ENVIRONMENTAL PROTECTION AGENCY
TECHNOLOGY TRANSFER SEMINAR
CHICAGO, ILLINOIS-JUNE 12-13, 1973
UPGRADING EXISTING
MEATPACKING FACILITIES
TO REDUCE POLLUTION
CHOOSING THE OPTIMUM
FINANCIAL STRATEGY FOR POLLUTION CONTROL
J. A. Commins & Associates, Inc. Fort Washington, Pennsylvania 19034
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UPGRADING EXISTING MEATPACKING FACILITIES
TO REDUCE POLLUTION
CHOOSING THE OPTIMUM FINANCIAL STRATEGY
FOR POLLUTION CONTROL
TECHNOLOGY TRANSFER SEMINAR
CHICAGO, ILLINOIS
JUNE 12-13, 1973
PREPARED FOR THE
ENVIRONMENTAL PROTECTION AGENCY
by
UDAY M. PATANKAR, Research Associate
and
CHARLES R. MARSHALL, Research Associate
J. A. GOMMINS § ASSOCIATES, INC.
506 Bethlehem Pike
Fort Washington, Pa. 19034
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Foreward
Much has been written on how to select pollution control
equipment, but relatively little on how to pay for it. A sound capital
investment strategy, however, can mean the difference between profitable
operation and controlled cash flow, on the one hand, and fiscal chaos on
the other. This is an explanation of how some proven tax and financing
strategies, and their use in various combinations, can help the financial
position of three hypothetical meatpacking operations with differing man-
agement goals who face capital equipment expenditures. For the meatpackers
who have a choice of on-site treatment or sending their pretreated wastes
to a municipal system, a method of financial analysis of these alternatives
is also presented.
No matter how adept and capable a financial manager may be, it
is entirely possible that he could overlook some important aspect of
fiscal management of pollution control expenditures, because of the new
and unique nature of the legislation, the high degree of complexity, and
the one-shot nature of the decision. This report was especially prepared
for the EPA Technology Transfer Seminar for meatpackers. It shows the
small businessman the type of financial analysis that should be accorded
a pollution control expenditure, because of the possibilities of substan-
tially reducing the funds expended, and smoothing out the cash flow trauma
that otherwise could develop.
The report has been tailored to the meatpacking industry which
is defined as slaughtering and processing, but not processing alone. The
meatpacking industry is faced with several federal regulatory programs of
which water pollution control represents the most significant dollar out-
lay. However, the financial laws and analytical techniques have applica-
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bility to all air and occupational safety and health situations for any
industry.
The major pollution situation referred to is wastewater be-
cause we are considering primarily the stunning, bleeding, cutting,
eviscerating and processing phases of curing, etc., where the processing
follows slaughtering. Wastewaters from domestic use, boiler and cleaning
operations are minor organic sources which are included in the definition
of wastewaters but not emphasized more than its mention now.
The analysis is applicable to meatpackers with their own
treatment facilities and to those connecting with the municipal system.
Presently 60-70 percent of all meatpacking effluent goes to municipal
facilities, and the remainder with some form of pre-treatment goes
from the meatpackers to receiving streams. Facing higher user chargers
in the future, brought about by the Federal Water Pollution Control Act
(FWPCA) and new standards for private treatment, this mix is subject to
the possibility of substantial change.
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. Much financing, and to a lesser extent, tax treatment varies
by jurisdiction. Consultation with the latest tax rulings and legisla-
tion governing in your location is necessary before undertaking the
final decision making process.
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Table of Contents
Page
Introduction 1
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 Meatpackers 1-5
Rapid Amortization 1-5
Straight Line Depreciation 1-7
Investment Tax Credit 1-7
Double-declining Balance Depreciation 1-8
Net Present Value Calculations 1-8
Depreciation Comparisons 1-9
Ability To Use Investment Tax Credit 1-13
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 2-8
Chapter III. Optimum Financial Strategy For Pollution Control
For Equipment Purchases 3-1
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Table of Contents (Continued)
Page
Chapter IV. State Financing and Tax Incentives 4-1
Iowa 4-6
Illinois 4-7
Missouri 4^7
Kansas 4-8
Nebraska 4-8
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
Chapter VI. Illustration of Optimum Financial Strategy For
Pollution Control For Municipal Versus On-Site
Treatment 6-1
On-Site 6-2
Municipal 6-3
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List of Figures and Table
Figure Page
1. Net Present Value of Tax Savings Through
Depreciation 1-10
2. Year-by-Year Tax Savings (Cash Flow Improvements) Through
Different Tax Strategies 1-12
3. Net Present Values of Cash Outflows From Financing 2-9
4. Year-by-Year Cash Outflow from Different Financing
Strategies 2-10
5. Illustrative Financial Characteristics of Pollution
Control Equipment for the Meatpacking
Industry 3-3
6. Comparisons of Peak Annual Cash Drains From Different
Tax and Financing Strategies 3-5
7. Comparisons of Short-Term Profit Impairment From Dif-
ferent Tax and Financing Strategies 3-6
8. Comparisons of Long-Term Profit Impairment From
Different Tax and Financing Strategies 3-7
9. Long-Term Profit Impairment From Various Financing
and Tax Alternatives 3-9
10. Guide to Management For Choosing The Optimum Financial
Strategy For Pollution Control 5-6
Table
1. Example of NPV Calculation For Straight Line Depreciation 1-9
2. Example of NPV Calculation For Bank Financing 2-7
3. Example of NPV Calculation for Combined Cash Inflows and
Outflows 3-2
4. Financial Assistance and Tax Incentives For Industry 4-3
5. NPV of Twenty Year On-Site Treatment Plant 6-4
6. NPV of User Charges for Twenty Year Cost Recovery
System 6-6
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INTRODUCTION
As the 1970's 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 provisions of the
1972 FWPCA amendments (PL92-500) 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 the necessary private equipment expenditures and public treatment
facilities by providing means of reducing or softening the financial ex-
penditures for pollution control. There exists.a mild governmental prac-
tice of spreading some of industries' pollution control costs over the
general public in place of just the company, and, to some degree, its cus-
tomers. 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 in-
come taxes by the addition of special depreciation alternatives. All of
these programs involve a company paying lower taxes than they normally
would have to pay if that equipment was for some other manufacturing or
service purpose. Another set of incentives provides for the possibility
of government treatment of wastes at lower costs than self-treatment
through federal government grant programs.
