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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 ?
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