Civil Penalties and the Economic Benefits of Noncompliance: A Better Alternative for Attorneys Than EPA's BEN Model

by Philip Saunders Jr.

Dr. Saunders is a consultant in economics and finance based in Weston, Massachusetts. He has over 20 years experience providing analytical and business evaluation services to financial institutions, government agencies, and attorneys. He has a B.A. from Yale University and a Ph.D. from the London School of Economics.

[22 ELR 10003]

My object all sublime

I shall achieve in time —

To make the punishment fit the crime.

— Gilbert and Sullivan, The Mikado

Federal environmental laws provide for civil penalties based on a number of factors, including economic benefits, if any, that violators gain from noncompliance.¹ This Dialogue describes how penalties based on the benefits of noncompliance are determined; explains how and why benefits gained (and therefore penalties incurred) can vary substantially from organization to organization and may be significantly miscalculated when based on standardized assumptions; and demonstrates the importance to the attorney, whether representing the plaintiff or defendant, of having a financial analysis performed specifically on the violating organization.

Environmental statutes that provide for penalties based on the benefits of noncompliance are the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA or Superfund),² the Federal Water Pollution Control Act (FWPCA),³ the Clean Air Act,⁴ and the Emergency Planning and Community Right-to-Know Act (EPCRA).⁵ The statutory objective is not only to penalize but to remove any economic incentive for noncompliance.

Civil penalties are also provided for in the Federal Insecticide, Fungicide, and Rodenticide Act (FIFRA),⁶ the Resource Conservation and Recovery Act (RCRA),⁷ and the Toxic Substances Control Act (TSCA).⁸ These three statutes do not specifically require that benefits of noncompliance be taken into account in assessing penalties. However, it is the Environmental Protection Agency's (EPA's) policy "that penalties generally should, at a minimum, remove any significant economic benefits resulting from failure to comply with the law."⁹

Inspecifying penalties based on economic benefits gained, Congress did not prescribe how the benefits were to be calculated. Congress left it to EPA and, ultimately, the courts to determine the methodology used, the identity of the benefits, and how the benefits are measured; each can make substantial differences in the benefit calculations and therefore in the penalties sought and awarded or negotiated. The methodology chosen by EPA is embodied in its computer model, BEN, which is used to calculate economic benefits of noncompliance.¹⁰ Attorneys for both plaintiffs and defendants need to be aware of the issues involved in calculating economic benefits, the deficiencies of EPA's model, and the use EPA makes of the model. With that awareness, attorneys can insure that the appropriate economic and financial analyses are performed and that any penalties assessed are appropriate — appropriate in the sense that they fit the economic circumstances of the case.

The defense attorney in particular needs to focus on any benefits analysis that is a basis for penalties because EPA has taken a relatively aggressive posture in assessing civil penalties. "The first goal of penalty assessment is to deter people from violating the law…. . If a penalty is to achieve deterrence, both the violator and the general public must be convinced that the penalty places the violator in a worse position than those who have complied in a timely fashion."¹¹

The "object all sublime" is not to make the punishment fit the crime so much as it is to encourage compliance. Therefore, erring on the high side in assessing penalties is [22 ELR 10004] evidently seen as less of a problem than underestimation. Since benefits estimates by EPA frequently are starting points for settlement negotiations with violators, EPA, as shall be apparent in the discussion below, uses assumptions in the BEN model that may be appropriate for some violators but that will inevitably produce penalties in excess of the actual benefits of noncompliance in most cases. The burden of making sure that the damage assessments are correct and, if they are not, demonstrating what they should be, falls to the defense attorney and his or her expert.

Direct Benefits of Noncompliance

To date, most, if not all, benefit-related penalties have been based on direct benefits of noncompliance. Direct benefits, for the most part, are savings from not having spent money on compliance in the conduct of an otherwise legitimate business. An example would be failure to install and operate treatment equipment to raise the waste water from a pulp mill to the required level of purity before discharging it into a navigable waterway. The violation stems not from being in the business of processing logs into paper pulp but from the failure to conduct the business in accordance with law. The remedy is not, in most cases, to close down the pulp mill. It is to make the necessary changes so that the pulp can be manufactured legally.