To put these incentives or cost reduction practices into 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.
On balance, more of this report is devoted to the financial
analysis for equipment purchases than for user charge analysis. The
reasons are: first, that most industries will face equipment purchases
for on-site treatment or municipal treatment since the latter alternative
requires pre-treatment; second, other regulatory programs, namely the
Clean Air Act, normally show their impact through required capital equip-
ment expenditures.
The financial techniques utilized in examining pollution con-
trol expenditures are well established; however, the future costs to be
analyzed are only beginning to become apparent. Under the enforcement
provisions of the FWPCA's National Pollutant Discharge Elimination System
(NPDES) effluent guidelines relating to the best practicable technology
have been specifically issued for many industries treating on-site.
These guidelines give many companies an idea as to how they will be re-
quired to control by 1977, but final cost estimates may not be ascer-
tainable until compliance terms of a company's specific permit are set
and issued.
For costs of discharging to municipal facilities pre-treatment
guidelines from EPA are expected momentarily as this report goes to print.
The other major cost factor of user charges for those who hook into muni-
cipal facilities which receive federal grants will not become accurately
known until June, 1973. These costs consist of the equitable cost
apportionment of recovering the capital, operating and maintenance costs
of the company's portion of municipal treatment costs. Once the EPA
111
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completes its process, meatpackers and others will then be able to
analyze 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. This report will indicate how to proceed
with an analysis once the permissibility and costs of using municipal
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
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 in-
formation should be analyzed as a minimum before equipment or charge
decisions are made.
1. Determine for all debt financing of pollution control
investments, the most effective combination of rate and
term of the loan. Calculate the negative cash flows in-
volved and their net present values.
2. Calculate the year-by-year cash inflows and the present
values for each available choice of depreciation.
3. Select the management objective by which you would want
IV
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to judge the financial impact of the investment in equip-
ment; for example, lowest short-term profit impairment,
least cash drain, long-term profit impairment, etc. Com-
pare the combinations of financing and depreciation values
calculated in Steps 1 and 2 against the established man-
agement 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 expenditure
necessary for any pre-treatment facility. Calculate the
present values for the treatment expense and a present lease
value for the user charge payment.
5. Compare the values and year-by-year effects of Step 4, and
and Steps 1 through 3, against the selected financial man-
agement objective. This will allow you to make a choice
between whether to plug into a municipality's waste water
or invest in a private treatment facility, from a financial
point of view.
This analysis presumes that the legal and tax implications of
each financial alternative are 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 meatpacking plant from being able to have the freedom of choice.
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Organization of the Report
The report is divided into six 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 for equipment to normal company
financial strategies. In other words, how do the incentives correspond
to a company's maximum cash flow strategy or its profit maximization
strategy, etc? Chapter IV is a look at the availability of the various
financing alternatives already discussed, both from the federal government
and from five mid-western states in which the greatest amount of meat-
packing takes place. Some financing alternatives are for practical
purposes always available, while others are dependent upon the source's
budget. The fifth chapter examines the combination of the first four
sections as opposed to the financial theory of a user charge system.
This alternative analysis sets up a basis for decision when the costs of
the Federal Water Pollution Control Act become predictable, an example of
which follows in Chapter VI.
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-years1-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-
1-1
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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 packer uses a foods
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 packer 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
1-2
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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
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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 = 1
V 1 + r
The present value of a dollar saved i years from now is obtain-
ed by discounting annually:
Thus, the present value of the net cash flow during year i,
termed discounted cash flow, DCF, is,
nrp- = „ NCFi
iA,f1 n +
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 -^
i=l 1=
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 meatpacking plants, the cost of capital (tnis is the same
1-4
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as the return if funds are reinvested) before tax is estimated to be
about 6%. After taxes, this figure reduces to about 3.0%. Therefore,
r = 3.0 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 Meatpackers
At this time no one can be quite sure as to what the costs are
for best practicable or the best available control technology for meat-
packers or any other industry. For illustrative purposes, we are going
to use an average investment figure of $400,000.
For accounting purposes, the Asset Depreciation Range of
equipment used in the foods manufacturing industry into which a
meatpacker usually falls, is 9.5 to 14.5 years. (Section 167, IRS Code.)
