Week # 7

Planning and Budgeting

for

Capital Improvements

Defining Capital Expenditures

Capital expenditures are the acquisition of fixed assets,

usually authorized in the capital budget, that includeland, buildings infrastructure and equipment.

Fixed assets can include:

>Infrastructure - streets, sewers, water lines, etc.>Public buildings - courthouses, police station, etc.>Equipment - large & costly items –vehicles, computers, etc>Land acquisition - purchasing/developing land for use.

Capital Infrastructure

Is costly – but necessary

Provides both direct and indirect benefits to business by making production and delivery of private goods and services more efficient.

Are widely recognized as the key to economic vitality and continued prosperity of developed and developing nations.

Two distinctive features about capital budgeting

First ---

Unlike the operating budget - with its emphasis onspending categories (e.g., salaries, supplies, etc),the capital budget shows…

(1) information by project, (2) the source of funding for each project, (3) expected expenditures for a multiyear period.

Two distinctive features about capital budgeting

Second ---

Not all capital expenditures are reported in the capital budget; particularly for less expensiveitems such as office equipment.

Typically, the Budget office sets a cost threshold(e.g., $20,000) and also a live expectancy limit(e.g., three years) to define the capital expenditureitems that will be included in the capital budget.

Another Important Feature pertaining to “Capital Budgeting”

In the private sector, the term capital budgeting refers to analytical techniques used to evaluate the financial merits of alternative investment proposals and the proper mix ofdebt and equity to fund those projects with the greatestreturn on investment.

For example…

Net-Present Value and Cost-Benefit Analysis are used tomake it possible to compare alternative proposals.

NPV versus CBR

Net Present Value is the difference between a project’s future costs and benefits, discounted for the time-value of money.

That is - what is the cost and how much might have been earned if that same sum of money was invested in another project or simply invested.

The alternative with the highest NPV will be selected because it will yieldthe greatest net benefits.

Cost-benefit analysis does the same sort of thing, but as you will recall,this analytical technique uses a ratio of total cost to benefits for eachalternative.

Capital Budgeting in the Public Sector

Capital budgeting in the public sector encompasses a much broader function, including…

The process of reviewing the projects and ranking them in the capital budget document.

Preparing an inventory of capital assets and… - evaluating the condition of those assets,- estimating the cost of their replacement, - preparing a multi-year capital improvement plan (the first year of which constitutes the capital budget).

Organizing the Capital Budget Process

Organizing the capital budget process and document,requires local government managers to resolve thefollowing three issues:

– What governmental unit should have responsibility for preparing the capital budget?

– What should be that unit’s range of duties?

– Should the timing of the operating and capital budget cycles coincide?

Location

The most logical locus is the budget office – but the finance, planning or public works departments are options.

While best located in budget office – development and implementation will require the support and expertise in planning and engineering.

A contract administrator may also be needed.

Location

Related to location is the question “who participates in selecting projects and what criteria are used for deciding on their inclusion in the CIP and capital budget.

Ultimately, political, financial and economic criteria will influence the selection of projects so many jurisdictions use an interdepartmental committee from a cross-section of departments.

Location

Jane Beckett-Camarata, a public finance scholar,found evidence of a beneficial effect on financialperformance when BOTH a strategic planningprocess was used that assessed citizen prioritiesa capital budgeting process.

Note: When both were used there was a positive effect on (1) per capita long-term debt, (2) own-source revenue, and

(3) the general fund balance.

Range of Duties

The unit assigned responsibility for capital budgetingshould have full responsibility for the full range ofmanagerial duties, including …

> managing capital improvements > planning & development > purchase & acquisition > inventorying all current capital assets > evaluating current condition of all assets

Timing – Strengths and Weaknesses

• Completing both the operating and capital budget concurrently can help establish a link between the two budgets and possibly revealhow one might impact the other.

• Completing the budget non-concurrently can evenly distribute the enormous workload associated with developing both budgets and thereby allow staff to conduct a more comprehensive analysis.

• Concurrent preparation is more appropriate if most funding comesfrom the general fund, but if funding comes from dedicated orearmarked funds, then non-concurrent preparation may be moreappropriate.

NOTE: See Page 154 – 155 for a succinct summary of the merits of using a separate budget cycle for capital budgeting

Developing a Capital Planning and Budget Policy

A policy statement should be established to provide financialstandards to guide deliberations for both the executive andlegislative branches.

As a matter of policy, every government should prepare a CIPeven it means integrating both budgets into one unifiedbudget.

All CIP should be governed by policy to ensure the integrity of finance and the budget operations within a jurisdiction.

Turn to Page 156 of the text and review the sample policystatement of San Luis Obispo, California.

Planning for capital improvements

The demand for capital acquisitions far exceeds a government’s capacity to finance them and this makes it necessary to direct funding to the most urgent and highest priorities.

A well-defined method is needed to review and select capital funding requests.

