Remediation Associates Incorporated (RAI) is a firm located in Gary, Indiana that treats hazardous wastes. The firm plans to build
Remediation Associates Incorporated (RAI) is a firm located in Gary, Indiana that treats hazardous wastes. The firm plans to build a new facility to treat industrial wastes that are contaminated by a chemical that the US Environmental Protection Agency (EPA) recently classified as hazardous. The chemical is a by-product of an inspection process used in automobile manufacturing that relies on dipping parts into a chemical solution and then inspecting the parts under ultraviolet light. This process was commonly used in foundries and assembly plants for automobile engine parts prior to 2015. Sites where this process is still used are scattered throughout the United States with the largest concentration near Detroit, Michigan and Gary, Indiana. RAI would locate its site about halfway between these two cities. While there currently is modest demand for treating this type of industrial waste, RAI expects the demand to double once the EPA issues a permanent compliance standard, which would establish requirements for treating waste contaminated by this chemical. Given current demand, RAI estimates that the new facility would produce an annual net revenue of $1,000,000. RAI expects this net revenue to double when the EPA issues the permanent compliance standard. RAI, however, does not know when the EPA will issue the permanent compliance standard because the EPA is still conducting research on the chemical and its impact of the environment. The current research study is expected to take two more years to complete. It thus will be at least three years until the permanent compliance standard becomes effective and, depending of the results of the research study, it could take even longer. RAI’s director for governmental relations estimates that the permanent compliance standard will become effective in either 3 years, 5 years, or 10 years with probabilities of 20%, 50%, and 30%, respectively. Because if this uncertainty, RAI’s management team is trying to decide how large a facility it should build now. The building could be sized to simply meet the current demand or it could be sized to meet the level of demand that is expected when the permanent compliance standard is issued. More specifically, RAI’s director of engineering had his staff develop the following three specific alternatives for the facility. In each case, initial construction includes one "treatment line” sufficient for meeting the current demand and the building to contain it. The alternatives differ based on how the facility would be expended to include the second treatment line that will needed to meet the demand anticipated after the permanent compliance standard is issued. In each case, the equipment needed for the second treatment line will be purchased and installed only when needed. Alternative M (Minimal Facility). The minimal facility would be sized to meet the current demand and will cost $6 million to construct. Expanding it later, when the permanent compliance standard is issued, will cost another $5 million. This facility will cost $200,000 annually to operate initially and this cost will double when the facility is expanded. Alternative S (Staged Expansion). In this case, the initial facility would be sized to meet the current demand, but also would include the installation of utilities, loading docks, and other infrastructure needed to support the later expansion. This adds very little to the annual operating costs (i.e., the operating costs would be the same as in the minimal facility), but it would increase initial construction costs by $1.15 million. In return, the expansion will only cost $3 million later, when the permanent compliance standard is issued. Alternative L (Large Facility). In this case, the facility would be initially constructed to be large enough to accommodate both treatment lines. Initial construction costs would be $9 million, and the annual operating expenses would be $400,000 per year. However, prior to the issuance of the permanent compliance standard, RAI would use the extra space for other projects that are expected to generate net revenues of about $200,000 per year; these projects would be terminated when the equipment for second treatment line is added. With each of the preceding alternatives, each construction stage (i.e., the construction of the initial building and then the later expansion, if needed) will take about a year to complete, with the associated costs occurring immediately before construction or expansion starts. The construction needed to expand the facility would take place in the year before the permanent compliance standard becomes effective. Other costs and revenues can be considered to be end-of-year cash flows. Objective. Suppose RAI has hired you to perform an appropriate economic analysis. If the firm uses a 30-year planning horizon and has established a 12% minimum attractive rate of return for this new facility, which alternative would you recommend be adopted? In developing your recommendation, be sure to consider both the expected rewards and risks. RAI’s chief executive officer (CEO) has asked you to also address the sensitivity of your recommendation with respect to the estimated net revenue, which could be as much as 10% larger or smaller. State your recommendations within a report that should be written as if it were being submitted to RAI for the purpose of convincing the firm that adequate analysis has been accomplished to justify the implementation of your recommendation—and to justify your compensation as the analyst as well! As such, while your work will be evaluated primarily with respect to the completeness and correctness of the analyses you perform, it will also be evaluated on your effectiveness in conveying what you have done.