We will select a 12 year life based on the guideline useful life of the
Asset Depreciation Range. 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 $400,000 waste treatment facility 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 $400,000 investment using
rapid amortization results in,
1-6
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Yearly Cash Flow = T D
= (.48) ($80,000)
n
NPV = 5DCF-
NCF,
DCF = L-r r - 3.0%
(1 + r)1
NPV = $175,918
Straight Line Depreciation
The base or most simple form of depreciation involves taking an
equal proportion of 8 1/3 percent for each year of the 12 year life of the
depreciable base under the appropriate foods manufacturing depreciation
class. In this case, the depreciable basis could have been reduced to
$398,000 by taking the additional first year bonus depreciation of $2,000
(maximum), but the point of emphasis is to have the straight line method
serve as a base. Using the above formula with the $400,000 basis, the
NPV of cash inflows is $159,266.
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 $28,000
in this example. This figure, adjusted by the NPV, should be added to the
straight line depreciation NPV, since the investment tax credit is allowed
for that method. The resulting NPV is $186,596. Also taken into account
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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 $81,600 (.2 x $398,000 =
$79,600 plus $2,000). In the second year, the 20 percent is taken against
($398,000-$79,60Q) or $318,400, resulting in a figure of $63,680.
When year-by-year cash flows are discounted using the rate of
return, the NPV for the $400,000 equipment using double-declining depre-
ciation becomes $203,001.
There is, of course, another depreciation method called, "sum
of the years digits", which has results between the straight line and
double declining methods.
Net Present Value Calculation
Mathematically, the table below shows how the NPV is calculated
for a $400,000 piece of equipment depreciated by the straight line depre-
1-8
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elation method over 12 years. The effect of the investment tax credit plus
the additional first year's depreciation is also considered.
TABLE 1
EXAMPLE OF NPV CALCULATION FOR STRAIGHT LINE DEPRECIATION
End
of
Year
1
1
2
3
4
5
6
7
8
9
10
11
12
Depreciable
Base
$400,000*
398,000
398,000
398,000
398,000
398,000
398,000
398,000
398,000
398,000
398,000
398,000
398,000
Rate
Deprec .
Max.
8 1/31
8 1/3%
8 1/3%
8 1/3%
8 1/3%
8 1/3%
8 1/3%
8 1/3%
8 1/3%
8 1/3%
8 1/3%
8 1/3%
After
Tax
Deprec .
$ 960
15,920
15,920
15,920
15,920
15-,920
15,920
15,920
15,920
15,920
15,920
15,920
15,920
Rate
of
Disc.
1.03
1.03
1.0609
1.0927
-1.1255
1.1592
1.1940
1.2298
1.2667
1.3047
1.3438
1.3841
1.4256
NPV
$ 928 AFYD
15,456
15,006
14,569
14,145
13,734
13,333
12,945
12,568
12,202
11,847
11,502
11,167
$159,402
PLUS: 7% investment tax credit
discounted back to year zero 27,184
Total NPV $186,586
*The $2,000 maximum additional first year's depreciation must reduce the
succeding year's depreciable base by the same amount.
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
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mooo
— BASE
210,000
200,000
190,000
180,000
170,000
160,000
150,000
FIGURE 1
NET PRESENT VALUE
OF
TAX'SAVINGS THROUGH DEPRECIATION
>
$159,300
UJ
i—i QJ
< o:
2 o.
\— uj
CO CD
$18L£Q[)
o
UJ
CD
UJ
25
$203,000
g
0.
UJ
O I-
CQ
o
O CO
1-10
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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. Ihe
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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$65,000
55,000
FIGURE 2
YEAR-BY-YEAR SAVINGS
(CASH FLOW IMPROVEMENTS)
THROUGH DIFFERED TAX STRATEGIES
45,000
35,000
25,000
15,000
I—4—4-4
1, STRAIGHT-LINE DEPRECIATION
2, STRAIGHT-LINE DEPRECIATION WITH
INVESTMENT CREDIT
3, DOUBLE-DECLINING BALANCE WITH
INVESTMENT CREDIT
4, RAPID AMORTIZATION
3— 3—3—3-2, — 3
5,000
12 34 5678 9101112
YEAR AFTER ACQUISITION
1-12
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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 slightly
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. Not
in this example, but in actuality, a company has to earn $71,875 before
taxes to use the $28,000 available investment tax credit. This calcula-
tion used the corporate tax rates of 221 of all income and 26% of income
over $25,000.
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
1-13
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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.
1-14
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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
money was to be borrowed to pay for the equipment, get in touch with his
normal financing source and request arrangements. With the advent of
special pollution control incentives, there are, in general, not only new
sources of funds available, but lower rates than normal for most sources
of financing. This situation requires another whole set of analyses be-
fore the best source of funds can be chosen.
Generally, two aspects of the financing strategy are covered in
this chapter. The first aspect is the quantitative analysis using NPV as
a tool for valuing each financial source and rate. The second aspect
describes each financial source and based on rate and terms, calculates
and compares the NPV of each. As in Chapter I, the example is based on
a $400,000 waste treatment system.
Methods Used in Analyzing Financing Costs
In order to determine the cost to the company of the various
available methods of raising funds, it is necessary to analyze the effect
of 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 b)
p - Q - I
where, Q = the operating -income
and, I = the interest expense
combining the above two equations,
P = (Q - 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 = QT
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
2-2
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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:
NCFi = ci + li . (1 - T) . i - 1, 2, --, n
where, C^ = principal payback during year i
li - 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,
+ r)i
2-3
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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 meatpacker, = 3.0 percent.
