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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
YEAR-BY-YEAR SAVINGS
(Cash Flow Improvements)
THROUGH DIFFERENT TAX STRATEGIES
—H—4-H
1.	Straight-Line Depreciation
2,	Straight-Line Depreciation with
Investment Credit
3,	Double-Declining Balance with
Investment Credit
4.	Rapid Amortization

\
3—3—3—3-3-a—3
12 3 H 5678 9 ID 11 12
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 22% 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
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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-
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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 = (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 = 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'
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
tenn loan. The net cash outflow, NCF;[ during year i is given by:
NCFi - q + Ii (1 - T)	i = 1, 2,
where, q = 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,

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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:
NPV-^DCFi 'YZ TTnrrJ*
i=l	i=l
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 dairy processor =3.0 percent.
For domestic corporations, the normal federal tax rate amounts to 22%
on taxable income, plus a 26% 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 dairy treatment system through a bank is
$422,353. The cash flows for this financing alternative are unique be-
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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 dairy 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 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 compan-
ies in the dairy processing industry will sustain substantial economic
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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 dairy processing belongs. Using the
5.5 percent rate and the 10-year repayment schedule, the NPV calculates
to $397,272.
Government Aid to Financing (Tax-Fr<;e)
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.
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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 61 and the loan is repaid quarterly.
TABLE II
EXAMPLE OF NPV CALCULATION FOR BANK FINANCING
Year
Repayment
Interest
Portion
Principal
Repayment
Yearly
Repayment
Interest
x
(1-T)
Plus
Principal
Discount
Factor
NPV
1
$ 42,286
$ 61,714
$104,000
$21,989
$ 83,703
1.031
$ 81,265
2
33,143
70,857
104,000
17,234
88,091
1.0609
83,034
3
24,000
80,000
104,000
12,480
92,480
1.0927
84,634
4
14,857
89,143
104,000
7,726
96,869
1.1255
86,068
5
5,714
98,286
104,000
2,971
101,257
1.1592
87,352

$120,000
$400,000
$520,000

Total NPV =
$422,353
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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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moco
120,000
110,000
100,000
390,000
380,000
370,000

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$100,000




FIGURE 4
YEAR-BY-YEAR CASH OUTFLOW
DIFFERBnIT financing strategies
A,	Ordinary Bank Loan
B,	SBA Water Polli/tion Control
Loan
C,	Tax-Free Loan
b-b.
B
•B—.£
~~B.
C-C
B—B.
-c
-C.
C—C-
12 31567 8 9 10 11 12 13 14
Year after Acquisition
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CHAPTER HI
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.
Few dairy 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
different management objectives that might exist in a dairy processing
*
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
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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 select a dairy 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.
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Figure 5
ILLUSTRATIVE
FINANCIAL CHARACTERISTICS
OF POLLUTION CONTROL EQUIPMENT FOR
THE DAIRY 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
$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
5-3/81 ~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)
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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 dairy processors 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 dairy 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 ($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 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
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FIGURE 6
COMPARISONS OF PEAK ANNUAL CASH DRAIN
FROM
DIFFERENT TAX AND FINANCING STRATEGIES
Useful life = IP. years
Investment Cost: $^0,000
TAX STRATEGY
FINANCING STRATEGY
A. B. C.
Conventional SBA Water Tax-Free
Bank Pollution Loan
Loan Control Loan
1, Straight Line Depreciation
0 Straight Line Depreciation
I' with Investment Credit +
Double Declining Balance
3 Depreciation with
Investment Credit+
Special Amortization for
4, Pollution Control
Equipment*
$87,500 (5)* $35,900 (1) $52,200 (15)
$87,500 (5) $35,300 (2) $52,200 (15)
$87,800 (5) $36,400 (6) $52,200 (15)
$68,300 (5) $45,700 (6) $52,203 (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.
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FIGURE 7
COMPARISONS OF SHORT-TERM PROFIT IMPAIRMENT
FROM
DIFFERENT TAX AND FINANCING STRATEGIES
Useful life = 12 years
Investment Cost: $*00,000
TAX STRATEGY
FINANCING STRATEGY
A, B. C,
Conventional SBA Water Tax-Free
Bank Pollution Loan
Loan Control Loan
1. Straight Line Depreciation
0 Straight Line Depreciation
with Investment Credit*
, Double Declining Balance
3. Depreciation with Investment
Credit *
Special Amortization for
H, Pollution Control
Equipment*
$98,000 $78,200 $88,500
$71,700 $51,900 $62,200
$90,600 $70,800 $81,100
$168,000 $118,200 $158,500
*Also includes effect of additional first year depreciation, Section 179, Internal
Revenue Code,
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FIGURE 8
COMPARISON OF LONG-TERM PROFIT IITORTCNT
FROM
DIFFERED TAX AND FINANCING STRATEGIES
Useful life -12 years
Investment Costs $400,000
TAX STRATEGY
FINANCING STRATEGY
A, B. C,
Conventional SBA Water Tax-Free
sank Pollution Loan
Loan Control Lxmn
1, Straigkt Line Depreciation
o Straight Line Depreciation
Zl with Investment Credit*
Double Declining Balance
3,	Depreciation with
Investment Credit*
Special Amortization for
4.	Rujtm on Control
Equipment*
$263,100 $238,000 $229,900
$235,800 $210,700 $202,500
$219,100 $194,300 $186,100
$2«,«0 $221,100 $213,200
*Also includes effect of additional first year depreciation, Section 179, Internal
Revenue woe,
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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

