.
5. Compare the values and year-by-year effects of step
4, and steps 1 through 3, against the selected fi-
nancial management objective. This will allow you
to make a choice between whether to plug into a mu-
nicipality's waste water or invest in a private treat-
ment facility, from a financial point of view.
This analysis presumes that the legal and tax implications of
each financial alternative are fully understood by the analyst in order
that present values and cash flows can be calculated. Likewise, the
analysis does not include the legislative and technical matters which may
preclude a poultry processor from being able to have the freedom of choice,
Organization of the Report
The report is divided into five chapters. Chapter I describes
the standard depreciation methods and those which have been established
for pollution control facilities. Chapter II examines the costs of dif-
ferent methods of financing pollution control equipment. Chapter III
relates the financing and tax strategies to the normal financial strate-
gies of a company. In other words, how do the incentives correspond to
a company's maximum cash flow strategy or its profit maximization stra-
tegy, etc? Chapter IV is a look at the availability of the various fi-
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nancing alternatives already discussed, both from the federal government
and from the five southern states in which the greatest amount of poultry
processing takes place. Some financing alternatives are for practical
purposes always available, while others are dependent upon the source's
budget. The last chapter examines the combination of the first four sec-
tions as opposed to the alternative of a user charge system. This anal-
ysis sets up a basis for decision when the costs of the Federal Water Pol-
lution Control Act become predictable.
VI
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CHAPTER I
DEPRECIATION
Many pollution control acquisition incentives are in the form
of special depreciation provisions. Sometimes, these provisions are
called "rapid amortization", except that the amortization period bears
no relation to useful life as in the case of strict depreciation. The
underlying effect of any type of depreciation is on the taxes payable by
a company and its cash flow. Normally, there exist two general kinds of
depreciation incentives for any kind of equipment. One set of depreci-
ation methods provides an annual deduction from income as a non-cash
expense over a certain guideline period. The timing of deduction selec-
tion changes with different depreciation techniques. In other words,
large portions of the cost of the equipment can be deducted early in the
life of equipment by using one technique, or equal proportions are deduc-
table over the life of the equipment, using another technique. This
gives rise to the familiar terms: straight-line depreciation, double-
declining-balance, sum-of-the-years'-digits, etc.
Another kind of equipment depreciation factor exists for all
types of equipment, and that is an incentive to actually buy equipment;
called an investment tax credit (Sections 46-48, 50, Internal Revenue
Code). This provision, in effect, actually reduces the cost of the equip-
ment because it gives a permanent tax credit. All the different depreci-
ation methods noted previously, allow a corporation to adjust its depre-
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elation schedule to conform with its financial management strategies.
To add an incentive for the purchase of pollution control
facilities, the IRS permits a pollution control facility to be amortized
over a period of 60 months (Section 169, IRC). Since the 60 month
period may have no relationship to the actual life of the equipment,
which could last 120 to 200 months, the incentive is called rapid amorti-
zation.
Depreciation involves consideration of both method and useful
life. The ability to take any method of depreciation for pollution con-
trol facilities is not precluded because of the method a company custo-
marily uses. The normal requirement for consistent adherence to class
depreciation method is waived. For example, if a processor uses a food
manufacturing Asset Depreciation Range, into which all the assets cus-
tomarily fall, and he uses the straight-line depreciation method, he
could still take double-declining depreciation for the pollution control
equipment.
Another nuance is that when an asset class depreciation range
is used, a different useful life can be used for pollution control facil-
ities upon sufficient justification. For example, if a processor custo-
marily uses a guideline useful life of 12 years (permitted in the 9.5 to
14 year ADR), he could use 8 years for the control device if he could sub-
stantiate. This may be advantageous if the life of the equipment is less
than that of the normal asset range.
Relationship of Depreciation to Taxes and Cash Flow
The financial strategy supporting the rapid amortization plan
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is a good entry into the methods of analysis for evaluating which depre-
ciation, amortization and/or investment tax credit method to use. The
incentive is that depreciation/amortization is an expense which does
not actually involve any cash outlays by the taxpayer. The lower pro-
fits from the expense before taxes means a tax savings. The tax savings
is a net cash inflow to the corporation and is represented by:
NCF = D T
where NCF = net cash flow
and D/A = amount of depreciation/amortization
T = the tax rate, expressed as a fraction
Positive cash flows (cash inflows) are able to be reinvested in
the business for the productive side of the operation or to reduce the
needs for obtaining cash from other sources. A shortened period of de-
preciation/amortization means larger deduction, larger tax savings and
more cash flow.
Net Present Value
An analysis of this net cash flow through the depreciable life
of the equipment will yield a Net Present Value. The total effect of
depreciation on a company's cash flow is determined by using the present
value approach which utilizes the time value of money. A dollar saved
today has a greater long-term effect on the financing situation of an
enterprise than a dollar saved a year from now, because the dollar that
was saved today has the potential of yielding a return if invested or
saved. Thus, at the end of the year, the future value of today's dollar
1-3
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IS,
FV = 1 + r
where, r = yield (interest earned) on one dollar.
The present value of the dollar saved a year from now is, on the
other hand,
PV = —^—
The present value of a dollar saved i years from now is obtain-
ed by discounting annually:
PV =
(1 + r)i
Thus, the present value of the net cash flow during year i,
termed discounted cash flow, DCF, is,
TVF. — NCFi t
i ~ (1 + rji
The sum total of all such discounted cash flows over the use-
ful life is the net present value, NPV, of the tax savings:
n n
NPV = 5~ DCFi =
Since NPV is the sum of discounted cash inflows (tax savings), the higher
the NPV, the more attractive the depreciation method. The annual discount
rate, r, is termed the after-tax return on investment for the enterprise.
For a poultry processor, the cost of capital (this is the same
1-4
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as the return if funds are reinvested) before tax is estimated to be about
7$. After taxes, this figure reduces to about 3.5%. Therefore,
r = 3.5 percent.