For domestic corporations, the normal federal tax rate amounts to 22%
on taxable income, plus a 261 surtax on income over $25,000. 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 $400,000 packing treatment system through a bank is
$422,353. The cash flows for this financing alternative are unique be-
2-4
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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 meatpackers 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 SBA 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 SBA 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 precarious is any attempt at determining how many com-
panies in the meatpacking industry will sustain substantial economic
2-5
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injury without assistance.
SBA loans are permissible to 30 years, however, we have cho-
sen a 10-year loan term to recognize the guideline useful life of the
Asset Depreciation Range into which meatpacking belongs. Using the
5.5 percent rate and the 10-year repayment schedule, the NPV calculates
to $397,272.
Government Aid to Financing (Tax-Free)
As a result of the effort to encourage industrial development
in general, and in some cases to encourage industry to install control
equipment on sources of pollution, governmental aid is 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.
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.
2-6
-------
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.
As a word of caution about tax-free status, it is prudent to
obtain the advice of counsel. A whole set of provisions exists on the
nature of the facilities qualifying and certified as eligible for tax-
exempt financing.
The NPV of cash outflows for the tax-free financing method for
the terms described above, and in our $400,000 example, is $389,137
As was shown in Chapter I, the following table is an example
of how NPV would be calculated for a five-year bank loan for $400,000.
The rate of interest is stated at 6% and the loan is repaid quarterly.
TABLE II
EXAMPLE OF NPV CALCULATION FOR BANK FINANCING
Repayment Interest
Interest Principal Yearly x Plus Discount
Year Portion Repayment Repayment (1-T) Principal Factor NPV
1
2
3
4
5
$ 42,286
33,143
24,000
14,857
5,714
$ 61,714
70,857
80,000
89,143
98,286
$104,000
104,000
104,000
104,000
104,000
$21,989
17,234
12,480
7,726
2,971
$ 83,703
88,091
92,480
96,869
101,257
1.031
1.0609
1.0927
1.1255
1.1592
$ 81,265
83,034
84,634
86,068
87,352
$120,000 $400,000 $520,000 Total NPV = $422,353
2-7
-------
Comparison of Financing Methods
Figure 3 is a bar graph of the net present values of the nega-
tive cash outflows in financing the $400,000 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
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 $400,000 piece of equipment, the range is approx-
imately $33,000; 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 (illus-
trated) , 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.
2-8
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$430,000
420,000
410,000
400,000
390,000
380,000
370,000
>
g
CD
o:
Ul
GO
PQ
— BASE
FIGURE 3
NET PRESENT VALUES OF CASH OUTFLOWS FROM FINANCING
2-9
-------
$100,000
80,000
X
A
X
A
x
FIGURE 4
YEAR-BY-YEAR CASH OUTRUN
FROM DIFFERENT FINANCING STRATEGIES
A, ORDINARY BANK LOAN
B, SBA WATER POLLUTION CONTROL
LOAN
C, TAX-FREE LOAN
60,000
40,000
20,000
C—C
12 31567 8 9 10 11 12 13
YEAR AFTER ACQUISITION
2-10
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CHAPTER III
OPTIMUM FINANCIAL STRATEGY FOR POLLUTION CONTROL
FOR EQUIPMENT PURCHASES
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 meatpackers 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
different management objectives that might exist in a meatpacking
operation. We will show how different strategy combinations affect each
situation.
Before discussing the objectives, we will present a table which
shows the calculations for another simplified example. The objective
is to show how the NPV of the combination of tax and financing strategies
was obtained. As we will later see, the term NPV becomes synomyous with
3-1
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the lowest long-term profit impairment a project has on a company. The
figures used are those developed in Chapters 1 and 2 for a $400,000 capital
investment. Note that the equipment was depreciated in twelve years and
financed in five years.
TABLE 3
EXAMPLE OF NPV CALCULATIONS FOR COMBINED
CASH INFLOWS AND OUTFLOWS
NPV of NPV of
Year Year-by-Year Cash Inflows Year-by-Year Cash Outflows
1 $ 43,568 $ 81,265
2 15,006 83,034
3 14,569 84,634
4 14,145 86,068
5 13,734 87,352
6 13,333 $422,353
7 12,945
8 12,568 NPV Cash Outflows $422,353
9 12,202 less NPV Cash Inflows 186,586
10 11,847 Total NPV $235,767
11 11,502
12 11,167
$186,586
First, let us look at an meatpacker 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.
3-2
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Figure 5
ILLUSTRATIVE
FINANCIAL CHARACTERISTICS
OF POLLUTION CONTROL EQUIPMENT FOR
Tlffi MEATPACKING 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
$400,000
-0-
12 years
48 percent
7 percent subject to
a certain maximum
$2000
3.0 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)
3-3
-------
The .lowest cash outflow, and the strategy combinations that
permit it, are shown in Figure 6. This value, shown boxed, is $35,300--
the result of following a combination of Tax Strategy 2 and Financing
Strategy B. It is the best choice for a meatpacker 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, $51,900, represents the lowest possible cash
outflow under the circumstances. It is derived from a combination of
Strategies 2 and B.