Direct benefits arising from noncompliance can be the savings to the violator from not having made various expenditures associated with compliance: (1) capital expenditures less subsequent tax savings from depreciation (e.g., for pretreatment plant and equipment); (2) one-time non-depreciable expenditures (e.g., for land acquisition, site surveys, testing); and (3) ongoing operations and maintenance expenditures (e.g., for operation of the plant and equipment, monitoring, reporting).

Another source of direct benefits can be the profits or other benefits accrued from having conducted an activity that is itself illegal (e.g., manufacturing or distributing a prohibited pesticide). The remedy is not to change the manner in which the activity is being conducted; the remedy is to cease performing the activity. EPA policy recognizes that "[t]o adequately remove the economic incentive for such violations, it is helpful to estimate the net profits made from the improper transactions…."¹² In practice, however, EPA focus has not been primarily, if at all, on recapturing profits but on stopping the illegal activity. Estimation of profits from a product, project, line of business, or activity, particularly in a multiproduct firm, is a more complex task than can be handled with a simplified analytical tool such as the BEN model. Also, the overall penalty, both fines and having to go out of business, can be sufficiently draconian that the issue of calculating benefits enjoyed by the violator can become moot.

Direct benefits may be retained within the organization; alternatively they may be passed on the customers in the form of lower prices. Either way they may produce indirect benefits in terms of product enhancement, increased market share, or other factors that affect profitability. Indirect benefits are discussed briefly later in this Dialogue.

Determining Direct Benefits: The Conceptual Framework

Penalties are typically assessed against an ongoing organization that receives an order from or enters into a settlement with EPA under which the violations cease. The violations and the resulting benefits to the violator are only temporary. To value the direct benefits of noncompliance one compares two courses of action: delayed compliance, which is what actually happened, and on-time compliance, which is what would have happened had compliance been timely and there had been no violation. The methodology for analyzing and comparing the two courses of action, thereby calculating benefits from noncompliance, relies on standards financial practice for evaluating alternative projects or courses of action.¹³ The methodology is also embodied in EPA's computer model, BEN.

The analysis requires two streams of after-tax cash flow. One stream consists of all the expenditures that have been and will be made in complying with the law: the delayed compliance stream. The other stream consists of all the expenditures, past and future, that should have been made had compliance been timely and there had been no violation: the on-time compliance stream. To the on-time compliance stream can be also be added, if the activity is illegal, any after-tax profits from conducting the activity after the initial date of noncompliance.

Both the on-time and the delayed compliance cash flow streams may contain capital, one-time nondepreciable, and ongoing expenditures. The capital expenditures occur in one or more of the earlier years and are depreciated over their tax lives, producing tax savings (i.e., negative cash flows in the stream of expenditure). The capital expenditures are repeated at intervals as the plant and equipment is replaced. Each interval equals the estimated useful life of the equipment. Each replacement is, of course, followed by a new stream of depreciation and tax savings.

The ongoing expenses occur annually in the expenditure streams; the one-time nondepreciable expenditures obviously occur only once; both are reduced by tax savings. It is generally assumed that there are no technological or other changes, that the same capital investments are made at each reinvestment interval, and that the same operating functions are performed each year, in perpetuity.

Two refinements are made in each stream, having to do with inflation and taxes. All expenditures are adjusted for inflation so that they reflect the dollar amounts it is estimated that the purchased items or services would cost in the years in which the expenditures are made. Tax rates are varied by year to take account of the presence or absence of the investment tax credit and changes in the marginal corporate tax rate over time. The on-time stream of cash flows starts when the violations began (the noncompliance date). The delayed-compliance stream starts when compliance is achieved (the date of compliance). Both streams continue forever.

In comparing the two cash flow streams two characteristics stand out. First, for the years of noncompliance, the cash flows, in the aggregate, of the on-time stream will always be larger than the cash flows, in the aggregate, of the delayed compliance stream (obviously, since the delayed [22 ELR 10005] compliance cash flows in the noncompliance years are zero).¹⁴ Second, the expenditures after the date of compliance will, in the aggregate, almost always be higher in the delayed-compliance stream.¹⁵

By not complying, the violator has, in the early years, the use of money that would otherwise have been spent on compliance. However, delayed compliance costs more later on. The differences in the aggregate between the two streams of cash flow (on-time minus delayed compliance expenditures in each period) are positive in the early years and negative once delayed compliance begins. These differences can be thought of as an interest-free loan that the violator enjoys in the noncompliance period and pays back in the post-compliance period. The benefit gained depends on what use the violator made of the proceeds of the loan — what activities the violator was able to perform or avoid.