The effect of the net present values from each method of de-
preciation is to reduce the effective cost of the capital expenditure
necessary for the pollution control facility.
Water Pollution Control Investment for Poultry Processors
At this time no one can be quite sure as to what will be the
best practicable or the best available control technology for poultry
processors or any other industry. For illustrative purposes, we are going
to use an average investment figure that has been surveyed for extended
aeration systems. The range of investment figures to install extended
aeration systems was $149,000-$424,000. The estimate to be used in the
depreciation calculations which follow, and in the remainder of the report,
is $200,000.
The Asset Depreciation Range, for accounting purposes, of equip-
ment used in the food manufacturing industry into which poultry processing
usually falls, is 9.5 to 14.5 years (Section 167, IRS Code). We will
select a 10 year life based on the reasoning that excessive wetness of
the process leads to a shortened life. Salvage value is assumed to be
zero.
Rapid Amortization
The Tax Reform Act of 1969, provides for rapid amortization of
certified pollution control facilities over a 60-month period, irrespec-
1-5
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tive of the guideline useful life of the equipment. This amortization
is available under certain conditions outlined in Article 169 of the
Internal Revenue Code. The accelerated writeoff was provided to encourage
capital investment in pollution control. Note that a process change,
even if it results in lower pollution does not qualify as a pollution
control device, and such costs cannot be rapidly amortized.
The rapid amortization applies to the first fifteen years life
of the equipment. The asset portion value over fifteen years can be de-
preciated by any method under Article 167 and depreciation taken immedi-
ately on that portion. The rapid amortization can begin in the month
after installation and continue for a full 60 months, or it could 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 this
provision is not considered a pollution control incentive, its inclusion
is needed for accuracy of calculations.
For simplistic purposes it will be assumed that the effective
date of purchase of the $200,000 extended aeration system is the beginning
of the fiscal year and that the corporate income tax rate is 48 percent.
Computation of the net present value of the $200,000 investment using
rapid amortization results in,
1-6
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Yearly Cash Flow = T D
= (.48) ($40,000)
n
NPV = 5DCF.
NCF:
DCF = W r - 3.5$
(1 + r)1
NPV = $87,649
Straight Line Depreciation
The base or most simple form of depreciation involves taking an
equal proportion of 10 percent for each year of the 10 year life of the
depreciable base under the appropriate poultry processing depreciation
class. In this case, the depreciable basis could have been reduced to
$198,000 by taking the additional first year bonus depreciation of $2,000
(maximum), but the point of emphasis is to have the straight line method
serve as a base. Using the above formula with the $200,000 basis, the
NPV of cash inflows is $79,839.
Investment Tax Credit
The Internal Revenue Service (Sections 46-48, 50) allows an in-
vestment tax credit of 7 percent of the equipment cost to be applied to
the reduction of corporate income taxes payable. Investment tax credit
is a special incentive for the business community to purchase capital
equipment. This tax credit is a full and direct tax savings of $14,000
in this example. This figure, adjusted by the NPV, should be added to the
straight line depreciation NPV, since the investment tax credit is allowed
for that method. The resulting NPV is $93,495. Also taken into account
1-7
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in this calculation, is the NPV of the after-tax additional first year
depreciation. There is a special caution on investment tax credit.
Rapid amortization and investment tax credit are mutually exclusive. A
choice between the two must be made at the outset.
There are also many other details of these amortization and
tax credits laws which are too detailed or peripheral to present here
and do not change the essence of the calculations.
Double-declining Balance Depreciation
The double-declining balance method is the quickest allowable
way, except for the aforementioned special rapid amortization of depre-
ciating equipment through its useful life. The calculation provides that
in each year, 20 percent of the remaining asset balance can be deducted.
In our case, the first year's depreciation is $41,600 (.2 x $198,000 =
$39,600 plus $2,000). In the second year, the 20 percent is taken against
($198,000 — $39,600)or $158,400, resulting in a figure of $31,680.
When year-by-year cash flows are discounted using the rate of
return, the NPV for the $200,000 equipment using double-declining depre-
ciation becomes $106,697.
There is, of course, another depreciation method called, "sum
of the years digits", which has results between the straight line and
double declining methods.
Depreciation Comparisons
Figure 1 is a bar graph of how the value of each depreciation
method relates to the overall cost of the equipment. The values are less
1-8
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$200,000
180,000
160,000
140,000
120,000
100,000
80,000
60,000
40,000
20,000
Base
Figure 1
Net Present Value
of
Tax Savings Through Depreciation
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1-9
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than the base cost because of the cost-offsetting earnings from the cash
generated by the tax savings from depreciation.
Limiting the consideration to net present value, the optimal
strategy in our example is the double-declining balance method accompanied
by the investment tax credit and additional first year depreciation. The
fact that this form of depreciation is favored over the special pollution
control rapid amortization makes one question how the situation arises.
When the rapid amortization provision was enacted into law, the investment
tax credit, which is historically an on-and-off type of tax incentive,
was not in effect. Later on, the investment tax credit became effective
for equipment installed after March, 1971. Economic resurgence was the
major consideration when the investment tax credit was reinstated, and
not how it would relate to the rapid amortization method.
The investment tax credit plus double-declining preference is
accentuated first by the fact that process changes made to comply with
pollution control regulations do not meet requirements for rapid amor-
tization (only control devices do), and secondly, by the fact that the in-
vestment credit, per se, never needs to be repaid whereas rapid amorti-
zation really represents only a postponement of taxes.
Figure 2 graphically shows the year-by-year after-tax positive
cash flows from the various depreciation alternatives. The difference
between the #l's and #2's is the additional tax investment credit and
additional first year bonus depreciation taken in the first year of the
#2's.