Finally, there's the meatpacker 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 ($186,100) 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 coiimon
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
3-4
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FIGURE F
COMPARISONS OF PEAK ANNUAL CASH DRAIN
FROT1
DIFFERENT TAX AND FINANCING STRATEGIES
USEFUL LIFE = 12 YEARS
INVESTMENT COST: #1^0, °00
TAX STRATEGY
1, STRAIGKT LINE DEPRECIATION
0 STRAIGHT LINE DEPRECIATION
*• WITH INVESTMENT CREDIT +
DOUBLE DECLINING BALANCE
3, DEPRECIATION WITH
INVESTMENT CREDIT+
SPECIAL AMORTIZATION FOR
1, POLLUTION CONTROL
EQUIPMENT*
FINANCING STRATEGY
A,
CONVENTIONAL
BANK
LOAN
$87,500 (5)
$87,500 (5)
$87,800 (5)
$68,300 (5)
B,
.SBA HATER
POLLUTION
CONTROL LOAN
* $35,900 (1)
I $35,300 (2)
$36,W (F)
$45,700 (6)
C,
TAX-FREE
LOAN
$52,200 (15)
$52,200 (15)
$52,200 (15)
$52,OT (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,
3-5
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FIGURE 7
COMPARISONS OF SHORT-TEP^ PROFIT IPFAIRfENT
FROM
DIFFERED TAX AND FINANCING STRATEGIES
USEFUL LIFE = 12 YEARS
INVESTMENT COST: $TO,000
TAX STRATEGY
1,
2,
3,
4,
STRAIGHT LINE DEPRECIATION
STRAIGHT LINE DEPRECIATION
WITH INVESTMENT CREDIT
DOUBLE DECLINING BALANCE
DEPRECIATION WITH INVESTMENT
CREDIT *
SPECIAL AMORTIZATION FOR
POLLUTION CONTROL
EQUIPMENT*
FINANCING STRATEGY
A, B,
CONVENTIONAL SBA WATER
BANK POLLUTION
LOAN CONTROL LOAN
$98,000
$71,700
$90,600
$168,000
$78,200
| $51,9nn |
$70,800
$148,200
C,
TAX-FREE
LOAN
$88,500
$62,200
$81,100
$158,500
*ALSO INCLUDES EFFECT OF ADDITIONAL FIRST YEAR DEPRECIATION, SECTION 179, INTERNAL
REVENUE CODE,
3-6
-------
FIGURES
COMPARISON OF LONG-TEW PROFIT WAIPfENT
DIFFERENT TAX AND FINANCING STRATEGIES
USEFUL LIFE = 12 YEARS
INVESTMENT COST: $400,000
TAX STRAHGY
1, STRAIGHT LINE DEPRECIATION
2 STRAIGHT LINE DEPRECIATION
1 WITH INVESTMENT CREDIT*
DOUBLE DECLINING BALANCE
3, DEPRECIATION WITH
INVESTMENT CREDIT*
. SPECIAL AMORTIZATION FOR
4, POLLUTION CONTROL
EQUIPMENT*
FINANCING STRATEGY
A,
CONVENTIONAL
SANK
LOAN
— — — — — — — — — .
$263,100
$235,800
$219,400
$246,400
B,
SBA WATER
POLLUTION
CONTROL LOAN
$238,mo
$210700
$194,300
$221,400
C,
TAX-FRFF
1 MA 1 r\CC
LOAN
$229,90n
$202,500
$186,100
$213,200
*ALSO INCLUDES EFFECT OF ADDITIONAL FIRST YEAR DEPRECIATION, SECTION 17^, INTERNAL
REVENUE CODE,
3-7
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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 all 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 $246,400. A tax-free loan and investment tax credit with
double declining balance depreciation resulted in an effective cost of
$186,100, a savings over the former plan of $60,300. 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 .
3-8
-------
$260,000
250,000
240,000
230,000
220,000
210,000
200,000
190,000
180,000
170,000
WITH
INVESTMENT
CREDIT
WITH
RAPID
AMORTIZATION
FIGURE 9
LONG-TERM PROFIT IfPAIRFENT
FROM VARIOUS FIMiOIG AND TAX ALTERNATIVES
3-9
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CHAPTER IV
STATE FINANCING § 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 meatpackers'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. Tins 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 4. 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.
The above relates to the alternative involving equipment pur-
chases, whereas we also need to be concerned about state and federal
programs for financing the municipal treatment plants into which individual
companies connect themselves. As for the federal portion of construction
grants, the monies contained in the 1972 FWPCA were based on a survey of
municipal areas planning to upgrade. Thus the authorization was designed
in nature to satisfy all plants. However, the municipalities then in
question were not necessarily relating their estimates to secondary
treatment, defined as best practicable, nor any advanced treatment. A
new survey will be taken to determine just how suitable was the FWPCA
authorization. Presumably, construction grant money over time will be
available for the vast majority of plants. A major appeal of this
money is that interest is not included in any repayments.
