For a mill needing to upgrade water treatment, a discounted cash flow analysis of outsourcing vs. capital expenditures is examined

Outsourcing Boiler Feedwater Treatment Can Aid Mill Bottom Line

Many companies prefer to devote valuable resources to areas of expertise or core competencies such as making pulp and paper, not to peripheral areas such as water treatment. If a mill needed to upgrade water treatment facilities, it traditionally invested capital in new equipment. However, outsourcing this function is an alternative method. This article outlines a step-by-step process for conducting a comparison of the two options, as well as results from mill experience at St. Laurent Paper Products Corp. in West Point, Va.

Water treatment is a key component in efficiently operating a power plant.

First Step: Determining Costs. Before a final decision can be made on whether to install new equipment or to hire an outsider to do it and run it for you, the true cost of the options must be determined. This can sometimes be difficult because of shared budget items. Additional costs to consider, but ones that are hard to quantify, are management time and corporate costs for finance, engineering, human resources, etc. In addition, several less tangible items need consideration, such as company strategic direction, philosophy/culture, capital available for investment, extent and timing of the need, and available companies to perform the service.

The financial decision requires a basic understanding of the cash flows of each alternative. The two types of projects may be evaluated and compared differently in each corporation. The decision to outsource a function (such as water treatment) in some cases may not produce net savings, although the Outsourcing Institute reports that, on average, companies save 5% to 9% on outsourced programs or projects. Other factors may enter into the decision, such as corporate strategy, quality control, technology upgrades, internal experience/knowledge of the process, backup systems, and obsolescence.

The financial tool most often used to evaluate capital investments is discounted cash flow or present value. This tool is based on the theory that a dollar today is worth more than a dollar received one year from today. The precise calculations of return on assets and present value are, at best, based on imprecise estimates of obsolescence or deterioration that relate to the equipment’s projected useful life. However, comparing the cash flow of options will give information that is useful in making a decision on how to finance a project. To help understand the methods used here for comparing options, this article includes a glossary of common terms used in financial analysis (page 53).

Boiler Feedwater Systems. Problems in boiler feedwater treatment can be due to capacity constraints, age, or high operating costs. Normally, addressing the problem will involve installation of newer technology with reduced operating costs. As noted, the project can either be outsourced to a company whose core competency is handling this feedwater or the mill can invest capital in new equipment.

A study of any problem in the boiler feedwater system will cause all areas of pure water production to come under review. For example, problems in demineralization probably mean that membrane technology will need to be introduced into the system. This technology will extend run lengths on demineralization units, thus saving regenerant costs. The new system will normally save operational costs, but it needs to be financed, which is a cost.

A capital expenditure normally involves financing a sum of money and making payments on it, plus the advantage of depreciation from a tax standpoint. In the case of producing boiler feed water, service contract payments for outsourcing will also be a predictable amount over a period of time. The long-term agreement can also have some flexibility in payment method. The service charge can be a flat, monthly fee, or a charge per unit volume, a charge per regener ation, or a combination of all of these payment methods. Fixed monthly costs allow level budgets that, in turn, could contribute to a level or slightly increasing profit.

The cost of both options should be carefully studied to determine which option efficiently meets the pure water demands of the present and future systems. Elements of cost shown in Table 1 are not all inclusive but should cover the major expenditures related to purchasing capital equipment for a major project. These same costs must be addressed when considering outsourcing.

Methodology to Compare Owning to Outsourcing. The projected cost of the boiler feedwater project can now be quantified in a model that converts all the expenditures listed into a series of after-tax cash flow. However, the impact of taking on debt, as it relates to restrictive covenants imposed by the financial institution loaning the money, must be considered. Also, how will the increase in debt impact the company’s stock price and dividend policy?

Table 2 shows assumptions for a case study that will be used to demonstrate the steps for evaluating a capital project versus an extended term agreement (see sidebar “Evaluating…”). The data used in preparing this analysis were developed to show the technique of evaluating the two methods of financing a boiler feedwater project. The data are not all inclusive and do not necessarily represent actual data. The model was also set up to produce a break-even point between the two options.

Once all of the categories are identified, cost figures can be determined for these areas. The use of setups in advance (Table 2) will allow an easy comparison between options and between different versions of the same option.

There are several approaches that can be used to evaluate the financial advantages or disadvantages of the two options. As noted, the present value technique is used here.

A break-even point on after-tax cash flows is assumed in order to eliminate perceived bias to either approach. The present value method of the cash flow differences shows an insignificant advantage to the service provider. It is our intent to concentrate on the methodology, not the results.

