Question

Consumers Energy Inc (CSI) operates a coal fired power plant in Michigan, which has to come in compliance with nitrogen oxide (NOx) standards by reducing its NOx emissions to 50 tons per year from its current level of 150 tons/year. It is considering the following options to come in compliance.

A)    Install Selective Catalytic Reactor (SCR) on its boiler. SCR reduces NOx emissions by absorbing NOx in exhaust flue gases. SCR requires a capital investment of $600,000 in year zero and has a life of five years. Annual costs of replacing catalysts in the SCR are estimated at $50,000 and other additional operating costs of SCR are estimated at $60,000 per year.

B)    Install lean burners in the boilers. Lean burners reduce the amount of NOx formed during combustion by reducing the air fuel ratio and the operating temperature. The lean burners cost $200,000 to install and have a life of five years. Installing lean burners reduces the efficiency of electricity generation, which results in increased coal consumption in boilers of 5000 tons/year to supply the same amount of electricity. Coal prices are $ 40/ton and expected to remain at that level for the next five years. Lean burners also increase maintenance costs by $8000 per year.

C)    Continue to operate as usual, but buy NOx emission permits from the market each year. The permit prices are expected to be $2500 per ton in year 1 and increase at the rate of 10% year.

Which option should CSI choose? CSI uses a discount rate of 10% in its decisions. The tax rate faced by CSI is 30%. CSI uses a straight line method in charging depreciation and both SCR and Lean burners are expected to have no salvage values. Capital costs are not tax deductible, while operating costs, permit costs and depreciation expenses are tax deductible.

How would your analysis change if the permit prices were expected increase at a rate of 15% per year?

Please show all your intermediate steps and clearly state your assumptions if any.

Answer 1

Particulars	Option 1	Option 2	Option 3
PV of cost	755,422	706,449	804,834
Option 2 is feasible
Option 1
Particulars	Year
	0	1	2	3	4	5
Capital investment	600,000	-	-	-	-	-
Annual cost of replacing catalyst		60,000	60,000	60,000	60,000	60,000
Operating costs		50,000	50,000	50,000	50,000	50,000
Tax benefit		(69,000)	(69,000)	(69,000)	(69,000)	(69,000)
	600,000	41,000	41,000	41,000	41,000	41,000
Discounting at 10%	1.00	0.91	0.83	0.75	0.68	0.62
Capital investment (PV)	600,000	37,273	33,884	30,804	28,004	25,458
PV of cash outflow	755,422
Tax benefit
Particulars	Year
	0	1	2	3	4	5
Depreciation		120,000	120,000	120,000	120,000	120,000
Other costs		110,000	110,000	110,000	110,000	110,000
		230,000	230,000	230,000	230,000	230,000
Tax savings @ 30%		69,000	69,000	69,000	69,000	69,000
Option 2
Particulars	Year
	0	1	2	3	4	5
Lean burners cost	200,000	-	-	-	-	-
Cost of increased coal consumption		200,000	200,000	200,000	200,000	200,000
Maintenance cost		8,000	8,000	8,000	8,000	8,000
Tax benefit		(74,400)	(74,400)	(74,400)	(74,400)	(74,400)
	200,000	133,600	133,600	133,600	133,600	133,600
Discounting at 10%	1.00	0.91	0.83	0.75	0.68	0.62
Capital investment (PV)	200,000	121,455	110,413	100,376	91,251	82,955
PV of cash outflow	706,449
Tax benefit
Particulars	Year
	0	1	2	3	4	5
Depreciation		40,000	40,000	40,000	40,000	40,000
Other costs		208,000	208,000	208,000	208,000	208,000
		248,000	248,000	248,000	248,000	248,000
Tax savings @ 30%		74,400	74,400	74,400	74,400	74,400
Option 3
Particulars	Year
	0	1	2	3	4	5
Permit prices		2,500	2,750	3,025	3,328	3,660
Nox emissions ( From 150 to 50 tons) - A		100	100	100	100	100
Cost of compliance		250,000	275,000	302,500	332,750	366,025
Tax benefit		(75,000)	(82,500)	(90,750)	(99,825)	(109,808)
	-	175,000	195,350	214,875	236,353	259,978
Discounting at 10%	1.00	0.91	0.83	0.75	0.68	0.62
Capital investment (PV)	-	159,091	161,446	161,439	161,432	161,426
PV of cash outflow	804,834
Tax benefit
Particulars	Year
	0	1	2	3	4	5
Permit costs		250,000	275,000	302,500	332,750	366,025
		250,000	275,000	302,500	332,750	366,025
Tax savings @ 30%		75,000	82,500	90,750	99,825	109,808