Capital Budgeting and Finance Lecture 2 September 6, 2005 PA 546 Constantine Hadjilambrinos

What is a “capital project”? A capital project purchases assets that can provide services for several years. A capital project purchases assets that can provide services for several years. Capital assets (infrastructure) often become inputs into private economic production. Capital assets (infrastructure) often become inputs into private economic production. Cost of capital projects tends to be high and is not recurrent. Cost of capital projects tends to be high and is not recurrent. Therefore, their impact on annual budget can be large, especially if financed from current revenue. Therefore, their impact on annual budget can be large, especially if financed from current revenue. PA 546 Constantine Hadjilambrinos

Why might we need a separate capital budget? Separate capital budget can assist in selection between individual projects. Separate capital budget can assist in selection between individual projects. Capital budget useful in distinguishing between obligations that may be deficit financed and those that should be paid for by current revenue. Capital budget useful in distinguishing between obligations that may be deficit financed and those that should be paid for by current revenue. Capital budget can stabilize tax rates. Capital budget can stabilize tax rates. Separate capital budget can facilitate special review. Separate capital budget can facilitate special review. PA 546 Constantine Hadjilambrinos

Capital asset inventory: Assesses current capital stock. Data for each facility should include: 1) Its age, 2) its condition, 3) its degree of use, 4) its capacity, 5) its replacement cost. Capital improvement plan: Identifies capital expenditure projects appropriate for the next six years or so. It also will provide a schedule for expenditures for each project. Long-term financial analysis: Keep infrastructure developing program within financial capacity. PA 546 Constantine Hadjilambrinos

Criteria for setting priorities Cost-benefit ratio: It makes some sense to undertake projects that provide most “bang for the buck” first. Cost-benefit ratio: It makes some sense to undertake projects that provide most “bang for the buck” first. Greatest return: It makes some sense to undertake projects that provide greatest return first. Greatest return: It makes some sense to undertake projects that provide greatest return first. Functional area: It may be best to spread projects among several functional areas (education, environment, transportation, etc.) Functional area: It may be best to spread projects among several functional areas (education, environment, transportation, etc.) Problem severity: It may be political suicide not to prioritize areas in which perceived problems are the worst? Problem severity: It may be political suicide not to prioritize areas in which perceived problems are the worst? Status of support: It may be necessary to prioritize projects which are on the agendas of other political players. Status of support: It may be necessary to prioritize projects which are on the agendas of other political players. Multi-criteria ranked scoring system: Prioritize project on the basis of several (weighted) criteria. Multi-criteria ranked scoring system: Prioritize project on the basis of several (weighted) criteria. PA 546 Constantine Hadjilambrinos

Time-value of money: Discounting and Compounding FV = future value, PV = present amount, r = interest rate PA 546 Constantine Hadjilambrinos For n years into the future:

If interest is added x times a year: PA 546 Constantine Hadjilambrinos where s is the annual interval