The rapid amortization plan cash flows #4's are practically
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Figure 2
$30,000
20,000
10,000
Year-by-Year Tax Savings (Cash Flow
Improvements) Through Different
Tax Strategies
1. Straight-Line Depreciation
2. Straight-Line Depreciation with
Investment Credit
3. Double-Declining-Balance with
Investment Credit
4. Rapid Amortization
34567
Year After Acquisition
10
1-11
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level because of the installation of the equipment at the beginning of
the fiscal year. The slight hump in the beginning results from the addi-
tional first year's depreciation. A mid-year installation with an elec-
tion to begin the 60 month amortization period the next fiscal year would
have resulted, under optimal conditions, in a higher hump in the first
year also with a level amount over the next five years at a very slighty
lower level.
The large hump in the first year of the double-declining balance
method shown by #3's, results from taking the investment tax credit and
the additional first year's depreciation.
Ability to Use Investment Tax Credit
A company must have a sufficient level of pre-tax earnings
to be able to fully utilize the investment tax credit. An investment
tax credit greater than the amount of corporate income taxes payable
would defeat some of the advantage of taking the investment tax credit.
In our example, and using a 48 percent tax rate, a company has to earn
a minimum of approximately $28,000 before taxes to use the $14,000 avail-
able investment tax credit.
It is true that unused investment tax credits can be carried
over into future, under certain conditions (Sec. 46b, IRC). However,
the net present value of an investment tax credit carryover reduces, and
its calculation here would present an unnecessarily complex situation.
This chapter demonstrated the large magnitude of differences
in NPV's by using the various depreciation methods. The purpose of using
1-12
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NPV was to have a common standard of analysis by which the available
depreciation methods for pollution control facilities could be compared.
The example used for calculations showed the advantage of the double-
declining balance method with investment tax credit over all other
methods including rapid amortization. The life of the equipment has to
be very long (over 30 years) before another depreciation method becomes
superior in this illustration.
Next we will look at the effect of the special incentives for
financing pollution control equipment. The determination of the differ-
ences in values for these financing methods coupled with the analysis
just performed will carry us into Chapter III where the tax and financing
strategies are combined.
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CHAPTER II
FINANCING STRATEGIES FOR POLLUTION CONTROL INVESTMENTS
Prior to any special pollution control legislation, a plant
manager would make the decision about a piece of equipment and then, if
meney was to be borrowed to pay for the equipment, get in touch with his
normal financing source and request arrangements. With the advent of
special pollution control incentives, there are, in general, not only new
sources of funds available, but lower rates than normal for most sources
of financing. This situation requires another whole set of analyses be-
fore a commitment is made with the optimal source.
Generally, two aspects of the financing strategy are covered in
this chapter. The first aspect is the quantitative analysis using NPV as
a tool for valuing each financial source and rate. The second aspect
describes each financial source and based on rate and terms, calculates
and compares the NPV of each. As in Chapter I, the example is based on
a $200,000 extended aeration system.
Methods Used in Analyzing Financing Costs
In order to determine the cost to the company of the various
available methods of raising funds, it is necessary to analyze the effect
of such a venture on the company's operating financial position: its
net profits after taxes. The methodology used in the subsequent compari-
sons is described below.
A comparison of the after-tax profits with and without the fi-
2-1
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nancing for pollution control equipment makes it possible to quantify
and analyze such an effect: net annual profit after taxes, P, and the
tax liability, L, can be related to other operating parameters by the
equation:
P -p (1-T) L =p T
where, p = annual taxable income
and, T = the tax rate, expressed as a fraction.
The annual taxable income is related to the interest expense for the year by,
P - Q - I
where, Q = the operating income
and, I = the interest expense
combining the above two equations,
P = CQ - I) (1 - T) L = (Q - I) T
= Q (1 - T) - I (1 - T) = QT - IT
If there was no interest expense during the year, 1=0, and the above equa-
tions become:
P - Q (1 - T) L = Q T
Thus, the effect of the interest expense I, is to reduce the net profit
after taxes by I (1-T). The tax liability is reduced by I T.
If C is the amount of principal that is paid back during a year,
and I the interest expense incurred as a result of the loan, the net cash
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outflow, NCF, is the net of cash outflows and the reduced tax liability
(or tax savings) :
NCF = (C + I) - (I T)
= C + I (1 - T)
The above equation represents the net effect of the loan on the company's
cash balance during a year. (It must be kept in mind that, in this anal-
ysis, the operating costs resulting from the control equipment are not
considered. The effect of initial investments in pollution control on
the company's fiscal position is analyzed here.)
Present Value Analysis
The payment of interest and principal payback extends through
the term of the loan, which is defined as more than one year for a long
term loan. The net cash outflow, NCF^ during year i is given by:
i = q + Ii (1 - T) i = 1, 2, --, n
where, C^ = principal payback during year i
Ii - interest expense during year i
n = term of the loan, years.
The total effect of the loan on the company's cash flow is de-
termined by using the present value approach which utilizes the concept
of time -value of money, described in Chapter I.
Thus, the discounted cash flow during year i,
DCFi
= _NCFj
r)i
2-3
-------
The sum total of all such discounted cash flows over the terms
of the loan is the net present value, NPV, of the loan:
n n
Since NPV is the sum of discounted outflows, the lower the NPV, the more
attractive the loan. The annual discount rate, r, as in Chapter I, is
the after- tax cost of capital for the poultry processor, =3.5 percent.
For domestic corporations, the federal tax rate amounts to 481 on taxa-
ble income, if the taxable income is more than $25,000 annually. A tax
rate of,
T = 48 percent
is assumed throughout this analysis.
Bank Financing
Some commercial banks across the country have announced pre-
ferential rates and terms for certified pollution control facilities.
Since these bank programs are quite random, the basis of analysis used
here for financing pollution control equipment will be the type of normal
equipment borrowing and not a special bank control loan.