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WITH
INVESTMENT
CREDIT
WITH
RAPID
AMORTIZATION
O
O
c_>
3=
LU
FIGURE 9
LQKrTERFi PROFIT IMPAIRMENT
FROM VARIOUS FIMiCIUG 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 conplex 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 dairy processors'
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
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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 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
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TABLE 4
FINANCIAL ASSISTANCE AND TAX INCENTIVES FOR INDUSTRY

State Sponsored Industrial
1-1 Development Authority
Privately Sponsored
Development Credit Corp.
State Authority or Agency
Revenue Bond Financing
City and/or County
"^Revenue Bond Financing
State Loans for
01 Equipment, Machinery
on Excise Tax Exemption
Tax Exemption or Moratorium
^On Land, Capital Improvements
Tax Exemption or Moratorium
°°On Equipment, Machinery
^ Sales/Use Tax Exemption
On New Equipment
M Sales/Use Tax Exemption
<=> Applicable to Lease of
Pollution Control Facilities
Alabama
Alaska
Arizona
Arkansas
California
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X

Colorado
Connecticut
Delaware
Florida
Georgia
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X


X
X
X
X
X
Hawaii
Idaho
Illinois
Indiana
Iowa
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X

X
X
X
X
X
X
Kansas
Kentucky
Louisiana
Maine
Maryland
X
X
X
X
X
X
X _
X
X
X
X
X
X
X
X
X
X
X
X
X
X

X
X
X
X
X
X
X
X
X
X
X

Massachusetts
Michigan
Minnesota
Mississippi
Missouri
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X

X
X
X
X
X
X
X
X
X
X
X
4-3

-------
TABLE 4 (cont'd)

