£EPA
United States
Environmental Protection
Agency
Office of Water
(4303)
E?A32'-R-37-Gca
November 1997
Economic Assessment for
Proposed Pretreatment Standards
for Existing and New Sources for
the Industrial Laundries Point
Source Category
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SECTION SEX
ANALYSIS OF FIRM-LEVEL IMPACTS
The firm-level analysis evaluates the effects of regulatory compliance on firms owning one or more
affected industrial laundry facilities, ft also serves to identify impacts not captured in the facility analysis. For
example, some firms might be too weak financially to undertake the investment in the required effluent
treatment, even though the investment might seem financially feasible at the facility level. Such circumstances
can exist, in particular, at firms owning more than one facility subject to regulatioa Given the range of
possible firm-level impacts, the firm-level analysis is an important component of this EA.
EPA determined that 903 firms are potentially affected by the proposed IL Standards. To evaluate
precompliance conditions at and postcompliance impacts on these firms, EPA divided the firms into two
categories—single-facility firms (described in Section Five) and multifacility firms. As with facility
groupings in Section Five, EPA based firm groupings on responses to Question 27 in Part B of the Section
308 questionnaire, which asked about organizational structure. Because of the differences in organizational
structure and size between two categories of firms (discussed below), results are presented separately for
each type of firm.
A total of 830 firms classified themselves as single-facility firms by responding with C or E to
Question 27 in Part B of the Section 308 Survey.1 These firms operate as independent entities, although, in
some cases, single-facility firms can have an ultimate parent company. As independent entities, these firms
maintain balance sheets and income statements and pay corporate taxes on their own earnings. Single-facility
firms also are generally smaller than multifacility firms in terms of revenues, production, and employment Of
these firms, 128 meet the definition of the small industrial laundries exclusion and thus incur no compliance
costs. Note that 33 single-facility firms were estimated to close in the postcompliance analysis in Section
Five. To avoid double counting impacts, these firms are removed from the results of the firm-level analysis.
'As noted in Section Five, single-facility firms are both firms and facilities. To fully capture both
facility- and firm-level impacts for these firms, EPA evaluates (hem as facilities in Section Five and as
firms in Section Six.
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Section Nine discusses the combined impacts of closures and failures on small firms in the industrial
laundries industry.
In addition to the 830 single facility firms, EPA estimated that there are 73 multifacility firms.
Multifacility firms are those whose facility representatives responded with A, B, or D to Question 27 in Part
B of the Section 308 Survey;2 these firms own and operate more than one facility and have at least one
industrial laundry facility.3 In addition, they maintain financial records for all their facilities at the firm level
and typically pay corporate taxes at the firm level for all owned facilities. As noted above (and as shown in
Section Three), multifacility firms tend to be substantially larger than single-facility firms."
The basic core of the firm-level analysis, both for single-facility and multifacility firms, is the Altaian
Z"-score analysis, a ratio analysis that employs several indicators of financial viability to assess firm-level
2 Because the Section 308 Survey only sampled industrial laundry facilities, EPA believes that the
number of surveyed owner companies of nonindependent facilities (the multifacility firms) does not include
all firms likely to own industrial laundry facilities. To estimate the total number of multifacility firms (not just
those surveyed), EPA compared the survey-weighted number of nonindependent facilities (those responding
with A, B, or D to Question 27} to the total number of industrial laundry facilities reported owned by the
surveyed firms with nonindependent facilities. (Most surveyed multifacility firms reported owning more than
one industrial laundry facility). EPA determined that the ratio of total survey-weighted nonindependent
facilities to the sum of the number of facilities the surveyed multifacility firms reported owning is 1.7 (i.e.,
1.7 times as many nonindependent facilities were estimated using the survey weights than the surveyed
multifacility firms report owning). EPA assumed that the difference between these two numbers of facilities
reflects the number of facilities owned by nonsurveyed firms. EPA therefore used this ratio as if it were a
statistical weight to estimate the total number of multifacility firms, multiplying the number of surveyed
multifacility firms by 1.7. Results of the firm-level analyses for multifacility firms were likewise multiplied
by 1.7. Basically, this approach embodies the assumption that the nonsurveyed firms own the same average
number of industrial laundry facilities as the surveyed firms. EPA considers this assumption to be reasonable
because it has no reasons to believe that the nonsurveyed firms as a group are any different from the surveyed
firms.