The terms and rate suggested here as normal for this type of
financing, are five years and 6 percent annually, with the effective rate
of interest being 11.08 annually. The Net Present Value (NPV) analysis
for financing the $200,000 extended aeration system through a bank is
$208,078. The cash flows for this financing alternative are unique be-
2-4
-------
cause of the bank repayments system. Although the repayment amounts
are the same, the proportion of interest in those repayments is higher
in the beginning. This interest is tax deductible, therefore, the net
cash outflow is approximately halved. Since the repayments are equal
and the proportions of the earlier payments have more tax-deductible
interest expense and lower principal repayments, the net cash outflow is
lower in the beginning.
Small Business Administration - Water Pollution Control Loans
Since it could occur that some poultry processors might have
access to the funds legislated under the Federal Water Pollution Control
Act, the cost of such an alternative will be analyzed. Since this fund
was just recently legislated and is as yet unappropriated, there are many
program details yet to be developed. The fund however will be adminis-
tered through the SEA and will most likely bear a rate equal to the weighted
average of all federal government borrowings. Presently, that rate is
5-3/8 percent, and with general interest increasing we have used 5.5 per-
cent in our calculations.
Those who qualify for the SEA loans are "any small business
concern in affecting additions to or alterations in the equipment, fac-
ilities (including the construction of pre-treatment facilities and
interceptor sewers] or methods of operation of such concern to meet water
pollution control requirement...if such concern is likely to suffer sub-
stantial economic injury without assistance."
Obviously, premature is any attempt at determining how many com-
panies in the poultry processing industry will sustain substantial economic
2-5
-------
injury without assistance. However, by choosing a company with $4 million
in sales and a sales-to-asset ratio of 3 to 1, we can demonstrate that a
$200,000 capital expense consumes a significant portion of a company's
capital program. If a complete asset turnover is accomplished every 10
years and the assets of a $4 million sales company are $1.3 million,
then the yearly average capital investment would be approximately $130,000.
At a 2 to 1 sales-to-assets ratio, the yearly capital expenditures would
average $200,000. The substantiality of the cost for an extended aeration
system as compared to normal capital expenditures becomes very evident if
this example is representative. It cannot be construed that this exercise
demonstrates substantial economic injury, but it does illustrate the need
for rates such as those for a special SEA loan.
SEA loans are permissible to 30 years, however, we have chosen
a ten year loan term to recognize rapidly changing technology and the nor-
mal Asset Depreciation Range into which a poultry processor belongs.
Using the 5.5 percent rate and the 10 year repayment schedule, the NPV
calculates to $194,171.
Government Aid to Financing (Tax-Free)
As a result of the effort to encourage industrial development
in general, and in some cases to encourage industry to install control
equipment on sources of pollution, governmental aid is available in the
following areas:
(a) Aids to individual borrowers for low-cost capital, and
(b) tax aids to industry through special regulations
and procedures.
2-6
-------
The consequences of the latter will not be described at length, as their
impact is not large and varies from state to state. They include sales,
use and property tax exemptions.
Many states now have financing programs for the purchase and
installation of pollution control facilities. These states, via govern-
mental and/or quasi-governmental agencies, assist in floating attractive
low-interest bond issues and in raising the required funds through indus-
trial mortgages. Such bonds bear a lower interest rate than any of the
aforementioned methods, since the interest payments are presently free
of federal and state income taxes.
The terms in our example include a 5 percent interest rate with
an initial underwriting cost of 5 percent. The repayment period is 15
years and the repayment schedule is as follows: 8 percent of principal
annually during years 5 through 14, and the remaining 20 percent of the
principal during year 15.
A word of caution about tax-free status concerns the advice of
counsel needed. .A whole set of provisions exists on the nature of the
facilities qualifying and certified as eligible for tax-exempt financing.
The NPV of cash outflows for the tax-free financing method for
the terms described above, and in our $200,000 example, is $184,529.
Comparison of Financing Methods
Figure 3 is a bar graph of the net present values of the nega-
tive cash outflows in financing the $200,000 cost by the three alternatives.
This set of alternatives actually represents a range of maximum and mini-
mum financial costs into which fall all methods of financing. In other
2-7
-------
$200,000
Base ___ ___
180,000
160,000
140,000
120,000
100,000
80,000
S
60,000
40,000
20,000
0
m
&
g
&
tH
0>
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pq
0)
8
UH
&
U
Figure 3
Net Present Values of Cash Outflows from Financing
2-8
-------
words, more alternatives exist, however, the results would fall between
the highest and the lowest bar.
The figure clearly shows the superiority of the tax-free method
of financing pollution control equipment under net present value consid-
erations. As equally important in emphasis, is the magnitude of the range
of values. Just on a $200,000 piece of equipment, the range is approx-
imately $23,000; a substantial cost if all the financing possibilities
had not been fully considered.
Figure 4 shows the great differences in year-by-year cash out-
flow that result from the three financing strategies. The conventional
bank loan, for example, leads to much higher outflow during the first
five years, than either of the other strategies. On the other hand, a
bond issue has the lowest cash outflow for an extended period. Depending
on the payoff method chosen, however, full repayment of principal at the
end or a sinking fund will be required. In the first instance (illustrated),
high cash outflow is generated due to the ballooning effect in the final
year.
Now that the ranges of financing and tax strategies have been
fully described and analyzed, we are prepared to relate the choices for
selection purposes. In order to perform selection, the objectives by
which companies are managed will be explained in the next chapter as they
impact possible combinations of the tax and financing alternatives.