Of quite a varying nature will be the cost and source of the
4-2
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TABLE 4
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
i— i
.1-1
State Sponsored Industr:
Development Authority
1
i^H^M^
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
Privately Sponsored
Development Credit Corp
2
i^M^HBHB
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
fr
State Authority or Agenc
Revenue Bond Financing
3
mmi^mmmm
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
City and/or County
Revenue Bond Financing
4
IM^BMMBH
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
State Loans for
Equipment, Machinery
5
•^•••MM
X
X
X
X
X
X
Excise Tax Exemption
6
^^^••i
X
X
X
s g
•H 6
Tax Exemption or Moratoi
On Land, Capital Improve
7
KMH^H
X
.x
X
X
X
X
X
X
X
n
•H
Tax Exemption or Moratoi
On Equipment, Machinery
8
••m«B
X
x
x
x
X
x
x
x
X
X
X
x
X
X
Sales/Use Tax Exemption
On New Equipment
9
•••M
X
X
X
x
x
X
x
x
X
x
x
X
X
X
J3
•H
•M
Sales/Use Tax Exemption
Applicable to Lease of
Pollution Control Facili
10
iBBB^^HB
X
x
x
4-3
-------
TABLE 4 (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
^^•^^•••••••••i
CTj
State Sponsored Industri
Development Authority
1
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
•••MM
Privately Sponsored
Development Credit Corp.
2
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
•••••
^
State Authority or Agenc
Revenue Bond Financing
3
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
••••^
City and/or County
Revenue Bond Financing
4
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
•••••
State Loans For
Equipment, Machinery
5
X
X
X
•MMi
Excise Tax Exemption
6
X
X
X
X
X
X
••MM
V)
J^l
+- '
| d
•H e
Tax Exemption or Moratoi
ON Land, Capital Improve
7
X
X
X
X
X
X
X
X
g
•H
s_
Tax Exemption or Morato]
On Equipment, Machinery
8
X
X
X
X
X
X
X
Sales/Use Tax Exemption
On New Equipment
9
X
X
X
X
X
X
X
X
X
X
, _J
n
.—I
Sales/Use Tax Exemption
Applicable to Lease of
Pollution Control Facil:
10
X
X
X
X
X
X
X
4.4
-------
monies to finance the remaining minimum 25 percent. Further compli-
cating the situation is the degree to which these funds have to be re-
paid. Obviously, if a bond issue was floated to raise the local por-
tion, the full cost plus interest requires repayment. Funds appropri-
ated from a state public works budget will have different repayment
schemes and degrees depending on the state.
What follows is a brief and simplified overview of several
states which are expected to be of special interest to this audience.
According to statistics from the last Census of Manufacturers
(1967), the following states had the highest value of shipments.
Iowa $2,497.7 million
Nebraska 1,382.9 million
Minnesota 1,119.6 million
California 1,116.1 million
Texas 732.8 million
Illinois 726.4 million
Ohio 692.6 million
Missouri 682.4 million
Kansas 601.3 million
The total of the above nine states is $9.552 billion or 631 of
the 1967 sales for the entire meatpacking industry, $15.248 billion.
Five of these states germane to the audience to whom this report will be
immediately distributed will be selected to alert the meatpackers about
provisions in their states. Their volume represents will over one-third
4-5
-------
the entire industry. Therefore, the legislation of Iowa, Nebraska,
Illinois, Missouri and Kansas has a very important financial as well as
technical impact on pollution control efforts of the meatpacking industry.
There are two categories of state tax incentives as aforementioned;
one being exemptions from certain state taxes whose consideration would
not enter the calculations performed in previous chapters. Examples in-
clude franchise taxes, property taxes, use and sales taxes. Equipment
purchases in the states with these kinds of incentives are straightforward
in the sense that a purchaser receives those benefits or he does not.
There are no other alternatives to analyze. The second category pertains
to the cost of financing involving low cost pollution control loans.
Iowa
The state legislature of Iowa has not yet passed any pollution
control incentives which permit exemptions or special deductions from any
form of taxation.
Iowa does have the legislation for allowing pollution control
facilities to be financed with industrial development bonds. The tax-free
status as mentioned earlier is not for any state legislative to enable
since that privilege belongs to the Internal Revenue Service.
Under the Iowa Department of Environmental Quality Act, there
are provisions for the states to fund up to 50 percent of the portion of
a municipal water pollution control construction project but at least 25
percent of total cost of construction. The fund is called the "sewage
works construction fund". The projects which qualify are also those which
qualify for federal construction grants under the FWPCA.
4-6
-------
Illinois
Under the Revenue Act of 1939 (Rev. Stat., Chapter 120 and
482, et. seq.) certified pollution control facilities are exempt from
real and personal property taxes. The assessment of property on which
the real or personal property tax is levied takes into account the
economic value of productivity to the owner which, for pollution control
facilities, is little, if anything, unless costs are partially recovered.
Also, under the Illinois-Retailers1 Occupation Tax (Article 2,
Section 6) sales of pollution control equipment are exempt from the
sales tax. Certification need not be acquired for this exemption.
As with the previous states and those to follow, Illinois also
permits pollution control facilities to be financed via industrial de-
velopment bonds.
Missouri
The State of Missouri provides a sales and use tax exemption
for pollution control facilities under Section 144.030 (13) and (14) of
the appropriate law.
A general property tax exemption for pollution control equip-
ment is not provided by legislation, however, control equipment financed
by industrial development bonds is actually municipally owned and con-
sequently requires no property tax.
In a few states, and Missouri is one, the specific enabling
legislation for pollution control financing via industrial development
bonds has not been passed. However, interpretations of the existing
4-7
-------
legislation have been sufficient to allow this method of financing.
Under various chapters of the Missouri Water Pollution Law
grants can be made for municipal treatment works. The state can grant
up to 25 percent of the construction cost for projects which also
qualify for federal aid (Chapter 204.210). Another Chapter, 204.230,
indicates that the water pollution board's "determination of relative
need, priority of projects, and standards of construction shall be con-
sistent with the FWPCA." This same chapter also requires a cost re-
covery system from the users, whereby all costs are recovered including
interest, depreciation for future replacement and maintenance and oper-
ation.