To determine a benefit or savings and assess a penalty one must reduce the cash flows to a single number at the date on which the penalty is to be paid. The amount of the penalty is the difference between the values of the cash flows as of the penalty date. The reader can visualize the penalty as the difference in value to the violator of two courses of action (i.e., the difference on the penalty date in the values of the two cash flow streams), or the reader can think of the penalty as the value to the violator of the interest free loan (i.e., the value on the penalty date of the differences between the two cash flow streams). The mathematical result is the same.

The values are then computed by compounding, at some interest rate, all past cash flows forward to the penalty date and discounting, at some interest rate, all future cash flows back to their present value as of the penalty date.¹⁶ All that is needed are the cash flow streams and one or more rates of interest.

While the methodology may be standard, there is less agreement on what the inputs to the calculations to execute the methodology should be. For example, creating the cash flow streams requires making assumptions about the rate of inflation that applies to capital expenditures and other costs. BEN uses McGraw Hill's Chemical Engineering Plant Cost Index, which, although a valid general price index, may or may not correspond to the prices faced by the violator for either capital costs or for operating expenses.¹⁷ Where there are substantial penalties involved, the attorney should at least have prices specific to the organization tested to see whether they produce measurably different results from standard industry indices.

A bigger area of difference in opinion and in impact on the results arises in selecting the rate or rates of interest for compounding and discounting the cash flows. The selection of these rates is the primary focus of the rest of this Dialogue.

Interest Rates

The significance of the choice of the rate of interest is both theoretical and practical. The theoretical significance is that the rate provides a measure of the value to the violator of having the use of the funds that would otherwise have been spent on compliance. Therefore, the appropriate rate is the rate on the alternative investment, or use of the funds, made by the violator. The practical significance is that changes in the rate can make dramatic differences in the penalties.

For instance, a penalty due in 1991 on $ 100,000 saved through noncompliance in 1986 would be $ 127,628, if the money had been invested in the interim at a five percent rate of return, but $ 201,136 if invested at 15 percent. For penalties due from past noncompliance there is an offset from any anticipated negative cash flow in future years caused by the delayed compliance cash flow exceeding the on-time cash flow.

If the anticipated negative cash flow in some future time, say 1996, is $ 100,000, its present value in 1991 is $ 78,353, using a discount rate of five percent, but only $ 49,718 at a 15 percent discount rate. Thus the net penalty in the 15 percent scenario is $ 151,418 ($ 201,136 of current value of past benefit minus $ 49,718 of present value of future negative cash flow). This is triple the $ 49,275 ($ 127,628 minus $ 78,353) net penalty in the five percent scenario.

BEN, correctly, uses the rate of return on the alternative investment for compounding and discounting. However,

BEN assumes that the violator invested the net economic benefit in plant and equipment similar to the violator's existing investment risk and financing. In addition, because … [EPA] … assumes that the violator is an average company, BEN applies the average rate of earnings that [22 ELR 10006] equity holders expect over the long-term [sic] from investing in a firm of average market risk.¹⁸

No justification is given for the use of the equity return as opposed to the average return on all the organization's assets or the return on any individual asset, group of assets, or project. Further, the model uses a 10-year average cost of equity rate for the capital markets (around 18 percent in the examples given), instead of making the rate of return organization-specific or even industry-specific.¹⁹

Whatever the theoretical justification for using the equity return, the choice has the practical advantage from an enforcement point of view of producing high penalty estimates. "In general, the BEN computer model is used for calculating economic benefit for purposes of developing a settlement penalty."²⁰ It appears that at least one of the functions of the high equity rate is to establish an aggressive bargaining position for EPA going into negotiations.