2-9
-------
$50,000
Figure 4
Year-by-Year Cash Outflow
from Different Financing Strategies
40,000
A. Ordinary Bank Loan
B. SBA Water Pollution Control Loan
C. Tax-Free Loan
30,000
20,000
10,00(
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Year After Acquisition
2-10
-------
CHAPTER III
OPTIMUM FINANCIAL STRATEGY FOR POLLUTION CONTROL
With the data now available from the calculations discussed
in Chapters I and II, it is now possible to develop the appropriate
management approach to financing and tax strategies. The idea is to
select the right combination of strategies to meet the management ob-
jectives of the company. To illustrate the pronounced effects involved,
we will use a hypothetical plant procurement.
Figure 5 contains the key characteristics of three financing
strategies, as well as fiscal characteristics of the hypothetical pollu-
tion control equipment needed. This will be used as the common base in
developing the three illustrative examples that follow.
No two poultry processors face the same financial problems.
And no two share exactly the same management objectives. To demonstrate
the cumulative effects of the various tax and financing strategies covered
so far, we have selected three typical business situations involving dif-
ferent management objectives that might exist in a poultry processing
operation. We will show how different strategy combinations affect each
situation.
First, let us look at a processor with a weak working capital.
He needs pollution control equipment, but cannot "afford" it, now or in
the foreseeable future. Clearly, the situation calls for the lowest
possible cash outflow, year by year, over the life of the investment.
3-1
-------
Figure 5
ILLUSTRATIVE
FINANCIAL CHARACTERISTICS
OF POLLUTION CONTROL EQUIPMENT FOR
THE POULTRY PROCESSING INDUSTRY
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
Interest Rate
Present Treasury Rate
Payment Period
(c) Tax-Free Loan
Interest Rate
Initial Cost of Obtaining Loan
Repayment Period
Repayment Schedule
$200,000
-fl-
lC years
48 percent
7 percent subject to
a certain maximum
$2000
3.5 percent annually
6 percent annually
11.08 percent annually
5 years
Weighted average trea-
sury rate
5-3/8% ~ 5.5 percent
As long as 30 years,
not more than life of
equipment, 10 years
5 percent
5 percent of capital
15 years
8 percent of principal
annually during
years 5 through 14
20 percent of principal
during year 15
(balloon)
3-2
-------
The .lowest cash outflow, and the strategy combinations that
permit it, are shown in Figure 6. This value, shown boxed, is $6,500--
the result of following a combination of Tax Strategy 4 and Financing
Strategy B. It is the best choice for a processor with weak working
capital acquiring pollution control equipment.
If we use a three-year period as the near term, Figure 7
shows the cumulative profit impacts of the different strategies in
their various possible combinations, resulting in the best near-term
profit. The boxed value, $43,800, represents the lowest possible cash
outflow under the circumstances. It is derived from a combination of
Strategies 1 and B.
Finally, there's the processor with enough resources and
stability to concentrate on maximizing its long-term profit. Figure 8
shows that the strategies producing the lowest long-term profit impair-
ment ($77,800) are double-declining-balance depreciation with investment
credit combined with a tax-free loan (Strategies 3 and C).
The hypothetical examples of Figures 6, 7 and 8 do not repre-
sent straightforward totals of year-by-year values, but rather the totals
of present values, attributable at the start of the period to the future
events portrayed in the examples. This replacement is necessary because
a meaningful comparison between financial effects occurring at varying
times in the future can be obtained only by relating them all to a common
point in time, such as the present.
Having chosen a combination of tax and financing strategies
based on analyses such as those presented in Figures 6, 7 and 8, it is
3-3
-------
Figure 6
COMPARISONS OF PEAK ANNUAL CASH DRAIN
FROM
DIFFERENT TAX AND FINANCING STRATEGIES
Useful life = 10 years
Investment Cost: $200,000
TAX STRATEGY
1.
2.
3.
4.
Straight Line Depreciation
Straight Line Depreciation
with Investment Credit4"
Double Declining Balance
Depreciation with In-
vestment Credit*
Special Amortization for
Pollution Control Equip-
ment"1"
FINANCING STRATEGY
A.
Conventional
Bank Loan
$41,000(5)*
41,100(5)
42,800(5)
31,400(5)
B.
SBA Water Pollution
Control Loan
$16,100(1)
15,600(2)
16,600(6)
16,500(1))
C.
Tax- Free
Loan
$41,000(15)
41,000(15)
41,000(15)
41,000(15)
*Indicates year after acquisition during which stated peak cash drain is reached.
-••Also includes effect of additional first year depreciation, Section 179, Internal
Revenue Code.
3-4
-------
Figure 7
COMPARISONS OF SHORT-TERM PROFIT IMPAIRMENT
FROM
DIFFERENT TAX AND FINANCING STRATEGIES
Useful life = 10 years
Investment Cost: $200,000
TAX STRATEGY
1.
2-
3.
4.
Straight Line Depreciation
Straight Line Depreciation
with Investment Credit*
Double Declining Balance
Depreciation with In-
vestment Credit*
Special Amortization for
Pollution Control Equip-
ment*
FINANCING STRATEGY
A.
Conventional
Bank Loan
$53,400
68,800
97,900
82,600
B.
SBA Water Pollution
Control Loan
l$45,800l
59 ,300
88,400
73,000
C.
Tax- Free
Loan
$48,700
64,100
93,200
77,900
4_ includes effect of additional first year depreciation, Section 179, Internal
£evenue Code.
3-5
-------
Figure 8
COMPARISON OF LONG-TERM PROFIT IMPAIRMENT
FROM
DIFFERENT TAX AND FINANCING STRATEGIES
Useful life - 10 years
Investment Cost: $200,000
TAX STRATEGY
1.
2.
3.
4.
Straight Line Depreciation
Straight Line Depreciation
with Investment Credit*
Double Declining Balance
Depreciation with In-
vestment Credit*
Special Amortization for
Pollution Control Equip-
ment*
FINANCING STRATEGY
A.
Conventional
Bank Loan
$128,200
114,600
101,400
121,400
B.
SBA Water Pollution
Control Loan
$114,300
100,700
87,500
107,500
C.