Planning for capital improvements

During planning – proposed capital projects are identified, evaluated, costed, and ranked.

The process is information intensive AND very competitive!

An intradepartmental capital allocation committee is frequently used to ensure all department requests are examined and fairly ranked.

Inventorying Existing Capital Assets

An effective capital budgeting system should begin with an inventory of existing capital assets.

Logically - a determination must be made of the current condition of existing assets before considering the acquisition of new assets.

Repair and maintenance of capital assets is essential – however – new construction may be more appealing for a number of reasons… > politically > tax payer sentiment > cost to repair maintain aging capital assets > economic conditions

Inventorying Existing Capital Assets

Michael Pagano, who authored “Notes on Capital Budgeting”, made the following important observation…

It is far easier for decision makers to eliminatefunding for maintenance and repair becausesuch investments are less visible and lesspolitically sensitive and unlike other budgetreductions, have no immediate repercussionson service delivery.”

Purchase new assets or maintain old assets?

When unfavorable economic conditions exist, decision makers maydelay the purchase of “big ticket” items. However, during such times it is also common for decision makers to reduce funding for repair and maintenance.

These circumstances make decisions regarding capital assets a verycomplex decision and one that generally inspires considerablediscussion and debate.

Purchasing new or maintaining old ??? Both sides of this issue must be fully considered and a rational and objective approach must be taken.

It is fiscally prudent to conduct a comprehensive inventory of fixedassets (including infrastructure).

Because state and local government are now required by GASB 34 tobetter account for these assets the completion of a comprehensiveinventory of fixed assets will likely become more common.

The Capital Investment Plan (CIP)

CIP are normally multi-year plans (e.g., 3 year plan, 5 year plan, 7 year plan, 10 year plan).

The “first year” of the multi-year CIP becomes the capital budget for the forthcoming year.

The governing body must adopt the CIP

each year as an appropriation.

The CIP

Each year the CIP is updated and…revenue and expenditure estimates are revisedanother year of projects are added to maintain time frame (e.g., 5 year)updating each year allows an assessment of the urgency and priority of new projects added to CIP.

The primary benefit of the CIP is that it forces decision makers to examine the full range of projects and rank them according to priority.

Selecting projects for the CIPEstablishing priorities is the first step of selectingprojects and normally involves members of the governingbody with input from citizens and department heads.

Ranking proposals is the next step which begins by firstidentifying possible projects for inclusion in the CIPfollowed by a full evaluation by the governing body orcapital projects committee.

Finalizing the capital improvement plan is the final stepand typically involves approval of projects to be includedin the CIP and may involve seeking citizen input andapproval of the governing body.

NOTE: See sidebar on Page 162 – Criteria for selecting capital projects for inclusion in the CIP

Budgeting for capital improvements

Step 1 - Putting together a capital budget manual (e.g., forms instructions, calendar, etc).

Step 2 - Determining exact costs of each project.

Step 3 - Providing a detailed estimate of the revenues, both recurring and from bond sales, that will be

available for the budget period.

Step 4 - Bundling debt needs and scheduling a voter referendum (where necessary).

Step 5 - Holding a public hearing on the proposed capital budget before it is approved.

Capital budget manual

Like its counterpart on the operating side of the budget, the manual provides department heads with detailed instructions and the required forms for completing capital budget requests.

A calendar is generally provided outlining the timeline for preparation and submission.

See Figure 7-6 on Pages 164 - 165.

Determining Costs

Initially, project costs are estimates based on departmental projections prepared in consultation with the budget office and/orpreliminary engineering studies.

Following initial estimates, more formal cost estimates are preparedfor those proposals that may actually be included in the CIP.

Cost estimates may be drawn from consultants and/or firms hired toprepare specifications and an estimate of the project cost.

For multi-year projects – annual costs estimates are usually requiredto demonstrate the out-year impact (i.e., relative costs that will beincurred each year.

See Figure 7-7 on Page 167 – an illustration of a single capitalproject excerpted from the CIP of Garland, Texas

Estimating Revenues

Stae and local governments usually rely on a variety of revenue sources to fund each capital project, such as: taxes, fund balances, grants, special assessments, and service charges).

The budget office generally compiles revenue projections and provides the compiled data for consideration by the capital projects committee and/or governing body.

Planning DebtThe budget office must determine early in the cycle how much money must be borrowed to fund capital projects.

Normally, debt for all general fund projects planned for the year should be bundled into one general obligation (GO) bond issue.

Generally, the cost of preparing documentation to support each sale makes it uneconomical to enter the bond market more often than necessary.

Smaller governments may go several years between bond sales.

Public Hearing

The final step in the cycle is a publid hearing on the proposed budget spending plan.

This hearing is usually combined with the hearning on the CIP so citizens have an opportunity to comment on projects for the current and future years.

Appropriating Capital Outlays

The governing body must approve the capital budget

before implementation can begin. The governing body will

generally use one of the three methods listed below:

Capital budget is adopted as part of the annual operating

budget.

