Applying Financial Arrangements A Case Study

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Suppose PizzaCo (the "host" facility) needs a new chilled water system for a specific process in its manufacturing plant. The installed cost of the new system is $2.5 million. The expected equipment life is 15 years, however the process will only be needed for 5 years, after which

*To be precise, the IRS uses a "half-year convention" for equipment that is sold before it has been completely depreciated. In the tax year that the equipment is sold, (say year "x") the owner claims only Q of the MACRS depreciation percent for that year. (This is because the owner has only used the equipment for a fraction of the final year.) Then on a separate line entry, (in the year "x*"), the remaining unclaimed depreciation is claimed as "book value." The x* year is presented as a separate line item to show the book value treatment, however x* entries occur in the same tax year as "x."

Table 1-1. Table of Sample Equations used in Economic Analyses.

Payments Principal Taxable

EOY Savings Depreciation Principal Interest Total Outstanding Income Tax ATCF

n+1 = (MACRS %)* =(D) +(E) =(G at year n) =(B)-(C)-(E) =(H)*(tax rate) =(B)-(F)-(I)

Table 1-2. MACRS Depreciation Percentages.

EOY

MACRS Depreciation Percentages

for 7-Year Property

0

0

1

14.29%

2

24.49%

3

17.49%

4

12.49%

5

8.93%

6

8.92%

7

8.93%

8 4.46%

the chilled water system will be sold at an estimated market value of $1,200,000 (book value at year five = $669,375). The chilled water system should save PizzaCo about $1 million/year in energy savings. PizzaCo's tax rate is 34%. The equipment's annual maintenance and insurance cost is $50,000. PizzaCo's MARR is 18%. Since at the end of year 5, PizzaCo expects to sell the asset for an amount greater than its book value, the additional revenues are called a "capital gain," (which equals the market value - book value) and are taxed. If PizzaCo sells the asset for less than its book value, PizzaCo incurs a "capital loss."

PizzaCo does not have $2.5 million to pay for the new system, thus it considers its finance options. PizzaCo is a small company with an average credit rating, which means that it will pay a higher cost of capital than a larger company with an excellent credit rating. As with any borrowing arrangement, if investors believe that an investment is risky, they will demand a higher interest rate.

Purchase Equipment with Retained Earnings (Cash)

If PizzaCo did have enough retained earnings (cash on-hand) available, it could purchase the equipment without external financing.

Although external finance expenses would be zero, the benefit of tax-deductions (from interest expenses) is also zero. Also, any cash used to purchase the equipment would carry an "opportunity cost," because that cash could have been used to earn a return somewhere else. This opportunity cost rate is usually set equal to the MARR. In other words, the company lost the opportunity to invest the cash and gain at least the MARR from another investment.

Of all the arrangements described in this chapter, purchasing equipment with retained earnings is probably the simplest to understand. For this reason, it will serve as a brief example and introduction to the economic analysis tables that are used throughout this chapter.

Application to the Case Study

Figure 1-6 illustrates the resource flows between the parties. In this arrangement, PizzaCo purchases the chilled water system directly from the equipment manufacturer.

Once the equipment is installed, PizzaCo recovers the full $1 million/year in savings for the entire five years, but must spend $50,000/ year on maintenance and insurance. At the end of the five-year project, PizzaCo expects to sell the equipment for its market value of $1,200,000. Assume MARR is 18%, and the equipment is classified as 7-year property for MACRS depreciation. Table 1-3 shows the economic analysis for purchasing the equipment with retained earnings.

Reading Table 1-3 from left to right, and top to bottom, at EOY 0, the single payment is entered into the table. Each year thereafter, the savings as well as the depreciation (which equals the equipment purchase price multiplied by the appropriate MACRS % for each year) are entered into the table. Year by year, the taxable income = savings - depreciation. The taxable income is then taxed at 34% to obtain the tax for

Purchase Amount

Chilled Water

PizzaCo

PizzaCo

System Manufacturer Equipment

Figure 1-6. Resource Flows for Using Retained Earnings

Table 1-3. Economic Analysis for Using Retained Earnings.

EOY

Principal

Payments Interest

Principal Total Outstanding

Taxable Income

Tax

ATCF

0

2,500,000

-2,500,000

1

950,000

357,250

592,750

201,535

748,465

2

950,000

612,250

337,750

114,835

835,165

3

950,000

437,250

512,750

174,335

775,665

4

950,000

312,250

637,750

216,835

733,165

5

950,000

111,625

838,375

285,048

664,953

5*

1,200,000

669,375

530,625

180,413

2,500,000

Net Present Value at 18%:

$320,675

Notes: Loan Amount:

Loan Finance Rate:

MARR Tax Rate

MACRS Depreciation for 7-Year Property, with half-year convention at EOY 5 Accounting Book Value at end of year 5: 669,375

Estimated Market Value at end of year 5: 1,200,000

EOY 5* illustrates the Equipment Sale and Book Value

Taxable Income: =(Market Value - Book Value)

each year. The after-tax cash flow = savings - tax for each year.

At EOY 5, the equipment is sold before the entire value was depreciated. EOY 5* shows how the equipment sale and book value are claimed. In summary, the NPV of all the ATCFs would be $320,675.

Loans

Loans have been the traditional financial arrangement for many types of equipment purchases. A bank's willingness to loan depends on the borrower's financial health, experience in energy management and number of years in business. Obtaining a bank loan can be difficult if the loan officer is unfamiliar with EMPs. Loan officers and financiers may not understand energy-related terminology (demand charges, kVAR, etc.). In addition, facility managers may not be comfortable with the financier's language. Thus, to save time, a bank that can understand EMPs should be chosen.

Most banks will require a down payment and collateral to secure a loan. However, securing assets can be difficult with EMPs because the equipment often becomes part of the real estate of the plant. For example, it would be very difficult for a bank to repossess lighting fixtures from a retrofit. In these scenarios, lenders may be willing to secure other assets as collateral.

Application to the Case Study

Figure 1-7 illustrates the resource flows between the parties. In this arrangement, PizzaCo purchases the chilled water system with a loan from a bank. PizzaCo makes equal payments (principal + interest) to the bank for five years to retire the debt. Due to PizzaCo's small size, cred-

Chilled Water System Manufacturer

Loan Principal

Amount

Bank

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