3 For example, a firm owning a number of hotels and laundries might own only one laundry that
meets the definition of an industrial laundry, with its remaining facilities being either hotels or linen supply
laundries.
* Impacts on parent companies (i.e., owners of the owner companies) are not analyzed in this EA
because the impacts of a given facility closure or major facility-level capital investment become more dilute
as assets increase at higher levels in the corporate hierarchy. Thus EPA's analysis assumes that the impacts
fall on the most vulnerable firms. Had EPA assumed that the firms in the analysis could be "bailed out" by
their parent companies, impacts would most likely have appeared less. For most of the 830 single-facility
firms, however, analysis at the facility level., firm level, and corporate parent level coincide.
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precompliance conditions and postcompliance impacts. Section 6.1 presents an overview of this ratio analysis
methodology. Section 6.2 discusses the Altman Z"-score model as it applies to the industrial laundries
industry. Section 6.3 summarizes the results of the firm-level analysis in terms of the number of firms that
face bankruptcy prior to regulatory compliance (baseline bankruptcies) and the number of firms that
experience bankruptcy as a result of additional regulatory compliance costs (incremental bankruptcies). It
also discusses the number of firms that, while considered financially healthy in the baseline, slip from the
financially healthy category into an indeterminate category in the postcompliance analysis (this is considered
an impact short of bankruptcy). Results are presented under an assumption that a portion of the compliance
costs can be passed through to customers, based on EPA's analysis of the industrial laundries market (see
Appendix A). Appendix D presents an alternative analysis assuming that no compliance costs can be passed
through to the industry's customers.
6.1 RATIO ANALYSIS METHODOLOGY
Ratio analyses are conducted from the perspective of creditors and equity investors who would
finance a company's treatment system investment. To attract financing for a treatment system, a company
must demonstrate financial strength both before and, on a projected basis, after the treatment system has been
purchased and installed. The ratio analysis undertaken in this section simulates the analysis an investor and/or
creditor would be likely to employ in deciding whether to finance a treatment system or make any other
investment in the firm.
The baseline ratio analysis evaluates the company's financial viability before the investment, and the
postcompliance analysis predicts the company's financial condition subsequent to the investment The
baseline analysis identifies companies in extremely weak financial condition, independent of pending
regulatory actions. Such companies are at risk of financial failure even without the additional cost of the
regulation. Firms that are projected to fail in the baseline analysis are excluded from the postcompliance
analysis. This development of a regulatory baseline is consistent with OMB guidance, as discussed in Section
Five.J
* OMB, undated. "Memorandum for members of the regulatory working group regarding economic
analysis of federal regulations under Executive Order 12866." Sally Katzen.
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The postcompliance analysis identifies companies for which regulatory compliance poses a threat to
financial viability, although they are otherwise financially sound. Such companies could be weakened by the
costs of meeting the requirements of the rule. These companies are characterized as experiencing a larger
impact from the IL Standards than the majority of industrial laundry firms.
For the industrial laundries industry, a ratio analysis based on the Altaian Z"-score is used to
characterize the baseline and postregulatory financial conditions of potentially affected firms. This method is
described in more detail below.
The Altman Z"-score, originally developed in the late 1960s for manufacturing firms, is a
multidiscriminant analysis (MDA) used to assess bankruptcy potential.6-7 Over the years, the Altman Z-score
model has gained acceptance among financial institutions8 and, more recently, has been used by EPA in the
regulatory impact analyses for centralized waste treaters and the pulp and paper industry. Altaian's Z-score
model analyzes a number of financial ratios simultaneously to arrive at a single number to predict the overall
financial health of a particular firm. The advantage of the Altman Z-score model over traditional ratio
analysis is its simultaneous financial consideration of liquidity, asset management, debt management,
profitability, and market value. It addresses the problem of how to interpret a series of financial ratios when
some financial ratios look "good" while other ratios look "bad."9 The Altman Z-function is given in
Equation 1:
2 « LIT, + 1.4*2 + 0.33.X, + 0.06JT, + 0.999*5 (i)
6 Multidiscnminant analysis is a statistical procedure similar to regression analysis. It is used
primarily to classify or make predictions in cases where the dependent variable is qualitative, hi this case, the
dependent variable would be "financially stable" or "financially unstable."
