CAPITAL BUDGETING

CAPITAL BUDGETING

Capital expenditures purchase physical assets to provide future services

Yields benefits in future without having to repeat purchase

Public capital assets also called infrastructure

Are inputs into production of public and private goods and services Streets, highways, water and sewer systems, airports

Public capital stock matters for production of public and private goods and services

Capital expenditures can be budgeted together with operating expenditures or separately

CAPITAL BUDGETING

Reasons Capital Expenditures merit special attention Capital asset decisions have future impact and thus merit extraordinary care

Capital Assets usually have a high price tag and the purchases impact government finances

Capital asset purchases occur at irregular intervals and need special attention to schedule

WHY HAVE SEPARATE CAPITAL BUDGET PROCESS Separate consideration can improve efficiency and equity of providing

and financing non-recurrent projects with long term service flows Pay as you go or pay as you use financing

Operating budgets pay as you go, Capital budgets are financed

Allows concentration on service delivery in the future with available annual funding

Special treatment of Capital expenditures can stabilize tax rates when large Capital projects could destabilize tax base Large projects could significantly effect tax rates

Recurring capital can be financed from operating

WHY HAVE SEPARATE CAPITAL BUDGET PROCESS Special reviews of Capital expenditures are appropriate because capital

projects are permanent(Mistakes will be around a long time)

Special reviews of Capital expenditures provide valuable tools for dealing with limited resources Smooth's out peaks and valleys

Regularizes construction activity

Avoids excessive drains on tax base

Balance spending within resources available

WHY HAVE SEPARATE CAPITAL BUDGET PROCESS American governments are mixed with regard to separate capital budgets Reasons for supporting separate capital budget is stronger for state and local

governments Fear separate Capital budget would add to bias of Federal Government for deficit

financing

Federal government is so large no single capital project will influence tax rates

Federal Government does not need careful planning of capital purchases to preserve debt rating

Another budget would allow another way to conceal fiscal conditions

Outlays that yield long-term benefits are included in separate section(Analytical Perspectives)

Federal Budget no separation between operating and capital expenditures

A PROCESS FOR MANAGING CAPITAL EXPENDITURES Planning

Inventory of Capital assets Age

Assessment of condition

Degree of use

Its capacity

Replacement cost

After inventory a catalogue of infrastructure projects can be developed(CIP)

Project list screened and priorities are developed

A PROCESS FOR MANAGING CAPITAL EXPENDITURES Planning

Priority systems Functional areas

Problem severity

Status of support(legislative , Agency)

Formal scoring system based on ranked criteria

Some criteria Fiscal impacts

Health and safety effects

Economic effects

Feasibility in terms of support

Implications of deferring projects

Disruption and inconvenience caused by project

A PROCESS FOR MANAGING CAPITAL EXPENDITURES Planning

Priority scheduling especially concerned with scheduling Projects scheduled to avoid waste( water line before street work)

Predetermined program emphasis's should be implemented

Review linked to long-term master plan

The Capital program ordinarily developed in agencies but with central instruction, oversight and coordination

An annual update of CIP is necessary

A PROCESS FOR MANAGING CAPITAL EXPENDITURES Budgeting

The government must keep its infrastructure development within its financial capacity Includes number of factors

Financing costs

Future operating costs

Revenues produced by facilities

Revenue capacity of government

The process includes a financial analysis of government operations with facilities envisioned in Capital Plan

The Capital component of the Budget must be prepared to be transmitted either in a separate Capital Budget or a unified Budget

A PROCESS FOR MANAGING CAPITAL EXPENDITURES Budgeting

The projects surviving cuts become Capital section of annual budget Total government expenditures include both operating expenditures from operating budget

and Capital purchases from Capital budget In a comprehensive budget the revenue that must be generated in any year equals

operating Budget plus any Capital component(Debt Service)

Implementation/Execution Rules under which contracts are executed(bidding) Controls to keep projects on schedule Monitoring to keep cost within Budget System for keeping Inventory current

Audit-Usually part of normal audit process and cycle Important due to size of expenditures

PROBLEMS IN CAPITAL BUDGETING

Assumes a continuous cycle of reappraisal and reevaluation of project proposals

Availability of funds can alter decisions Projects with earmarked funds receive higher priorities

Donor may impact decision

Capital Budgeting can unduly and uneconomically favor use of Debt Service financing(some capital purchases should be made from current revenues)