Tax- Free
Loan
$104,700
91,000
|77,80Qf
97,800
*Also includes effect of additional first year depreciation, Section 179, Internal
Revenue Code.
3-6
-------
good practice to refer to separate year-by-year projections like those in
Figures 2 and 4. Doing so determines year-by-year effects and makes them
fall within acceptable limits.
In two of the three cases above the rapid amortization plan
for pollution control equipment was not the optimal choice. By the very
fact that tax incentive exists it is logical to be drawn to its use.
However, as demonstrated, the management objective carries the deciding
weight in determining whether or not rapid amortization is the optimal
choice.
Figure 9 clearly demonstrates why all this analysis is so im-
portant. From the consideration of long-term profit impairment, the mag-
nitude of the difference in costs to a company is the height of the dif-
ference in the maximum and minimum costs. If a pollution control faci-
lity in our example was financed by an ordinary bank loan and rapid am-
ortization was taken (a fairly traditional choice), the effective cost
would have been $121,400. A tax-free loan and investment tax credit with
double declining balance depreciation resulted in an effective cost of
$77,800, a savings over the former plan of $33,600. It is well worth de-
voting whatever cost is necessary to explore the various alternatives
available to arrive at the optimal choice.
To determine how optimal the choice can be for an equipment
investment, we will further explore in the next chapter just how available
are all of these alternatives. Limitations in the availability may possi-
bly reduce the optimum savings, however, the savings will still be sub-
stantial .
3-7
-------
$130,000
120,000
110,000
100,000
90,000
80,000
a
With
Investment
Credit
With
Rapid
Amortization
Figure 9
Long-Term Profit Impairment
From Various Financing and Tax Alternatives
3-8
-------
CHAPTER IV
STATE FINANCING 5 TAX INCENTIVES
The tax and financing strategies discussed in Chapters I and
II and the simplified examples of how they relate to management objec-
tives (Chapter III) were based on an assumption that all companies
would have access to each alternative. Whether or not this is true
for a company depends considerably on size and location. The depreci-
ation methods for tax strategies are available for any size company in
any location.
Financial strategy availability is a much more complex matter
requiring expert legal and tax advice. For example, although the tax-
exempt financing is generally more attractive than regular bank borrow-
ing, smaller companies generally do not have access to this source
throughout the United States, except for a very few states.
A general statement cannot be made concerning tax-free finan-
cing which conveys obvious advantages to the borrower because of the
many variations from state to state, but generally the borrower must
qualify for the credit from either the public or a private source of
capital. Enabling legislation must have also been passed in the state
that permits revenue bond/industrial development financing for pollution
control facilities. The ultimate tax-free eligibility ruler is the IRS.
Specific attention must therefore be paid to what each poultry processor's
state has passed into law as to availability of anti-pollution revenue bonds.
Size also is an important factor since there is usually a fixed
4-1
-------
portion of any bond underwriting expense. This requires a bond issue
to be large enough to make those initial fixed costs effectively mini-
mal. This limitation cuts off many potential users, or requires that
a state have a form of private placement system for loans of less than
nominally a million dollars.
The possible financing via states varies widely as can be
seen from Table I. The tax regulations are usually fairly lengthy, and
considerably involved so that they generally defy any attempt to con-
dense and simplify. They are also time-varying so that the reader is
cautioned to obtain a current reading before selecting a course of
action. Nevertheless, what follows is a very brief and simplified over-
view of several states which are expected to be of special interest to
this audience.
According to statistics from the last Census of Manufactures
(1967), the following states had the highest value of shipments in the
poultry processing industry:
Georgia $333.7 million
Arkansas 253.4 million
North Carolina 224.6 million
California 195.9 million
Alabama 192.1 million
Texas 150.0 million
These states by themselves accounted for 46 percent of the value of
shipments of the entire United States. Therefore, the tax and other
4-2
-------
TABLE 1
FINANCIAL ASSISTANCE AND TAX INCENTIVES FOR INDUSTRY
Alabama
Alaska
Arizona
Arkansas
California
Colorado
Connecticut
Delaware
Florida
Georgia
Hawaii
Idaho
Illinois
Indiana
Iowa
Kansas
Kentucky
Louisiana
Maine
Maryland
Massachusetts
Michigan
Minnesota
Mississippi
Missouri
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2
X
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4-3
-------
TABLE I (cont'd)
Montana
Nebraska
Nevada
New Hampshire
New Jersey
New Mexico
New York
North Carolina
North Dakota
Ohio
Oklahoma
Oregon
Pennsylvania
Rhode Island
South Carolina
South Dakota
Tennessee
Texas
Utah
Vermont
Virginia
Washington
West Virginia
Wisconsin
Wyoming
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4-4
-------
pollution control incentives available in these states have a very sig-
nificant relationship to the pollution control efforts of the poultry
processing industry. To keep the amount of detail to a reasonable level
we will limit the overview to five poultry producing southern states.
There are two categories of state tax incentives as afore-
mentioned; one being exemptions from certain state taxes whose considera-
tion would not enter the calculations performed in previous chapters.
Examples include franchise taxes, property taxes, use and sales taxes.
The second category pertains to the cost of financing involving low
cost pollution control loans.
Alabama
Alabama leads the rest of the states reviewed here in the
number of their pollution control incentives.
State Corporate Income Tax Deductions: The State of Alabama
allows as a deduction for purposes of computing state corporate income
taxes "all amounts invested in devices, parts of devices, systems or
facilities used or placed in operation in the State of Alabama...pri-
marily 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 one year depreciation writeoff of pollution control
facilities or the election of a customary depreciation method, for
state tax purposes. (Amendment to Section 402 of Title 51 of the Code
of Alabama, 1940.)