7Altman, Edward, 1993. Corporate Financial Distress and Bankruptcy. NewYork: John Wiley
and Sons.
8 See for example, Altman, 1993, Ibid.; Breafy, Richard A., and Stewart C. Meyers, 1996.
Principles of Corporate Finance, McGraw Hill Companies, Inc.; and Brigham, E.F., and L.C. Gapenski,
1997. Financial Management Theory and Practice. Chicago: The Dryden Press, 8th edition, pp. 1064-
1066.
9 Brigham, Eugene F., and Louis C. Gapenski, 1997. Ibid.
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where,
Z = Overall Index
x _ Working Capital
1 Total Assets
Y _ Retained Earnings
2 Total Assets
Y > Earnings Before Interest and Taxes
3 Total Assets
X - Market Value of Equity
4 Book Value of Total Liabilities
X =
5 Total Assets
In a later work, Altaian developed two modified versions of this original model for use in evaluating
privately held firms (Z' -score) and firms within a service industry (Z"-score).10 In the original model, the
market value component (X4) uses stock price data; consequently, the Altaian Z-score is only applicable to
firms with publicly traded stock. The Z'-score model substitutes the book value of equity (owner equity) for
the market value in X4 and thus can be used to evaluate privately and publicly held firms on an equal basis.
Altaian developed the Z" function to extend the analysis to nonmanufacturing industrial firms. This
revision removes the sales/asset component (Xj) to minimize the industry-sensitive aspect of asset turnover.
Altaian farther notes that, "This particular model is also useful within an industry where the type of financing
of assets differs greatly among firms and important adjustments, like lease capitalization, are not made."11
Because the industrial laundries industry is a nonmanufacturing industry, the Altaian Z"-score is the
most appropriate model to use to evaluate the financial conditions of firms in this industry. The equation for
the Altaian Z"-score model is shown in Equation 2:
10 Altaian, Edward. 1993. Op. cit.
11 Ibid.
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Z" = 6.56JTj + 3.26X7 + 6.72AT3 + 1.05A; (2)
where,
Z" = Overall Index
y _ Working Capital
1 Total Assets
Y
2 Total Assets
_ Earnings Before Interest and Taxes (£5/7)
3 Total Assets
_ Owner Equity
4 Total Liabilities
Each of the above ratios is further defined below.
• Working Capital to Total Assets is a liquidity ratio which measures a firm's net liquid
assets relative to total capitalization.12
• Retained Earnings to Total Assets indicates the total amount of reinvested earnings and/or
losses associated with a firm over its entire life, relative to total capitalization.I3
• EBITto Total Assets measures the productivity of a firm's assets. Earnings are total firm
revenues minus total firm costs (including general and administrative costs and
depreciation).
• Owner Equity to Total Liabilities is a solvency ratio that measures the firm's total
indebtedness to the venture capital invested by the owners. High debt levels can indicate
high levels of risk.
12 Working capital is current assets minus current liabilities and is a measure of available cash on
hand.
13 For this analysis, owner equity (which is total assets minus total liabilities) is used as a proxy for
retained earnings. Owner equity includes retained earnings; it also includes paid-in capital, which is the
dollar amount over par in stock value. Many industrial laundries are believed to be privately held (according
to the Section 308 Survey, 42 percent are S corporations or other noncorporate entities, which are typically
privately held) thus owner equity will equal retained earnings in these cases.
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Taken individually, each of the ratios given above (X, through X4) is higher for firms in good
financial condition and lower for firms in poor financial condition. Consequently, the greater a firm's
bankruptcy potential, the lower its discriminant score. An Altman Z"-score below 1.1 indicates that
bankruptcy is likely; a score above 2,6 indicates that bankruptcy is unlikely. Z"-scores between 1.1 and 2.6
are indeterminate.14 EPA treats firms with indeterminate scores as financially viable but nevertheless
undertakes a separate postcompliance analysis of firms that have baseline scores in the range indicating that
bankruptcy is unlikely and postcompliance scores in the indeterminate range. These firms are considered to
experience some financial distress short of bankruptcy.