Establishing priorities(Cost Benefit analysis)

ACCOUNTING FOR TIME:DISCOUNTING AND COMPOUNDING Discounting and compounding are building blocks of Financial analysis

Discounting allows comparison of costs or benefits on Present value basis(converting stream of costs or returns in time to a single present value, TIME VALUE OF MONEY)

Compounding Principal plus accumulated interest is allowed to accumulate and is reinvested

FV1= PV+PV*r(r= rate of interest, PV= the present amount, FV1= original principal)

Each passing year the increase becomes greater

Sometimes contract call for increase more that once a year

ACCOUNTING FOR TIME:DISCOUNTING AND COMPOUNDING Discounting

Adjusts sums to be received in the future to present value equivalent, the amount that will accumulate to that future sum if invested at the current rate

PV=FVn/(1+r)2 Projects yielding dramatically different returns over time can and must be

compared using this method Sometimes compare alternatives by determining what discount rates would

cause present value of projects to be equal(Internal rate of return) Annuity formula

Income stream maybe constant

Annuity formula quicker than present value

Used in Bond pricing

COST BENEFIT ANALYSIS

Provides way of organizing information about a program under consideration so priorities may be reasonably established

Cost Benefit analysis is government analog to that process in private capital budgeting

Whether gain to society is greater than cost

Worthwhile projects direct resources where their use provides greater return than would Alternative uses

Public decision-making is political bargaining( offsets political bargaining)

Cost benefit not limited to complex projects but is useful in decisions about alternative methods of accomplishing tasks

COST BENEFIT ANALYSIS

Five Steps of Cost Benefit analysis Project objectives

Identify project benefits(relationship between project and objective)

New fire station reduces operating costs and fire loss

Water project reduces flood damage and increases water supply

Nothing gained by examination of factors not changed by the decision

Benefit Estimation and valuation Must estimate for the life of the project the physical changes from the project and the

value of those changes

Decision is made from best estimates not facts

Initial step estimates size of projects expected change

COST BENEFIT ANALYSIS

Benefit Estimation and valuation

Models usually used to estimate the change

When projects impact has been estimated the worth of benefits must be gauged

Permits comparison of project costs to project returns and helps establish whether project increases net well being

Valuation approach depends on project but easiest when values can be connected to private market(cost of public transportation against private transportation)

Some projects outputs not linked to goods or services sold in private markets, output desired for its own sake

Consumers surplus-Difference between the maximum price consumers would willingly pay for given amounts of a commodity and the price the market demands for the commodity(could be zero for public services)

Only reasonable evaluation technique for certain public services

COST BENEFIT ANALYSIS

Estimating Project costs Include construction cost and operating cost for life of the project Also includes opportunity costs of sacrifices. Cost is value of paths not taken Three types of cost estimate adjustments based initially on resource purchase

pricesOrdinary project costs include only private and internal costs, not cost of

undesirable impacts Adjustments are appropriate if the project uses completely unemployed

resources or resources for which there is no alternative useMany Public projects utilize property already owned by Government Decisions have to be based on alternatives sacrificed and opportunities

foregone

COST BENEFIT ANALYSIS

Selecting a discount rate

Public projects create a flow of costs and returns that spans several years

Both streams must be converted to present value(Discounting)

Two alternatives for discounting

Cost of borrowed funds to the government

Closest analog to private project analysis

Complicated by factoring reducing interest rates for Governments(low risk and tax exemptions)

The return that could have been achieved in displaced private spending is generally more appropriate for cost benefit analysis

Rate analyst must estimate there is no defined rate

Use weighted average formula

COST BENEFIT ANALYSIS

Decision Criteria

Final stage is to apply decision criteria to discounted cost and return flows to summarize economic case for project

Identify whether project is economically feasible or establish rankings among projects to fit into a limited budget

BCR(Benefit Cost Ratio)-Present value of benefits divided by present value of costs

NPV(Net Present Value)-the present value of Benefits less present value of costs

NPV greater than 0 or BCR greater than 1

Payback period-shorter period more attractive project

Internal rate of return

Seeks the interest rate that would equate the present value of benefits with present value of costs

Rate is compared with discount rate

Present value methods are simpler, safer easier and more direct

COST BENEFIT ANALYSIS

Decision Criteria More difficult if attempting to rank group of projects

In public project analysis difficult questions involve estimating benefits, costs and discount rates. Conflict between criteria seldom is a concern