Another writer has argued a contrary view concerning the interest rate, namely that the appropriate rate is not the rate on the alternative investment, but rather that (1) the appropriate rate for discounting the cash flow streams is the rate of return earned or expected to be earned by the compliance expenditures, and (2) the appropriate rate for compounding past benefits of noncompliance forward to the penalty payment date is a risk-free rate of interest, such as the Treasury bill rate.²¹

With respect to the first point, it is true that according to standard financial theory, the rate used to discount any stream of expenditures should be the rate of return earned or expected to be earned by the expenditures. The problem with this approach in the present context is that for purposes of determining noncompliance penalties, the compliance expenditures and any return thereon are not of interest in and of themselves; they are merely measures of the funds available for some alternative investment to the extent that they are not spent on compliance. It is the rate of return on the alternative investment that determines the benefit gained from noncompliance.

There is also the practical problem that it is not at all clear what the rate of return is on environmental expenditures. Compliance does not generate any direct economic benefit to the organization in the normal sense.²²

The second point, that past benefits of noncompliance should be compounded to the penalty payment date at a risk-free rate, is drawn from litigation damages theory. However, as EPA has correctly pointed out, "In BEN, we are calculating the economic benefit a firm gained. This is not a 'damages' calculation."²³

In a normal tort case the objective of assessing damages is to compensate the plaintiff for injuries suffered. Whether or not the defendant reaped any benefits from causing the injuries is generally irrelevant. There is usually no reason to focus on benefits to the defendant. Conversely, under the environmental statutes the purpose of valuing benefits accrued from noncompliance is specifically to deny the benefits of noncompliance to the violator, not to compensate for damages; any damages are irrelevant to the calculation. Besides, to the extent that damages per se are a basis for penalty assessment, they are captured in the gravity component of the penalty criteria.²⁴

Alternative Investments

The benefit gained from noncompliance is based on the alternative use to which the funds are put. The rate or rates for compounding or discounting the two cash flow streams (on-time compliance and delayed compliance) are the rate, or rates, of return on the alternative investments. The alternatives, and therefore the interest and discount rates, benefits, and penalties, will be different from organization to organization. There is no general presumption that the same alternative is available, feasible, desirable, rational, or a likely choice for every organization. The attorney who accepts an analysis and a penalty based on a generalized, theoretical, or industry average interest rate may be giving up substantial dollars in penalties. A closer organization-specific analysis by a financial expert is necessary to determine the appropriate rates, benefits, and penalties.

This section examines hypothetical examples to demonstrate the points that rates of discount can vary widely from one alternative investment to another and that they should be analyzed separately from organization to organization.

Example 1: An organization that is cash rich during the noncompliance period would not have to raise equity capital or borrow funds to make the compliance expenditures. The organization might merely run down its cash and short-term holdings.

The benefit gained from noncompliance is, then, the ability to continue investing in short-term investments, and the appropriate rate of return is one or more short-term interest rates over the noncompliance period. Short-term rates normally, and at this writing, are several percentage points below long-term financing rates and even further below equity rates. Therefore, the organization that merely used the noncompliance funds for short-term money market investments will accrue a substantially lower benefit, and penalty, than an organization putting the funds to a higher-return use, especially a use that had an equity rate of return.

A caveat should be kept in mind by the attorney reading a balance sheet and determining that an organization had a large cash and short-term account relative to the amount of funds required for compliance. The cash and short terms might not have been in excess of operating needs; they might have been there for specific purposes, such as compensating balances, meeting seasonal cash flow needs, collateral [22 ELR 10007] for letters of credit, or funding multiple operating accounts.

Example 2: Another alternative is that the organization might have had to raise capital to fund any compliance expenditures. In this case the benefit gained from noncompliance is avoidance of the financing costs. Those costs will depend on how the organization would likely have raised the capital. Relevant factors to be examined include those specific to the organization, such as its size, profitability, prospects, amount of capital being raised, management and financial philosophy, visibility in the capital markets, banking and investment banking relationships, existing financing, capital and debt structure, credit rating, type of ownership whether public or private, and other then current and prospective capital requirements, to name a few.