6.2 EVALUATING BASELINE AND POSTCOMPLIANCE RATIOS
6.2.1 Baseline Analysis
As discussed in Section Five, OMB requires EPA to establish a regulatory baseline. There are a
number of firms in this analysis that are likely to fail before the rule is promulgated. As in Section Five, EPA
divides vulnerable firms into those likeliest to fail in the baseline vs. those likeliest to fail postcompliance as a
way to avoid either overcounting or undercounting impacts.
The baseline analysis uses the Altman Z"-score model to separate financially healthy firms from
those likely to fail regardless of whether the regulation is promulgated. To evaluate the baseline viability of
the companies analyzed, the baseline Altman Z"-score values were calculated for each firm using Section 308
Survey data. Where sufficient data were available, 3-year average (1990-1993) financial ratios were
calculated and used as the baseline ratios.15 At a minimum, 1 year of data was available for all firms.
'"Altaian, 1993. Op. cit.
15 Data on assets, liabilities, owner equity, and EBIT from the Section 308 Survey were inflated by
the CPI for SIC 2718 and averaged over the available years of data (which ranged from 1 to 3 years).
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Those firms with baseline scores below 1,1 are considered baseline failures'6 and are removed from
the analysis.17 All other firms (including those with scores in the indeterminate range) are included in the
postcompliance analysis.
6.2.2 Postcompliance Analysis
EPA undertakes postcompliance analysis for those firms found to be financially viable in the baseline
analysis (i.e., those firms for which the baseline results are "bankruptcy unlikely" or "indeterminate").18 The
total number of potentially affected firms in the postcompliance analysis is adjusted downward to exclude the
baseline bankruptcies.
Postcompliance bankruptcy predictions are based on changes in the financial status of a firm as a
result of incremental pollution control costs.19 The change in a firm's bankruptcy potential as a result of
incremental pollution control costs, as predicted by the Altaian Z"-score, is determined using firm-specific
capital and annual O&M costs associated with each regulatory option. For the postcompliance analysis, the
relevant survey data (total assets, total liabilities, and EBIT) are adjusted to reflect annual facility compliance
16 The terms "failure" and "bankruptcy" are used interchangeably in this EA.
17 In the rare instance when single-facility firms were shown to close in the baseline in Section Five
but to remain open in Section Six, these closures are also considered baseline failures because EPA assumes
that single-facility firms that close in the baseline are not financially viable as firms and assigns them an
Altman Z" score of 1.00. The facilities in this group are generally firms with very strong equity positions
that closed in the baseline facility-level analysis because they reported a small negative cash flow. These
firms were found to have baseline Altman Z"-scores in the "bankruptcy unlikely" or "indeterminate" range,
so would not have been shown to fail in the baseline without this additional consideratioa This approach
was taken for consistency with the baseline closure analysis, which also characterized single-facility firms
that closed in the baseline as baseline firm failures,
18 As noted above, EPA considers firms with Z"-scores that fall in the "indeterminate" range to be
viable operations, although the financial stability of these firms might be somewhat uncertain.
19 The annualized pollution control costs for each option were calculated with the cost annualization
model described in Section Four.
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costs for all facilities owned by a particular company.20 Compliance costs for each facility owned by each
company are incorporated into the analysis as follows:
• Postcompliance Total Assets = Total Assets + Capital Cost (3)
• Postcompliance Total Liabilities = Total Liabilities + Capital Cost (4)
• Postcompliance EBIT = EBIT - (Postcompliance Change in EBIT)21-a (5)
The postcompliance analysis is performed under the assumption that the industry can pass through
some portion of compliance costs to its customers. (The percentage cost passthrough is estimated by the
market model analysis discussed in Appendix A). The change in EBIT presented in Equation (5) reflects the
estimated cost passthrough.23 The results of the alternative assumption that firms are unable to raise prices to
20 To estimate firm-level impacts at multifacility firms owning nonsurveyed industrial laundry
facilities, EPA assumes that the capital costs and change in EBIT associated with compliance costs for
nonsurveyed facilities are equal to the capital costs and change in EBIT at the surveyed nonindependent
facility with the median annual compliance costs. For each multifacility firm, costs and change in EBIT for
surveyed facilities are summed with estimated costs and change in EBIT for nonsurveyed facilities to develop
firm-level figures. The number of nonsurveyed industrial laundry facilities owned by each multifacility firm
is calculated based on responses to the Section 308 Survey, which asks for the total number of industrial
laundry facilities owned by the firm.