Choice in most cases whether or not to proceed with project not how to rank a group pf projects

SPECIAL PROBLEMS OF COST-BENEFIT ANALYSIS Multiple objectives

Economic impact may not be sole or most important objective of some programs

Normal cost benefit analysis accepts all portions of the economy as equal, who gains or loses doesn’t matter. Some theoretical justification for this. Changes effecting income distribution are negligible

Public Investment not effective or proper tool for redistribution and other policies can correct any investment related maldistribution over time

Many projects will randomly distribute benefits causing overall effect to average out at no redistribution change

Techniques to deal with the distributional concerns Weight benefits according to societal importance of the recipient

Supplement general cost and benefit totals with tabulation of how costs and benefits are divided among the population

SPECIAL PROBLEMS OF COST-BENEFIT ANALYSIS Valuing projects that save lives

Problems occur when public projects seek to reduce loss of human life Any decisions that deny resources to activities that have lifesaving element have

placed implicit value on life Three techniques proposed to value lifesaving

Average life insurance value outstanding(value of loss on life individuals placed on themselves)

The human capital or earnings-loss methods(present value of life time earnings minus subsistence cost through the work career of individual)

Willingness to pay-What people would pay to reduce risk to life

Cost-benefit analysis must ensure that these evaluations are conscious and consistent. We can hope for little else

CONCLUSION

Public capital infrastructure contributes to both Public and Private production Leaving future generations with depleted Capital is a significant violation of

sustainability Capital Budgeting provides a separate review of capital as opposed to

operating Budgets and establishes a decision-making process concerning development and replacement of long term assets

Capital project involve payments now with flow of services in the future Discounting provides method for converting flows occurring at different times

into a standard equivalent and is important in analysis of debt and investment Cost-Benefit analysis provides technique for organizing information to evaluate

public programs when the resources used are dissimilar from return received from the program

BEST PRACTICES-TOWN OF GILBERT

Infrastructure challenge faced by Gilbert due to growth Creating a strategy

Cross Departmental team formed(Management, Finance, Public Works and Parks)

Revenues important part of discussion-need to determine impact of availability of revenue on financing infrastructure

Need to determine future infrastructure needs

Planning Process Develop an asset inventory

Helps fully understand maintenance costs

Gives opportunity to discuss cost of infrastructure versus value of infrastructure

BEST PRACTICES-TOWN OF GILBERT

Cost refers only to expenditures while value refers to both cost of infrastructure and benefits provided

When considering value one would favor the asset that provided the most service to the public for the expenditures required to acquire and maintain the asset

Inventory gives better understanding about how infrastructure ages as well as conditions that contribute to longer or shorter useful lives for assets. This helps develop future replacement schedules

Discuss acceptable level of service(useful life depending on experience and needs)- Assists with replacement schedule

Determine Revenues available to fund asset upkeep at desired level of service

Enterprise funds-user fees

General revenues such as sales tax

Bond proceeds for specific projects

BEST PRACTICES-TOWN OF GILBERT

Determine Revenues available to fund asset upkeep at desired level of service Use what if models to help analyze resource requests

Weigh proposals for spending on Infrastructure against other potential uses during annual Budget deliberation

Impact of Planning Better link between asset maintenance and replacement needs and forecasted

revenues

Led to better decisions on how to use resources

Effective planning requires making investments in maintenance and repair before replacement becomes necessary-and making those investments consistently over time

BEST PRACTICES-TOWN OF GILBERT

Lessons learned Identify specific Issue-How to support a sustainable infrastructure maintenance and

replacement strategy

Put Forecast in context- Revenue forecast in terms of expenditures needed to provide service to public

Understand details-Details of asset inventory and condition assessment

Help non-financial leaders understand– give audience an understanding of what forecaster knows

Work closely with operational departments

Integrate forecast into decision-making process– The Community vision allows policymakers to see well maintained infrastructure as a necessity

Build forecast to suit planning purpose-Model should provide detail necessary to provide detailed analysis of funding options(Development fees, utility revenues, etc.)

BEST PRACTICES-TOWN OF GILBERT

Lessons learned Be open to new Conclusions

One time investments could be viewed as ongoing maintenance costs

Embarking on a multiyear, multilevel effort to inventory all City-owned infrastructure while forecasting future needs may evolve into other discussions

QUESTIONS ?