Then there are industry-specific factors, such as prevailing and prospective business conditions in the industry and how the capital markets viewed the industry at the time. There are also capital market factors, such as levels of interest rates, relationships between short-term and long-term rates (shape of the yield curve), and cost and availability of capital from various sources (e.g., short-term bank borrowing, factoring, long-term secured or subordinated debt, debt with equity participation, public equity, venture capital, private backers).²⁵

Example 3: Example 3 presents the possibility that the compliance funds would have been raised by elimination of some other project (e.g., a new product, a capital expansion, retooling). Since the alternative project will already be some years old at the time the attorney is having the analysis performed, there will be some history on the project and therefore some evidence as to what the rate of return has been and is likely to be. If the project has a long-term payoff, extending well beyond the time at which the analysis is being performed, the prospects for that rate of return need to be taken into account in estimating the rate of return in the noncompliance years. It would be ingenuous to consider only the returns in the start-up years in assessing the benefit gained by the organization. Consideration should be given to using the project's projected return, adjusted for performance to date in terms of such factors as whether there have been schedule changes, cost overruns, and changes in the need for the project.

The estimated project return could be very high (producing high penalties) if the project is very successful, or the return could be very low (producing low penalties) if the project is a dud. Conceptually, if the organization lost money on the project, the return (and hence the penalties) could be negative, although EPA making payments to violators for negative benefits is presumably not what Congress had in mind.

Example 4: Yet another possibility is that the organization, had it complied, would have raised the funds by cutting back on a whole range of activities, making the organization lean and mean. The history of the 1980s was the leaning of corporate America. Companies found they could do without functions previously thought to be necessary (e.g., layers of management, institutional advertising, staffs, health benefits without copayment, executive perks, marginal or money-losing lines of business previously tolerated for historical or defensive reasons). To some extent the process has also gone on in some government and nonprofit organizations. Instead of spending on compliance, the violator may only have used the funds to avoid the leaning process and continue to carry the old costs. Since these extra costs may have had little or no benefit to the organization, the associated rate of return (and penalties) may be minimal.

While the above four examples are not even remotely exhaustive of the possibilities, they do demonstrate the variety of possibilities for alternative uses and investments for noncompliance funds.

Moreover, the possibilities are not mutually exclusive. Indeed it is highly likely that more than one alternative use of the funds may have been made by the violator. Because the cash flow streams may contain a mixture of initial capital expenditures, one-time nondepreciable expenditures, tax savings from depreciation, and ongoing expenditures, the cash flows are not likely to be uniform from period to period. A large capital expenditure in one period might have justified a bond issue whereas several much smaller regular expenditures might have been accommodated as part of normal operations. In this case the alternative uses of the funds available due to noncompliance would be avoidance of a bond issue plus cutting back on some expenditures in other parts of the operation. With more than one alternative use there will be more than one cash flow stream (or to put it another way, the on-time and/or the delayed-compliance cash flow streams may each be broken up into one or more separate cash flow substreams), each associated with a different alternative use and each with its own set of interest rates.

The only way to know the alternative uses of the funds made available by noncompliance is to examine the organization and determine what would have been possible, feasible, economically rational, and likely for the organization to have done to produce the necessary funds, had they decided to comply.

Single Versus Multiple Interest Rates

So far we have discussed alternative investments and rates of return as if there were a single rate of return associated with an alternative investment, or use, for the funds that might otherwise be used for compliance. Actually, multiple rates may be appropriate. Before discussing multiple rates it is important to make a distinction between expenditures that were made, or might have been made, in the past and expenditures in the future. Past rates of return used to compound past expenditures to the present are facts of history. It is realistic to talk of different rates in different past years when the rates are known.

Future rates of return, used to discount future expenditures back to the present, are not known; they can only be projected. One may reasonably suppose that rates in the next few months may be within a certain range. One may make assumptions about average rates in the future. We may have information on some future rates because commitments have already been made or money borrowed. Generally, however, there is little or no basis for postulating how rates in one distant future period will differ from rates in any other future period; they almost certainly will be different, but no one knows how. As a result, for discounting over [22 ELR 10008] long periods of future time, single discount rates typically are used.