21 These calculations assume 100 percent financing of compliance equipment through long-term debt,
although tax shield on interest payments are not included (see Appendix B). Finns are assumed to incur all
compliance costs for all facilities regardless of whether the facilities close in the baseline or postcompliance
facility-level analyses, since liquidation and other costs associated with a facility closure will not exceed the
compliance costs associated with a closing facility. Note that working capital and owner equity do not change
with compliance costs because current assets and liabilities are assumed to be unaffected by long-term debt
and total assets and total liabilities are assumed to change in tandem (i.e., as debt is paid off, depreciation
reduces the book value of the asset).
22 The postcompliance change in EBIT (in absolute value terms) is calculated using the cost
annualization model described in Section Four. The total pretax cash outflows calculated by this model are
composed of cash outflows for depreciation and O&M. The change in EBIT related to compliance costs
corresponds to the change in O&M plus the change in the depreciation expenses. EPA adds the present value
(PV) of depreciation to the PV of O&M payments to calculate the PV of the change in EBIT. This value is
then annualized. The value is annualized because the Altaian Z analysis is a period-by-period analysis (i.e., a
firm's health is analyzed on the basis of one or more "snapshots" corresponding to, for example, quarterly or
annual accounting reports). EPA is creating a 1-year Altaian Z" analysis for simplicity and speed in model
calculations.
23 Postcompliance EBIT is calculated in the following manner to reflect the cost passthrough
(continued...)
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pass through costs are presented in Appendix D. EPA considers this worst-case scenario highly unlikely, as
discussed in Section Five.
Note that even if a firm is considered likely to fail, its facilities (as determined in the facility-closure
analysis) might not close. In the cases where a firm is considered likely to fail, its viable facilities could be
sold as part of the company liquidation process and operated successfully under different ownership. Also
note that some facilities could be sold (and continue to operate) to raise the necessary capital to finance the
installation of pollution control equipment at a firm's remaining facilities. Thus multifacility firms that are
estimated to fail but that do not have facilities that are estimated to close (as discussed in Section Five) are
not considered as severely affected as firms that are estimated to fail and to have to close some or all of their
facilities. Single-facility firms that fail but do not close are assumed to be sold, so the primary impact to these
firms is their loss of independent status. This impact is considered to be a lesser impact than closure and,
further, has minimal impact on employment in the industry.24 Single-facility firms that fail and close would
not be counted here because the significant impacts to these entities are already captured in the closure
analysis in Section Five. Note that EPA found no firm that would both fail and close in the postcompliance
analysis prior to any adjustments to eliminate double counting of impacts. This result occurs because the
equity positions of the closing firms are relatively strong and the postcompliance cashflow position is not
strongly negative. This result indicates that cost-cutting or other similar measures might be sufficient to
prevent these closures. EPA, however, does not make this assumption, to be conservative.
a(... continued)
assumption:
Baseline EBIT - [(change in EBIT)*(1 - 0.32)]
where changes in EBIT = depreciation + O&M
v This is not always the case in all industries, but does tend to be true for industrial laundries. These
firms are not asset-rich, and hold little attraction for predatory takeovers with subsequent liquidation.
Furthermore, single-facility firms' markets are tied to their physical locations (service areas), unlike
manufacturing firms' markets, which are likely to be independent of their locations. Therefore, jobs tend to
stay in the local market area more readily in this industry than in many manufacturing industries. See also
discussion in Section Three discussing the nature of acquisition in the industry.
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