A separate capital budget is adopted appropriating sufficient

monies for project completion (sum-sufficient basis).

A bond referendum is approved – but a separate appropriation for each project is usually required by law.

Capital Spending Impact on the Operating Budget

Capital investment decisions have long-term impacts onoperating costs.

A CIP project may increase operating costs. Whilefunding may be sufficient for project implementation, it isimportant to identify any additional costs that will be incurred in the operating budget (e.g., a new piece ofequipment may add costs for insurance, repairs andmaintenance.

Generally, managers should expect new capitalinvestments will include new or additional operatingcosts.

Financing Capital Improvements

Two approaches are used:

Pay-as-you-go financing is used by state and localgovernments who choose not to issue debt and relyonly on current revenues such a taxes, grants,development impact fees, and other own sourcerevenues such as utility fees.

Pay-as-you- use financing relies on the issuance ofdebt such as municipal bonds and repay the debt overthe life of the capital asset using special assessments,grants, and other own source revenues.

Using Debt

Using debt raises a number of issues and concerns,such as accountability for debt, the term of the debt and amount of debt.

Policies should be developed to address… -procedures for issuing debt

-purposes fro which debt may be used -role of citizens in approving use of debt proceeds -maximum amount of debt that will be incurred

AccountabilityRepayment of debt must have a high priority –

annual debt service (principal and interest) must

be met before all other obligations.

Failure to do so results in a default – the loss of

public confidence and increased difficulty issuing

future debt.

A default may also prompt an unfavorable for the

local government – if/when future debt is issued.

Term of Debt

Debt should never be used to cover revenue shortfalls.

The rule of thumb is to use long-term debt only to acquireassets with a life expectancy longer than one year ANDpayment should not extend beyond the life of the asset.

It should be noted that short-term debt, such as tax anticipation notes (TANs) are used to cover a temporarycash shortfall – but not budget shortfalls.

TANs usually have a life of less than a year and are almostalways repaid from revenues received in the current year.

Amount of DebtAs a rule of thumb, the annual cost of servicing the debt (principal and interest) should not exceed 20% of the operating budget (according to the credit-rating industry).

However, jurisdictions experiencing rapid population growth may temporarily exceed the 20 percent limit – to build needed infrastructure and with the anticipation of increased revenues.

Conversely, jurisdictions with slowing or no growth should reduce its debt service obligation to 15 percent or less.

Amount of Debt

Research suggests substitution effect exists between taxes for debt service and those for general operations occurs – that is…

> When a jurisdiction must increase tax revenues

for debt service, rather than increasing taxes, it

decreases the amount of money spent on other

services.

Debt Capacity

Debt capacity for revenue bonds is a more complex issue because it depends on the revenue-producing capabilities of each project.

Annual debt service should not exceed what the project is capable of generating in excess of operating costs.

- For example, it is possible to project the revenue that will be generated from parking fees from a government owned parking garage and the revenue must cover both operating costs and also repayment of the debt.

Planning the Sale of Debt

The local government must determine the type of revenue that willbe pledged to repay the bond, the interest rate, maturity date, andpar or face value.

Municipal bonds are almost always sold with serial maturities –that is, the bonds mature in a series over the life of the debt.

A basic rule in debt financing – the higher the demand for municipalbonds – the lower the interest rate.

By issuing bonds in serial form, with smaller par values (e.g., $5000)and with relatively short maturities, local government can broadenthe pool of potential investors and thereby increase the demand forbonds.

Selling the Bond IssueBuyers expect full disclosure with respect to the financial condition, pertinent facts about the capital project and the legal pledge about repayment.

An official statement issued 4 – 6 weeks in advance of the sale provides this data.

In some instances, local governments will seek the backing of a third-party who will agree to repay the bond in the case of a default – this practice is known as credit enhancement.

A standby letter of credit (LOC) from an international bank is a morecommon form of credit backing.

In some instances, the state government may also extend its credit backing to municipal bonds.

Administering Repayment of Outstanding Debt

In the final phase of the debt cycle – the financeofficer ensures timely payment to investors.

A debt service fund is established to account forthe receipt and disbursement of money inpayment of debt and contracting with a localbank to handle processing of interest and principal payments.

Interest is paid semi-annually and principal is paid annually on the anniversary date of the sale of the bonds maturing that year.

Project Implementation

Once the governing body adopts the capital budget appropriations – departments in the executive branch can begin awarding contractsunder the close supervision of the budget office, finance departmentand other administrative departments charged with responsibility for purchasing, planning and engineering

The budget office and the finance office will monitor incomingrevenues to make sure they are consistent with revenue projectionsand also monitor spending which will be curtailed if revenue collections fall below projections.

There will also be close scrutiny of any contracts awarded to ensurethey are consistent with the appropriation ordinance.

The Planning and Engineering departments will also review anycontracts to review contract specifications.