Kansas and Nebraska
Our records indicate that Kansas and Nebraska do not have
tax-exemption programs for pollution control. These states do have
industrial development bond programs through which tax-free loans are
used for pollution control financing.
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.
4-8
-------
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 chapter, the realm of
user charges and their possible modifications in the future will be
discussed. Complete optimization under long-range management objectives
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.
4-9
-------
CHAPTER V
FINANCIAL DECISION MAKING THEORY FOR
MUNICIPAL VERSUS PRIVATE FACILITIES
Assuming that each are available, many meatpacking
plants have the ability to choose whether they should have private or
municipal waste water treatment. The present mix of meatpacking
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-
5-1
-------
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
municipalities; provisions of the FWPCA will permit up to 75 percent of
the construction costs to be derived from the federal grant.
It also appears that a significantly higher user charge rate
structure is in the offing as the FWPCA requires the municipality to re-
cover, through charges, the operational costs and replacement value at-
tributable to the industrial proportion of the federal grant. For cer-
tain replacement equipment based on flow only, a municipal plant devot-
ing 60 percent of its capacity to the general population and 40 percent
to industry, must recover at least 40 percent of the 75 percent federal
portion if the maximum grant contribution was used. Other replacement
costs might be charged by the user's waste strength.
The 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 accurate cost
estimates. One major reason why it is difficult at this stage to estimate
user costs is the lack of EPA or other guidelines as to the number of
years over which the replacement value is to be recovered from industrial
5-2
-------
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
nature 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
quite 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 meatpacking 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
5-3
-------
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 meatpacking industry. The emphasis on by-product
recovery here is the very likely increase in extent as events proceed in
the meatpacking 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
5-4
-------
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.
5-5
-------
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 5 Financial
Strategies Under The
Management Objective
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
-------
CHAPTER VI
ILLUSTRATION OF OPTIMUM FINANCIAL STRATEGY FOR
POLLUTION CONTROL FOR MUNICIPAL VS ON-SITE TREATMENT
Chapter III developed various financial decision making pro-
cesses for management use where pollution control equipment is bought.
These took into consideration cash flow, long and short-term profit
management objectives, and compared various strategies in buying and
writing off the equipment. This chapter presents an example of the
application of this financial theory where the comparison is between
buying equipment for treating your wastes on-site versus municipal
treatment costs. This assumes that the pertinent regulations permit such
choice.
Rather than repeat the theory for all three financial manage-
ment strategies discussed in the previous chapter when buying equipment,
the complexity of each is enough to only make it desirable to limit the
illustration to one strategy. For illustration of the analysis for
economically choosing municipal versus on-site treatment, we will choose
the financial strategy analysis of long-term profit which is primarily
net present value consideration. This method, incidently, is the one
used most frequently by EPA in their economic impact studies.
Recalling the costs from the previous chapter which were to be
utilized in the comparison, we find for on-site treatment the capital
costs which include financing and depreciation, the operating costs and
6-L
-------
by-product values. For municipal treatment, the costs are pre-treatment
plus the associated operating and maintenance costs and the user charge
assessed by the municipality. In order for the costs of each option to
be comparable, the number of years or length of analysis must be the same
over which the calculations are performed.
On-Site
In choosing the length of analysis, the lives of the two alter-
natives must be relatable for proper costs matching. The user charge
cost recovery guidelines to be issued by EPA in June, 1973, will have an
impact on the length of analysis. One of the guidelines will determine
the number of years in which industry's portion of the capital construction
cost granted by the federal government must be repaid. Our estimation is
that the guidelines will specify cost recovery for the shorter of 20
years or the life of the equipment. Therefore, we will choose a 20-year
analysis for the two alternatives. The meatpacking investment we used
earlier in the report was for 12 years at a cost of $400,000. We will
speculate that even though that equipment could last longer than 12 years,
regulatory obsolescense will require updating which will leave us with an
$800,000 cost of on-site treatment over 20 years.
One of the assumptions we will make is that the on-site equip-
ment will be depreciated and financed by the same methods which were
superior in the long-term profit analysis of Chapter III; double-declining
balance depreciation with investment tax credit and a tax-free pollution
control loan. The terms of the tax-free loan will be repayment of 8 per-
6-2
-------
cent of the principal in years ten through nineteen and a 20 percent
balloon payment in the twentieth year. The tax-free loan rate will be
5 percent.
Since the meatpacking plant has to perform all maintenance and
operation, we have to include those costs as well as any sludge handling
and disposal costs. We will consider the "0 § M" costs to be 8 percent
of the total facilities investment cost or $64,000 per year.
The table below shows how the NPV for this example was derived.
Municipal Treatment
The size, capital and operating characteristics of the munici-
pal treatment plant directly influence the fee they charge for treatment.
We will assume a municipal treatment plant capable of handling 16 million
gallons per day (MGPD). At an approximate capital cost of $1.2 million
per MGD, the total plant cost would round out to $19,000,000. We will
further assume for illustrative purposes that a meatpacking plant con-
tributes to 5 percent of this total flow. The flow of the on-site
treatment plant for the costs assumed would be a medium size meatpacking
plant with an assumed flow of .8 MGD.