^ State Sponsored Industrial
Development Authority
^ Privately Sponsored
Development Credit Corp.
w State Authority or Agency
Revenue Bond Financing
^ City and/or County
Revenue Bond Financing
w State Loans For
Equipment, Machinery
on Excise Tax Exemption |
w
ll
o I
¦M O
Oj
u a,
•M
e -h
.8#
•M U
^1 A
sj
7
^ Tax Exemption or Moratorium
On Equipment, Machinery
g
•H
I
^ g
H 'El
aj &
tn w
II
-------
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.
Wisconsin	$1,446,2 million
California	1,068.3 million
New York	943,6 million
Minnesota	787.4 million
Ohio	768,9 million
Pennsylvania	752.3 million
Illinois	636,7 million
Michigan	510.0 million
The total of the above eight states is $7,372 billion or 581
of the 1967 sales for the entire dairy processing industry, $12,629 billion.
Five of these states germane to the audience to whom this report will be
immediately distributed will be selected to alert the dairy processors about
provisions in their states. Their volume represents about one-third the
entire industry. Therefore, the legislation of Wisconsin, Minnesota,
Michigan, Illinois, and Ohio has a very important financial as well as
4-5
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technical impact on pollution control efforts of the dairy processing
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.
Wisconsin
Wisconsin has three types of tax incentives; one property and
two involving depreciation for corporate and personal income taxes. Statute
70.11 (21) of Wisconsin exempts air and water pollution control equipment
of income producing properties from general property taxation.
Against the corporate income tax of Wisconsin companies, having
to comply with the various regulatory bodies, may deduct all of the cost
of depreciable air and water pollution control equipment in one year
(Statute 71.04 (2b)).Or,if a company so desires the cost of pollution
control equipment can be amortized over a period of five years. The
election of either method of depreciation cannot be changed once one is
selected.
The state of Wisconsin also has a provision for the cost of
depreciable pollution control equipment, less any Federal depreciation
4-6
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taken, to be deducted from gross personal adjusted income.
(Statute 71.05 (1) (h).
Pollution control equipment and facilities in Wisconsin can
be financed via industrial development bonds, however, it is not expressly
written into the legislation. Interpretation of the legislative has allowed
for such provision.
State assisted financing and grant programs are available to a
certain dollar limit for municipalities in Wisconsin. There are two
methods by which municipal waste treatment facilities can be assisted.
First, municipalities can receive up to 25 percent and not more than 30
percent from state funds. Under a second program, municipalities not able
to generate bond or other financing for the project can make annual lease
payments to the state for 75 percent of the total of the cost divided by
the number of years. The yearly amount of the payments by the department
to the municipalities less the lease payments received from the municipali-
ties cannot exceed a certain amount which, from our records, appears to be
$6 million. Considering that the need, as determined in a 1971 EPA
survey, for municipal facilities in Wisconsin was $243 million, that figure
of $6 million would be inadequate to cover local portions.
Minnesota
Minnesota permits a property tax exemption for pollution control
equipment and an investment credit against income tax. To be exempt from
the property tax the device must be certified by the state pollution control
agency as meeting applicable regulations, and operated in accordance with
permit conditions.
4-7
-------
A 5 percent investment credit up to $50,000 can be deducted
from Minnesota income taxes for eligible air and water pollution equip-
ment. Again the equipment must comply with permit conditions and the
regulations of state pollution control agencies.
Pollution control facilities may be financed via industrial
development bonds in Minnesota. As applies to all states, the Internal
Revenue Service is the agency which determines the tax-free status of the
financing and each state must enact legislation which enables pollution
control facilities to be financed by industrial development bonds.
Minnesota has two programs for assisting municipalities in
constructing municipal waste facilities. Under Section 116.15 of the
Crystal Waters Act the state may assist municipalities with grants for
interest payments on loans that municipalities would undertake in antici-
pation of the receipt of federal funds. The second program sets up a
water pollution control fund in the State of Minnesota for loaning and
appropriating funds to municipalities. Loans are to be repaid from charges
or taxes assessed to the users of the municipalities waste treatment system.
Michigan
Current laws of Michigan permit pollution control equipment to
be exempt from rural and personal property taxes and state sales and use
taxes.
Michigan also permits pollution control facilities to be financed
via industrial development bonds.
4-8
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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-Retailers' Occupation Tax (Article 2,
Section 6) sales of jtollution control equipment are exempt from the sales
tax. Certification need not be acquired for this exemption.
As with the previous states and that to follow, Illinois also
permits pollution control facilities to be financed via industrial de-
velopment bonds.
Ohio
Under the Ohio Revised Code, Section 5709,25 (A) and (C) air
and water pollution control devices are exempt from franchise, sales and
property taxes.
Ohio also has the Ohio Water Development Authority (OWDA) and
Ohio Air Quality Development Authority (OAQDA) to assist in the financing
of pollution control facilities. Eligible pollution control facilities
financed by industrial development bonds can qualify for tax-free 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,
4-9
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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 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.
4-10
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CHAPTER V
FINANCIAL DECISION MAKING THEORY FOR
MUNICIPAL VERSUS PRIVATE FACILITIES
Assuming that each are available, many dairy processing
plants have the ability to choose whether they should have private or
municipal waste water treatment. The present mix of dairy 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-
5-1
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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
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 migjht 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
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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
natore 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 processing plant, however, the relativity of the
subject here is fox its value in a complete private facility. For our
purposes, we will describe the value of annual by-product recoveries as
5-3
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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 dairy processing industry. The emphasis on by-product
recovery here is the very likely increase in extent as events proceed in
the dairy 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 NFV 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
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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.
5-5
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Figure 10
Guide to Management For Choosing The Optimum
Financial Strategy For Pollution Control
.MtV and
Yearly Cash
Flows For
Tax Strategies
I
Assignment of
Management
Objective as
Criteria
J
tn
i
NPV and
Yearly Cash
Flows For
Available
Financing
Strategies

Analysis of All
Possible Conbinations
of Tax § Financial
Strategies Under The
Management Objective
Adjustment by
Incremental NPV	Adjusted Effective
of:	Equipment Cost
(i)	by-product recovery ® For a Private
(ii)	operating costs
for Private Facility
NPV of
Costs,
if any
vs
Treatment Facility
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
6-1
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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 March, 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 processing 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
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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 dairy processing 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 dairy processing plant
contributes to 5 percent of this total flow. The flow of the on-site
treatment plant for the costs assumed would be a dairy processing 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
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TABLE 5
NFV OF TWENTY YEAR ON-SITE TREATMENT PLANT







