Capital Budgeting, Public Infrastructure Investment, and Project Evaluation Troy University PA6650- Governmental Budgeting Chapter 6

Capital Expenditures Purchase of public capital assets –Public infrastructure for private purposes Roads, sewers, transportation systems Crucial for private economic growth –Public infrastructure for public purposes Schools, parks, hospitals, jails, police/fire stations, bases

Capital Budgeting Focuses decisions Facilitates financial planning Smooths tax rates over time Regularizes the provision of projects that: Have a long life (10 or 15 years) Have a high price tag Are non-recurring

Why Have a Capital Budget? Separate consideration can improve both efficiency and equity of projects –Won’t be cutting capital projects from a tight ops budget –Big-ticket items don’t make a budget appear abnormal Capital budgets can stabilize tax rates Special review of capital budgets necessary because projects have high cost and high impact Capital budgets are a good tool to manage resources

Capital Budget Process 5 steps: –Capital Asset Inventory –Development of the Capital Improvement Plan (CIP) –Development of the financing plan –Implementation of the capital budget –Execution Concerned with: –Selection from a multitude of alternatives –Timing of the expenditure of the projects –Impact on total government finances

Capital Asset Inventory Assessment of the existing situation Inventory of capital facilities including: –Age –Condition –Degree of use –Capacity –Replacement cost Repair or build new?

Capital Improvement Plan A list of projects for the next 6 years or so Includes narrative and cost data Screening for costs, interrelationships, priorities Scheduling to avoid waste (new sewers precede paving) Based on growth Based on strategic goals

Financing Plan & Analysis Must stay within financial capability Review of revenue, debt structure Present and anticipated revenue Partnering with other governments & agencies Recurring expenditures Buy it when it is affordable

Implementation of the Capital Budget Prioritization process –Functional areas (safety, recreation, health) –Problem severity (alligators in swamp) –Status of support (mandate, referenda) –Formal scoring system Legislative review, executive signs

Execution of the Capital Budget Special attention to: –Rules (bidding, procurement) –Controls (keep it on schedule) –Monitoring project cost (no overruns)

Problems In Capital Budgeting Assumes a continuous cycle of reappraisal due to a dynamic world. Things change. Which projects belong in the capital budget? Availability of funds can distort priorities –Different pots/colors of money A strong bias towards borrowing Difficult to establish priorities

Accounting for Time Discounting –The process of converting a stream of returns or costs incurred over time to a single present value (net present value, or NPV) Compounding –The time value of money calculating principal and interest (interest can be compounded annually, semi-annually, quarterly, monthly, weekly, or daily)

Discounting and Compounding Examples of discounting –Bond market –Early payment of invoice –Lottery payoffs Examples of compounding –IRA –Certificate of Deposit

Time Value of Money r = interest rate (usually a decimal…6% =.06) FV = future value PV = present value n = number of years FV = PV (1 + r) p.258 compounding example: 1050 = $1,000 + ($1,000 x 0.05) For multiple years, FV = PV (1 + r) n If compounded semi-annually, then: FV n = PV (1+ (r/x)) 2n

Time Value of Money r = interest rate (usually a decimal…6% =.06) FV = future value PV = present value n = number of years p.260 discounting example: PV = FV 1 (1+r) For multiple years, PV = FV n (1+r) n

Practice R = 6% PV = $1000 FV after 1 year? FV after 2 years? FV after 1 year compounded semi- annually?

Practice R = 6% PV = $ year? $1000 x (1.06) = $1,060 2 years?$1060 x (1.06) = $1, FV after 1 year compounded semi- annually? $1000 +($30 + $30.90) = $

Discounting Works backwards…$1000 next year is worth $ right now assuming 5% interest compounded annually NPV Analysis –Used to compare dissimilar projects –Look at page 261 –Project A is the best choice at 10% interest –Project B is the best choice at 3% interest

Cost-Benefit Analysis A means to prioritize and decide Does not necessarily outweigh politics One measure of efficiency Helps evaluate alternative proposals 5 steps: –Categorizing project objectives –Estimating the project’s impact on objectives –Estimating project costs –Discounting cost & benefit appropriate rates –Summarizing findings for decision makers

Cost-Benefit Analysis Project objectives –What desirable benefits and results? –Annual cost, revenue, loss Benefits estimation and valuation –Pilot studies for impact –Worth of the impact measured in dollars –Estimation of consumer’s surplus = “What would a consumer be willing to pay?” –Contingent Valuation Method

Cost-Benefit Analysis Estimating project costs –Construction –Operating –Opportunity –Life cycle Three adjustments necessary –Undesirable effects (negative externalities) –Unemployed resources with no alternative use –Social costs (other possible uses)

What Discount Rate? Cost of borrowed funds (what the government has to pay for borrowing) Opportunity cost (what private resources could earn) Sidebar 6-2

Decision Criteria Summarize the economic case for the project Benefit/Cost Ratio (BCR) (greater than one desired) Cost/Benefit Ratio (CBR) (less than one desired) Net Present Value (greater than zero desired) Payback Period (time taken to recover the cost) Internal-rate-of-return (interest generated compared to discount rate – it should be higher)

Special Problems of Cost-Benefit Analysis Multiple objectives –Economic –Income redistribution –Distribution effects –Social benefits Cost of human life Can’t account for everything Politics

Conclusion Public capital infrastructure contributes to both public and private production Most capital projects involve a stream of income or payments Cost benefit analysis helps to determine what the return will be. Numbers are important. There are, however, other considerations.