Analysis of the violating organization in the period of noncompliance may well reveal that multiple rates are in order. For example, if the organization's alternative use of funds was investment in short-term securities, there will be a record of the returns on those securities, and the individual rates in each time period can be used to compound the on-time compliance cash flow stream to the penalty payment date. The funds for delayed compliance may come from short-term investments, in which case the future rate of return, and discount rate, could be the average short-term interest rate expected over the long term. Alternatively, circumstances may have changed; the short-term investments may no longer be considered surplus funds or may be liquidated to meet other needs; the organization may have to borrow long term to pay for delayed compliance. In this case several short-term rates would be appropriate for the past, noncompliance period, and a long-term rate would be appropriate for discounting the future expenditures.

Indirect Benefits

We have discussed the penalties and interest rates associated with direct benefits to the violator. The direct benefits may be used within the organization or passed on to customers, producing various kinds of indirect benefits.

Possible uses within the organization include higher dividends, capital investments, research and development, advertising, financial investments, reduction of debt, and higher employee compensation, to name a few. Depending on the use of the benefits, the circumstances of the company, the magnitude of the benefits relative to company finances, and the external environment, the direct benefits may produce indirect benefits, such as modernization of facilities, new products, higher employee retention, higher stock price, opportunity to make acquisitions, or attractiveness as a merger candidate. These indirect benefits may or may not enhance the organization by increasing its attractiveness to investors, enhancing its products, and/or lowering its cost structure. When the direct benefits are passed on to the customers in lower prices, the indirect benefit could be increased competitiveness and market share, depending on the price sensitivity of the market for the organization's products, the degree of competition in the industry, the organization's position within the market, and the reactions of competitors.

Even this cursory discussion of indirect benefits makes several points apparent. First, generalization about indirect benefits is very difficult; the existence and magnitude of such benefits will vary substantially from violator to violator and from industry to industry. Second, quantification of the benefits would be complex. Third, because of the difficulty and complexity of the subject, attempts to quantify indirect benefits, and the related penalties, would be a fruitful source of litigation, justified only in large cases, where potentially substantial penalties were involved.

Conclusion

To encourage compliance with the environmental statutes, it is the intent of Congress and EPA to assess penalties that take away from the violator any economic benefits gained from noncompliance. The benefits exist because the violator, in the period of noncompliance, has use of the funds that would otherwise have been spent on compliance.

While the methodology for estimating the benefits of noncompliance is fairly standard, the estimates produced can vary widely depending on the alternative use by the violator of the funds available from noncompliance. Standard assumptions about alternative uses may substantially misstate the benefits and associated penalties. It is up to the attorney, whether representing the plaintiff or defendant, to make sure that a financial analysis of the offending organization be performed to determine the actual alternative uses and the correct penalties.

Those in search of a simpler world will argue for standard assumptions about alternative uses and rates of return. As first approximations, standardized assumptions are useful. They may also be the only practical alternatives in small cases where the potential penalties do not justify detailed analysis of the violating organization. However, where tens of thousands of dollars or more in penalties are at stake, the attorney ignores the specifics of the organization at the peril of the client's pocketbook.

1. The terms "benefits" and "benefits or savings" are used variously in the statutes. Since a savings can be a kind of benefit, the two are economically equivalent.

2. CERCLA § 109(a)(3), 42 U.S.C. § 9609(a)(3), ELR STAT. CERCLA 031.

3. FWPCA § 309(d), (g)(3), 33 U.S.C. § 1319(d), (g)(3), ELR STAT. FWPCA 040.

4. Clean Air Act §§ 113(e), 120(d)(1)(A), 205(b), (c)(2), 42 U.S.C. §§ 7413(e), 7420(d)(1)(A), 7524(b), (c)(2), ELR STAT. CAA 51, 56, 107.

5. EPCRA § 325(b)(1)(C), 42 U.S.C. § 11045(b)(1)(C), ELR STAT. EPCRA 011.

6. FIFRA § 14(a), 7 U.S.C. 136l(a), ELR STAT. FIFRA 024.

7. RCRA § 3008(a)(3), (g), 42 U.S.C. § 6928(a)(3), (g), ELR STAT. RCRA 021.

8. TSCA § 16(a), 15 U.S.C. § 2615(a), ELR STAT. TSCA 026.

9. EPA, POLICY ON CIVIL PENALTIES (Feb. 16, 1984), ELR ADMIN. MATERIALS 35083 (emphasis in original).

10. BEN stands for economic benefit. See EPA, BEN: A MODEL TO CALCULATE THE ECONOMIC BENEFITS OF NONCOMPLIANCE, USER'S MANUAL (June 1990). See also Libber, Penalty Assessment at the Environmental Protection Agency: A View From the Inside, NAT'L ENVTL. ENFORCEMENT J., Apr. 1991, at 3.

