Capital Budgeting Public Infrastructure Investment and Project Evaluation

Capital Budgeting, Public Infrastructure Investment, and Project Evaluation Troy University PA 6650 - 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: FVn = PV (1+ (r/x))2 n

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 = FVn (1+r)n

Practice • • R = 6% PV = $1000 FV after 1 year? FV after 2 years? • FV after 1 year compounded semiannually?

Practice • • R = 6% PV = $1000 FV @ 1 year? $1000 x (1. 06) = $1, 060 FV @ 2 years? $1060 x (1. 06) = $1, 123. 60 • FV after 1 year compounded semiannually? $1000 +($30 + $30. 90) = $1060. 90

Discounting • Works backwards…$1000 next year is worth $952. 38 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 flows @ 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.