Taking the above assumed costs, we will make the following
additional assumptions:
• 75% of the cost of the construction is provided by federal
grant at no interest
• 25%, or the local/state share is raised through a tax-exempt
bond issue at 5 percent
6-3
-------
TABLE 5
NPV OF TWENTY YEAR ON-SITE TREATMENT PLANT
Year
1
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
O&M
$64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
Yearly
Depreciation
$161,600*
127,680
102,144
81,715
65,372
52,298
41,838
33,471
11,157
11,157
11,157
11,157
11,157
11,157
11,157
11,157
11,157
11,157
11,157
11,157
Interest
Payments
$80,000***
40,000
40,000
40,000
40,000
40,000
40,000
40,000
40,000
40,000
36,800
33,600
30,400
27,200
24,000
20,800
17,600
14,400
11,200
8,000
Principal
Payments
_
-
-
-
-
-
-
-
-
$ 64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
64,000
160,000
After- Tax
Negative
Cash Flow
$ 74,160
54,080
54,080
54,080
54,080
54,080
54,080
54,080
54,080
118,080
116,416
114,752
113,088
111,424
109,760
108,096
106,432
104,768
103,104
197,440
After-Tax
Positive
Cash Flow
$133,568
,61,286
49,029
39,223
31,379
27,195
21,756
16,066
5,355
5,355
5,355
5,355
5,355
5,355
5,355
5,355
5,355
5,355
5,355
5,355
Net
Cash
Flow
NPV
$ 57,678**
6 792**
VJ y / */ ^
4 622
i • V/ w £<
13,200
19 583
-*-—' y fcJ \J +J
22 517
^> £* j *J J. i
26 284
*•< \-i y L* W~
30,010
37 346
*J t y ^J'~T\J
83 885
-------
bond issue at 5 percent
• the yearly "0 § M" of the municipal plant is 3 percent of total
investment cost or $570,000
• the meatpacking plant requires pre-treatment equipment which,
for the 20 years cost, is $100,000 and is financed via a 5 per-
cent tax-free loan and depreciated via the double-declining
balance plus investment credit method
• the "0 $ M" for the pre-treatment facility incurred by the
meatpacking plant is 8 percent or $8,000 per year
The user charge for the meatpacking plant thus consists of the
following costs:
• 5% (percentage flow) of 75% of $19,000,000 over 20 years which
equals $35,625 (federal capital appointment)
• 5% of 25% of $19,000,000 plus yearly interest of 51 on the un-
paid balance (local/state capital appointment)
• The NPV of the pre-treatment capital costs after cash flow
considerations from depreciation and financing costs
• Yearly principal and pre-treatment "0§M" of $28,500 and $8,000
In the example presented here, the financial choice between
buy and treat on-site versus pre-treat and use of municipal facilities,
results in the pre-treat and municipal facility choice by a sizable
margin of $134,167. It would not be prudent to extend the implications
of this simplified example to a general meatpacking industry preference
for municipal treatment. As one reason, we excluded the value of by-
6-5
-------
TABLE 6
NPV OF USER CHARGES FOR TWENTY YEAR COST RECOVERY SYSTEM
Year
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
Federal
Portion
User Charge
$35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
35,625
Local*
State
Portion
$23,750
23,156
22,562
21,968
21,374
20,781
20,188
19,594
19,000
18,407
17,814
17,220
16,626
16,032
15,438
14,845
14,251
13,658
13,064
12,470
Pre- Treatment
Capital
Costs
Pre-Treatment
0$M
$36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
36,500
Depr.
$21,600
15,680
12,544
10,035
8,028
6,423
5,138
1,581
1,581
1,581
1,581
1,581
1,581
1,581
1,581
1,581
1,581
1,581
1,581
1,580
Int.
$10,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
4,600
4,200
3,800
3,400
3,000
2,600
2,200
1,800
1,400
1,000
Prin.
$8,000
8,000
8,000
8,000
8,000
8,000
8,000
8,000
8,000
8,000
20,000
After
Tax
Positive
Cash
Flow
$17,368
7,526
6,021
4,817
3,853
3,083
2,466
759
759
759
759
759
759
759
759
759
759
759
759
758
After
Tax
Negative
Cash
Flow
$55,055
52,146
51,837
51,528
51,219
50,910
50,601
50,292
49,983
7
57,674
7
57,160
56,643
56,127
55,609
55,093
54,576
54,060
53,543
53,026
64,509
Net
Cash
Flow
NPV
$36,589
42,058
41,929
41,503
40,859
40,056
39,140
39,104
37,728
42,353
40,749
39,200
37,708
36,267
34,878
33,541
32,253
31,009
29,812
35,304
$752,040
* Pre-Calculated
-------
product recovery from the on-site and pre-treatment facilities. Should
the yearly by-producy recovery from on-site be greater than that from
pre-treatment by $17,000 in this example, the two alternatives become
equal in value. In addition, the reader will note that this chapter is
rife with assumptions since many pertinent regulations are not available
at this writing. Nevertheless, this chapter can serve as a general guide
to completing a more definitive analysis for your plant when appropriate
data is available.
Completed now are the analytical financial guides necessary
for making the proper choices of treatment alternatives and pollution
control incentives as soon as they are available. In this era of regula-
tory programs for health and welfare, it is, as demonstrated herein,
important to perform the financial analysis with as much zeal as goes into
the choice of proper equipment.
6-7
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