11. EPA, supra note 9.

12. EPA, A FRAMEWORK FOR STATUTE-SPECIFIC APPROACHES TO PENALTY ASSESSMENTS: IMPLEMENTING EPA'S POLICY ON CIVIL PENALTIES (Feb. 16, 1984), ELR ADMIN. MATERIALS 35076.

13. See, e.g., R. BREALEY & S. MYERS, PRINCIPLES OF CORPORATE FINANCE (3d ed. 1988).

14. The qualification "in the aggregate" is necessary because it is entirely possible that in some years after the initial investments and one-time costs have been incurred the expenditures will be negative due to depreciation-related tax savings.

15. The unusual exception would occur if there were no one-time costs, the useful life of the capital investment exactly coincided with the period of noncompliance, and tax rates were the same in each period. In this case the post-compliance cash flow streams would be the same for both the on-time and the delayed cases.

16. Compounding is the process of increasing an amount periodically by the interest earned during each period, so that the increase in the next period represents interest not only on the original amount but interest on the previously earned interest as well. Compounding is what happens to money left at interest in a bank account, assuming, these days, that the bank is solvent. A dollar received today is worth more than a dollar received yesterday, and the difference is the amount the dollar could have earned at compound interest in the interval.

Discounting is the reverse of compounding. It is the process of placing a value on a future amount. The present value of a future amount is the sum that, when compounded at a given interest rate over a given period of time, will increase to the designated future amount. The price of a CD today is the present value of the amount for which the bank will redeem the CD at maturity.

To calculate the present value of a stream of future cash flows one calculates the present value of each payment and then adds up all the separate present values. The balance of a mortgage loan is the present value of all future interest and principal payments necessary to pay off the mortgage. Similarly, to calculate the current value of a stream of past cash flows one calculates the current value after compounding of each payment and then adds up all the separate current values. The balance in an interest-bearing payroll savings account from which no withdrawals have been made is the current value of all previous deposits including compound interest.

The higher the interest rate the higher the current value of any past payment. Similarly, the higher the interest rate the smaller the present value of any future payment.

EPA's BEN model actually handles the compounding and discounting slightly differently, but the results are the same as long as only one interest rate is used. BEN discounts both cash flow streams back to present values on the noncompliance date, subtracts the delayed compliance present value from the on-time present value, and compounds the difference forward to the penalty payment date, using the same interest rate for both the discounting and the compounding.

17. EPA, BEN: A MODEL TO CALCULATE THE ECONOMIC BENEFIT OF NONCOMPLIANCE, USER'S MANUAL (June 1990), at III-8.

18. Id. at A-I-7.

19. Id. at III-30, IV-11, IV-15.

20. Id. at I-1 (emphasis in original).

21. Fuhrman, The Role of EPA's BEN Model in Establishing Civil Penalties, 21 ELR 10246, 10249-50 (May 1991).

22. At best, the benefit from compliance is avoidance of further penalties. Following this logic, the net cash flow for an investment of funds in compliance would be the anticipated stream of penalties to be avoided in each period minus the necessary compliance expenditures in each period. If the anticipated penalties were very high relative to the expenditures, the interest rate would be enormous. Indeed, if the penalties exceeded the compliance expenditures in every period, the rate of return would be infinite.

It is simpler to regard compliance as a cost of doing business embedded in a larger set of costs related to a project, product line, department, or organization. If the rate of return on the compliance expenditures was relevant for the calculations, which it is not, one would probably have to use the return on the assets of the larger unit (e.g., the project or organization).

23. EPA, supra note 17, at A-I-1.

24. See supra notes 2-8.

25. For a theoretical discussion of long-term financing and the related decision process, see L. GITMAN, M. JOEHNK & G. PINCHES, MANAGEMENT FINANCE (1985), at 697-934 (pts. 6-7).