4-5
-------
Ad Valorem Taxation Exemption: Section 2 of Title 51 of the
Code of Alabama, 1940, was amended in 1969 by adding paragraph S. This
amendment permits the same type of pollution control facilities as des-
cribed above to be exempt from the ad valorem tax.
Sales Tax Exemption for Equipment and Materials: Section 33
of Act No. 100 (1959) was Amended in 1969 to exempt from sales tax all
equipment and materials to be used in the control of air and water
pollution.
Domestic Corporation Shares of Ad Valorem Tax Deduction for
Pollution Control Devices: Every share of a corporation in Alabama is
assessed at thirty percent of its value to the person in whose name the
shares stand for the purposes of computing a taxation. The assessed
value of pollution control equipment can be deducted from the assessed
shares value. This deduction was permitted by an amendment to Section
25 of Title 51 of the Code of Alabama, 1940.
Use Tax Exemption (Amendment to Section 789 of Title 51: The
storage, use or consumption of all equipment and materials for air and
water pollution control purposes is exempt from the Alabama use tax.
Tax-Free Financing: Municipalities [Title 37, Section 511 (20)
(32), Code of Alabama-1958] and local non-profit development corpora-
tions [Title 37, Sections 815-830 (1)] can issue tax-exempt industrial
revenue bonds to finance pollution control acquisitions. The methods by
which the program operates are similar to those already covered in
Chapter II.
4-6
-------
We note that Alabama is an example of the most progressive
pollution control finance and tax incentives of the states described
here and elsewhere in the country. One unique fact is that the ex-
emptions provided for the sales and use taxes include material pur-
chases for pollution control as well as the device per se. A second
feature of Alabama's incentives is the provision of the industrial
development tax-exempt financing for pollution control facilities.
As we illustrated in Chapter II and III, the tax-free method
of financing yields the lowest net present value of negative cash flows.
Therefore, a poultry processor in a state such as Alabama has the com-
petitive advantage of financing his control facilities at a lower cost
over a processor in a state where revenue bonds cannot be used for pol-
lution control.
The ability to issue eligible tax-exempt revenue bonds depends
on a company's ability to float bond issues. To find a tax-free bond
economically attractive, the amount usually has to be quite large (as
a minimum, one to two million dollars). Therefore, the tax-free route
is not open to all, even if their credit rating is basically good to
excellent. In some states other than those being described, the local
development corporation could arrange for the small tax-exempt revenue
"bonds" to be purchased by a single financial institution such as a
bank. Each poultry processor should determine what is the practice
of the local development corporation. In some instances around the
country, it is likely that a number of smaller corporations could be
grouped together for financing purposes to permit a bond issue large
enough to be floated without excessive underwriting costs.
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In place of listing the Codes and Titles of each of the four
remaining states pollution control tax incentives, we will generally
describe the incentive in relation to the scope of Alabama's.
Arkansas
Arkansas has a tax-exempt revenue bond provision for indus-
trial development but not for pollution control facilities. For equip-
ment purchases, the state allows an exemption from the personal property
tax for seven years provided that all pollution control equipment is
owned by the municipality or county in which it operates. Arkansas also
has a compensated use tax exemption for pollution control equipment.
Georgia
Georgia also has a revenue bond program that is avail-
able for pollution control. Georgia has a sales tax exemption for both
purchased and leased pollution control equipment.
North Carolina
North Carolina has a franchise tax on domestic and foreign
corporations operating within the state. The tax is essentially com-
puted on net worth after certain taxes, dividends and reserves for de-
preciation have been deducted. In this state, the entire cost of cer-
tified pollution control facilities can be deducted from the base on
which the tax is calculated.
For state corporate income tax calculations, North Carolina
permits an allowance for depreciation of the polution control equipment
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to be spread over a 60 month period. This resembles the rapid amortiza-
tion plan for federal corporate taxes payable.
In North Carolina the assessment value of property should not
be increased by pollution control facilities, and a property tax is not
levied against the same equipment.
Texas
The State of Texas has not extended their tax-exempt indus-
trial revenue bond for pollution control facilities in general. There
are limited provisions for pollution control revenue bonds in the solid
waste area. The only tax-exemption which Texas appears to have is a
property tax exemption.
The above description of incentives in various states should
strongly demonstrate two aspects:
1. It would be unusual to find the exact condition in two
states, especially where the incentive legislation is time-varying.
2. It is worth the effort to study the tax and financing
schemes available in the pertinent state.
Review
From the above explanation, it becomes clear that the ability
to achieve an optimum financial strategy is highly dependent upon the
size of the firm and its location. Parameters used in Chapters II and
III in the optimal choice analysis may have to be altered to reflect a
firm's real spectrum of choices. The stress in the analysis thus far
has been a firm's capital costs. In the next and last chapter, the
realm of user charges and their possible modifications in the future will
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be discussed. Complete optimization under long-range management objec-
tives can then be made by weighing the ramifications of being a part of
a municipal waste water treatment system vis-a-vis constructing private
treatment facilities.
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CHAPTER V
MUNICIPAL VERSUS PRIVATE FACILITIES
Assuming that each are available, many poultry processing
plants have the ability to choose whether they should have private or
municipal waste water treatment. The present mix of poultry processing
plants as stated in the foreword to this report favors municipal tie-ins.
Such a mix is not unexpected when considering the fact that user charges
have generally not been assessed based on any cost accounting system for
allocating the entire costs of operations and replacements. Likewise,
many rural and developing areas over the years have been able to attract
plant locations by purposely keeping user charges low.
This user charge system as we know it today, is headed for
abrupt change due to the 1972 Federal Water Pollution Control Act (FWPCA)
amendments. As generally known, all waste water control standards for
private and waste water treatment will become highly stringent as a re-
sult of the aforementioned legislation. Unless private or public current
plants happen to have advanced waste water treatment, all will be expected
to make significant investments in the best practicable or best available
technology.
