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 thatis 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 environ-mental 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 totreat 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. Theclosed-loop system would produce only four pounds of sludge, and the sludge would be virtuallypure metal, with significant market value. The system requires an investment of $630,000 andwill cost $45,000 in increased annual operation plus an annual purchase of $7,500 of filtrationmedium. However, management projects the following savings:Water usage $ 67,500Chemical usage 442,000Sludge disposal 90,000Recovered metal sales 45,000Sampling of discharge 120,000Total $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 rateis 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 envi-ronmental 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 theanalysis? 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?
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 environ-
mental 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
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
2. What is the payback period?
3. Calculate the
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 envi-
ronmental 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?
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