Net





After-Tax
After-Tax
Cash


Yearly
Interest
Principal
Negative
Positive
Flow
Year
0§M
Depreciation
Payments
Payments
Cash Flow
Cash Flow
NFV
1
$64,000
$161,600*
$80,000***
-
$ 74,160
$133,568
$ 57,678**
2
64,000
127,680
40,000
-
54,080
61,286
6,792**
3
64,000
102,144
40,000
-
54,080
49,029
4,622
4
64,000
81,715
40,000
-
54,080
39,223
13,200
5
64,000
65,372
40,000
-
54,080
31,379
19,583
6
64,000
52,298
40,000
-
54,080
27,195
22,517
7
64,000
41,838
40,000
-
54,080
21,756
26,284
8
64,000
33,471
40,000
-
54,080
16,066
30,010
9
64,000
11,157
40,000
-
54,080
5,355
37,346
10
64,000
11,157
40,000
$ 64,000
118,080
5,355
83,885
11
64,000
11,157
36,800
64,000
116,416
5,355
80,241
12
64,000
11,157
33,600
64,000
114,752
5,355
76,738
13
64,000
11,157
30,400
64,000
113,088
5,355
73,373
14
64,000
11,157
27,200
64,000
111,424
5,355
70,133
15
64,000
11,157
24,000
64,000
109,760
5,355
67,021
16
64,000
11,157
20,800
64,000
108,096
5,355
64,033
17
64,000
11,157
17,600
64,000
106,432
5,355
61,162
18
64,000
11,157
14,400
64,000
104,768
5,355
58,403
19
64,000
11,157
11,200
64,000
103,104
5,355
55,755
20
64,000
11,157
8,000
160,000
197,440
5,355
106,371







$886,207
* Includes Additional First Year's Depreciation of $2,000
** Positive Cash Flows, the remaining eighteen years being negative
***Includes 5% underwriting expense for bond issue
-------
' the yearly "0 § M" of the municipal plant is 3 percent of total
investment cost or $570,000
•	the dairy processing 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
dairy processing plant is 8 percent or $8,000 per year
The user charge for the dairy processing 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 proportion)
•	5% of 251 of $19,000,000 plus yearly interest of 5% on the un-
paid balance (local/state capital proportion)
•	The NPV of the pre-treatment capital costs after cash flow
considerations from depreciation and financing costs
•	Yearly municipal 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 dairy processing industry prefer-
ence for municipal treatment. As one reason, we excluded the value of by-
6-5
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TABLE 6
NPV OF USER CHARGES FOR TWENTY YEAR COST RECOVERY SYSTEM




Pre-Treatment

After
After




Treatment

Capital

Tax
Tax
Net

Federal
Local*
S

Costs

Positive
Negative
Cash

Portion
State
Pre-Treatment



Cash
Cash
Flow
Year
User Charge
Portion
0§M
Depr.
Int.
Prin.
Flow
Flow
NPV
1
$35,625
$23,750
$36,500
$21,600
$10,000

$17,368
$55,055
$36,589
2
35,625
23,156
36,500
15,680
5,000

7,526
52,146
42,058
3
35,625
22,562
36,500
12,544
5,000

6,021
51,837
41,929
4
35,625
21,968
36,500
10,035
5,000

4,817
51,528
41,503
5
35,625
21,374
36,500
8,028
5,000

3,853
51,219
40,859
6
35,625
20,781
36,500
6,423
5,000

3,083
50,910
40,056
7
35,625
20,188
36,500
5,138
5,000

2,466
50,601
39,140
8
35,625
19,594
36,500
1,581
5,000

759
50,292
39,104
9
35,625
19,000
36,500
1,581
5,000

759
49,983
37,728
10
35,625
18,407
36,500
1,581
5,000
$8,000
759
57,674
42,353
11
35,625
17,814
36,500
1,581
4,600
8,000
759
57,160
40,749
12
35,625
17,220
36,500
1,581
4,200
8,000
759
56,643
39,200
13
35,625
16,626
36,500
1,581
3,800
8,000
759
56,127
37,708
14
35,625
16,032
36,500
1,581
3,400
8,000
759
55,609
36,267
15
35,625
15,438
36,500
1,581
3,000
8,000
759
55,093
34,878
16
35,625
14,845
36,500
1,581
2,600
8,000
759
54,576
33,541
17
35,625
14,251
36,500
1,581
2,200
8,000
759
54,060
32,253
18
35,625
13,658
36,500
1,581
1,800
8,000
759
53,543
31,009
19
35,625
13,064
36,500
1,581
1,400
8,000
759
53,026
29,812
20
35,625
12,470
36,500
1,580
1,000
20,000
758
64,509
35,304









$752,040
* Pre-Calculated
-------
product recovery from the on-site and pre-treatment facilities. Should
the yearly by-product 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 conpleting 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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