It is fairly safe to say that a major decision-making process
in water pollution control will take place in the United States due to
the large number of companies expected to need change. A major part of
the decision-making scope includes the financial implications of equip-
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ment buying versus yearly municipal waste treatment rates.
Under previous amendments to the FWPCA there has always been
a grant system, although comparatively small, through which federal funds
were apportioned to the states. The 1972 FWPCA amendments continue the
grant concept but at a tremendously bolstered dollar level. The fraction
of total municipal treatment construction costs that can be funded by
the federal grants has also been increased: At least $21 billion in future
and repayment construction grants will eventually be funneled to munici-
palities; provisions of the FWPCA will permit up to 75 percent of the
construction costs to be derived from the federal grant.
It also appears that a significantly higher user charge rate
structure is in the offing as the FWPCA requires the municipality to re-
cover, through charges, the operational costs and replacement value at-
tributable to the industrial proportion of the federal grant. In other
words, a municipal plant devoting 60 percent of its capacity to the general
population and 40 percent to industry, must recover at least 40 percent
of the 75 percent federal portion if the maximum grant contribution was
used. Never before has such a replacement value recovery system existed.
The remaining portions of this chapter will construct a type
of analysis for use in making the "user charge versus private facility"
decision. The FWPCA is recent and its effects on the rate structure are
yet to unfold. It would therefore be premature to portray any cost esti-
mates. One major reason why it is difficult at this stage to estimate
user costs, is the lack of EPA or other guidelines as to the number of
years over which the replacement value is to be recovered from industrial
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users of a municipal facility.
There are at least three major factors -- pre-treatment costs,
by-product recovery value, and two sets of operating costs -- which must
be separately calculated before the final decision phase is consummated.
Pre-Treatment Costs
The first factor is pre-treatment costs for the conditioning
or pre-treating of a company's waste water by a company before the wastes
reach the municipal system. The costs of pre-treatment depend on the
natrare and volume of the wastes and will vary widely from industry to
industry. It is conceivable that very little in the way of expensive
equipment may be needed for some industries, where pre-treatment costs
would consist of chemicals and other consumable supplies. Certain other
industries will require capital investments for pre-treatment but not
nearly as large as would be needed for complete private treatment.
The net present value (NPV) method of analysis will again be
used to calculate a cost for pre-treatment. The financial and tax stra-
tegy calculations for this, equipment are the same as those used in Chap-
ters I and II. Further analysis would have to take into account the
expected difference in useful life of a pre-treatment facility from a
municipality's.
By-Product Recovery Value
It is reasonable that pre-treatment will produce by-product
recovery in a poultry processing plant, however, the relativity of the
subject here is for its value in a complete private facility. For our
purposes, we will describe the value of annual by-product recoveries as
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an offset to the equipment costs. Rather than offset the recovery values
against annual operating costs, the reason for offsetting against capital
costs involves the factor that by-product recovery could effectively have
in the initial facility decision.
We purposely did not enter by-product considerations earlier
in the equipment decision phase. Its description here takes note of the
fact that before the 1972 FWPCA, by-product recovery of some degree did
exist in the poultry processing industry. The emphasis on by-product
recovery here is the very likely increase in extent as events proceed in
the poultry processing industry.
Operating Cost Differentials
Intuitively, the operating costs for a pre-treatment and muni-
cipal use system will be less than the costs to operate a private facility.
This yearly difference must be assigned a NPV to be added to the NPV of
the private treatment facility. The analytical method is the same as
that described in Chapter II for a negative cash flow.
Municipal Versus Private Waste Water Treatment
To complete the sequence necessary for constructing a municipal
versus private treatment analysis the remaining step is the calculation
of a NPV for user charges. Using the formula in Chapter II, the yearly
cash flows for the longest predictable horizon of the user charge system
should be valued at NPV (as that horizon lengthens, the NPV approaches
the value that would have resulted if the present value of an annuity had
been used where the payments are infinite in duration). The sets of costs
that we now have to compare in the decision process, have been adjusted
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as follows:
effective equipment cost
minus NPV of by-product recovery
plus NPV of greater operations cost
equals Adjusted Effective Equipment Cost for a Private
Treatment Facility
effective use charge value
plus NPV of pre-treatment costs
equals Adjusted Effective User Charge Value for Using a
Municipal Facility
The basis for a financial decision between the two alternatives is out-
lined above. The financial data can be added to the technical factors
that enter into the final decision.
Summary
Figure 10 is a flow chart of the analytical guides suggested
for choosing the optimum financial strategy for pollution control. The
chart summarizes the entire flow of this Report. Under the previously
defined pollution control laws we were able, as we did in Chapters I, II,
and III, to use.quantifiable examples to optimize tax and financial
strategies for equipment decisions. This area of the chart is depicted
to the left of the dashed line. Chapter IV, while not in the flow, showed
how these alternatives may be limited due to specific state programs.
The tradeoffs and factors entering the municipal versus private
treatment decision process are shown on the right of the dashed line.
They are not quantifiable at this time, and are intended as a guideline
at the time when these costs become firmly known.
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Figure 10
Guide to Management For Choosing The Optimum
Financial Strategy For Pollution Control
NPV and
Yearly Cash
Flows For
Tax Strategies
en
NPV and
Yearly Cash
Flows For
Available
Financing
Strategies
Assignment of
Management
Objective as
Criteria
Analysis of All
Possible Combinations
of Tax § Financial
Strategies Under The
Management Obi ective
Adjustment by
Incremental NPV
of:
(i) by-product recovery
(ii) operating costs
for Private Facility
NPV of
Pre-treatment
Costs,
if any
Adjusted Effective
Equipment Cost
*|For a Private
Treatment Facility
vs
Adjusted Effective
User Charge Value
For Using Munici-
pal Facility
Equipment Choice Only-
Private Treatment Versus Municipal Tie-in
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