The capital investment requirements are summarized as follows. The remaining 20% will be financed internally. Depreciation, which is not a cash item, is excluded from the computation of operating expenses. The next step is to assume a tax rate, which should be the federal rate, adjusted for tax benefit of state taxes. We have used 40% for simplicity. The after-tax cash flow is computed by using a 60% factor (100% - 40%) times the pre-tax operating expenses. This after-tax cash flow is reduced for the tax benefit of tax depreciation and increased in the first year for the 20% internal financing. An additional cash flow adjustment is made for each year’s principal payment on the debt. This results in the after-cash flows associated with owning the equipment.

The outsourcing or service contract is assumed to be a flat monthly fee adjusted for inflation covering the same items used in the purchase option. The contract fee is converted to after-tax cash flows by applying the after-tax factor of 60%. The difference between these two cash flow streams could be either positive or negative. The value in today’s dollars can be determined by computing the present value of these differences.

FIGURE 1: Cash flow for the two financing options by year.

The cash outflow for the two financing methods is shown in Figure 1. Capital cash flow fluctuates due to the purchase of membranes at various times during the life of the project.

Table 3 shows some of the calculations necessary to perform the evaluations. As can be seen, there is no cost or savings between the two scenarios. Again, it is the method of evaluation which is important here.

Table 4 shows a summary of cash flow by year alone. When all of the savings and costs are added up, the sum is zero.

EXAMPLE: St. Laurent mill. Saint Laurent Paper Products Corp.’s West Point, Va., facility (formally Chesapeake Paper Products Co.) is a turn-of-the-century pulp and paper mill. The mill produces hardwood, softwood, and secondary fiber pulps used in linerboard and kraft papers. Two black liquor recovery boilers and four power boilers provide process steam. As is typical in a pulp and paper mill, about 60% of the steam condensate is returned for use as boiler feedwater. The remainder of the boiler feedwater is produced by processing water from mill operated wells. Historically, the treatment of the water consisted of strong acid cations, vacuum decarbonation, strong base anions, and polishers (mixed bed and split bed demineralizers). The average boiler feedwater production rate is 1,000 gal/min.

There are several issues that drove the mill to look for alternative methods for producing water. The price and use of the regenerant chemicals (sulfuric acid, sodium hydroxide) had increased steadily in recent years. Speculation was that caustic prices would continue to rise. The mill also has a regeneration neutralization system with insufficient capacity, which would cause a shortage of boiler feedwater. About half of the feedwater treatment plant’s capacity consisted of aged demineralization equipment. Replacement for this equipment was expected to occur in the five- to ten-year time frame and would only have a minor effect on the neutralization system.

In 1993, the process of developing and evaluating options was initiated by power plant supervision. At the time, the major issue was the need to increase the ability to effectively neutralize the feed water plant’s effluent. Two different solutions were identified: (1) increase the size of the neutralization system, or (2) reduce the use of acid and neutralization requirements were reduced. In order to evaluate the two different courses of action, detailed financial options were developed in advance. Four different options for analysis were defined: (1) do nothing (not really an option), (2) expand the neutralization system (base for the entire study), (3 & 4) install a new reverse osmosis system located in front of the present demineralizers. By installing this equipment, the number of regenerations would decrease and thus the total amount of neutralization needed would decrease. Two different cases were studied: a capital project and a service contract.

All four of the options were compared using the present value technique outlined in this article. The first option, to do nothing, was going to cost approximately $1,000,000 more than the reverse osmosis options. The cost to increase neutralization was approximately $1.75 million above the reverse osmosis options. Therefore, installing the reverse osmosis system in front of the present demineralizer system was the most economical choice.

Next, a decision had to be made whether to fund the project through capital expenditure or to outsource the project to an outside service provider. The present value of the funds involved were essentially equal in both options. At this stage of evaluation, other items were introduced into the equation. As noted earlier, this included the alternate use of capital cost and availability of funds, in addition to corporate strategy. The corporate philosophy was to delegate capital funds to core business areas, such as paper machines and items directly associated with making paper. Non-core areas should be carefully studied for the possibility of outsourcing the function. The decision was made to outsource the water treatment to a service provider. In the long run, this option was the most economical for the mill. The next step was the evaluation of the service providers. Better technology was the main criteria, which drove the decision on the choice of service provider. The 1,200 gpm system was installed in the fall of 1997.

Mr. Istre and Mr. Temple are with Ecolochem. Inc. Mr. Frost and Mr. Fertig are with St. Laurent Paper Products Corp., West Point, Va.