Heaps Company produces jewelry that requires electroplating with gold, silver, and other valuable metals. Electroplating uses large amounts of water and chemicals, producing wastewater with a number of toxic residuals. Currently, Heaps uses settlement tanks to remove waste; unfortunately, the approach is inefficient, and much of the toxic residue is left in the water that is discharged into a local river. The amount of toxic discharge exceeds the legal, allowable amounts, and the company is faced with substantial, ongoing environmental fines. The environmental violations are also drawing unfavorable public reaction, and sales are being affected. A lawsuit is also impending, which could prove to be quite costly.
Management is now considering the installation of a zero-discharge, closed-loop system to treat the wastewater. The proposed closed-loop system would not only purify the wastewater, but also produce cleaner water than that currently being used, increasing plating quality. The closed-loop system would produce only four pounds of sludge, and the sludge would be virtually pure metal, with significant market value. The system requires an investment of $630,000 and will cost $45,000 in increased annual operation plus an annual purchase of $7,500 of filtration medium. However, management projects the following savings:
Water usage ....... $ 67,500
Chemical usage ....... 442,000
Sludge disposal ....... 90,000
Recovered metal sales .... 45,000
Sampling of discharge ... 120,000
Total .......... $364,500
The equipment qualifies as a seven-year MACRS asset. Management has decided to use straight-line depreciation for tax purposes, using the required half-year convention. The tax rate is 40 percent. The projected life of the system is 10 years. The hurdle rate is 16 percent for all capital budgeting projects, although the company’s cost of capital is 12 percent.
Required:
1. Based on the financial data provided, prepare a schedule of expected cash flows.
2. What is the payback period?
3. Calculate the NPV of the closed-loop system. Should the company invest in the system?
4. The calculation in Requirement 3 ignored several factors that could affect the project’s viability: savings from avoiding the annual fines, positive effect on sales due to favorable environmental publicity, increased plating quality from the new system, and the avoidance of the lawsuit. Can these factors be quantified? If so, should they have been included in the analysis? Suppose, for example, that the annual fines being incurred are $75,000, the sales effect is $60,000 per year, the quality effect is not estimable, and cancellation of the lawsuit because of the new system would avoid an expected settlement at the end of Year 3 (including legal fees) of $300,000. Assuming these are all after-tax amounts, what effect would their inclusion have on the payback period? On the NPV?