Shane Sorensen, the CEO for Fobbs Manufacturing, was wondering which of two pollution control systems he ought to choose. The company's current production process produced a gaseous and a liquid residue. A recent state law mandated that emissions of these residues be reduced to levels considerably below current perfor- mance. Failure to reduce the emissions would invoke stiff fines and possible closure of the operating plant. Fortunately, the new law provided a transition period, and Shane had used the time wisely. His engineers had developed two separate propos- als. The first proposal involved the acquisition of scrubbers for gaseous emissions and a treatment facility to remove the liquid residues. The second proposal was more radical. It entailed the redesign of the manufacturing process and the acquisi- tion of new production equipment to support this new design. The new process would solve the environmental problem by avoiding the production of residues.
Although the equipment for each proposal normally would qualify as seven- year property, the state managed to obtain an agreement with the federal govern- ment to allow any pollution abatement equipment to qualify as five-year property. State tax law follows federal guidelines. Both proposals qualify for the five-year property benefit.
Shane's marketing vice president has projected an increase in revenues because of favorable environmental performance publicity. This increase is the result of sell- ing more of Fobbs's products to environmentally conscious customers. However, because the second approach is "greener," the vice president believes that the revenue increase will be greater. Cost and other data relating to the two proposals are given below.
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Scrubbers and Treatment
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Process Redesign
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Initial outlay
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$25,000,000
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$50,000,000
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Incremental revenues
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5,000,000
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15,000,000
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Incremental cash expenses
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12,000,000
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5,000,000
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The expected life for each investment's equipment is six years. The expected salvage value is $1,000,000 for scrubbers and treatment equipment and $1,500,000 for process redesign equipment. The combined federal and state tax rate is 40 percent. The cost of capital is 10 percent.
Required
1. Compute the NPV of each proposal and make a recommendation to Shane.
2. The environmental manager observes that the scrubbers and treatment facility enable the company to just meet state emission standards. She feels that the standards will likely increase within three years. If so, this would entail a modi- fication at the end of three years costing an additional $4 million. Also, she is concerned that continued liquid residue releases-even those meeting state standards-could push a local lake into a hazardous state by the end of three years. If so, this could prompt political action requiring the company to clean up the lake. Cleanup costs would range between $20,000,000 and $30,000,000. Analyze and discuss the effect this new information has on the two alternatives. If you have read the chapter on environmental cost management, describe how the concept of ecoefficiency applies to this setting.