CAPITAL BUDGETING Infrastructure & Project Evaluation

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Next page CAPITAL BUDGETING Infrastructure & Project Evaluation Making decisions having significant future net benefits or costs

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Making decisions having significant future net benefits or costs. CAPITAL BUDGETING Infrastructure & Project Evaluation. JUSTIFYING PUBLIC SPENDING. Spending/Proposing agencies are responsible for justifying their proposals (I.e., presenting the case for spending in ABC terms) - PowerPoint PPT Presentation

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CAPITAL BUDGETINGInfrastructure & Project Evaluation

Making decisions having significant future net benefits or costs

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JUSTIFYING PUBLIC SPENDING• Spending/Proposing agencies

are responsible for justifying their proposals (I.e., presenting the case for spending in ABC terms)

• Budget analysts are supposed to guarantee that the proper justification has been provided

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Exercise 3.7Questions:

What are: new social procedures, valid test results and scores, sociological

recommendations, evaluation professionals, specialty counselors,

maximum effectiveness, and success factor? Don't use possibly empty

jargon.

What actually is being requested? What makes up a "counselor team" and

where will the "teams" be located?

How did the case service funds for abused children get included in this

request?

What is the advantage of bringing together battered spouses? Explain.

And why does this apparent objective require testing and special training?

Is this really a workload change--or a program improvement?

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An illustrative rewrite:

Program Improvement--2002-03 Biennial Cost: $184,300

Counseling programs for battered spouses have the objective of protecting

battered spouses and, eventually, allowing them to continue life without

outside assistance. This request would provide two part-time

psychologist/ counselors trained in abuse management in each of the

following state mental health centers: Baileyville, Roberts, Needmore, and

Trevlac. Each team would counsel clients and refer them to other state and

local social programs. (Then: separate Workload Change request for child

abuse.)

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As a Practical MatterIf this proposal were consistent

with executive priorities, we would stop here:• The dollar values are small• The activities are more or less

reversible• Estimating program benefits

would be prohibitively costly

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ButThe following is also true:

• Present Value of the workforce commitment is approximately $6million, excluding hiring and training costs

• Overheads are probably of roughly the same magnitude

• Some benefits can be estimated • e.g., savings to state from reductions in future

assistance. If teams would counsel 4000 battered spouses a year,

they would pay for themselves if they reduced future assistance by $100 on average.

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Public Sector Project Assessment should take all benefits and costs to public

into account Federal Gov. treats consequences to

itself as costsConsequences for citizens as benefits

Hence, revenues are negative costs and payments by citizens negative benefits

REVENUE TO GOVERNMENT ≤ COST TO CITIZENS

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TWO ASSUMPTIONS

The welfare of an entity's stakeholders will be maximized by the implementation of all policy choices that generate positive net-present values.

Timing of benefits or costs accruing from a policy choice is generally of no importance -- so long as benefits/ costs are properly discounted.

The source of financing does not matter -- shouldn’t influence capital budgeting decisions, value will be the same regardless of whether an activity is financed with debt, fund balances, or taxes

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Together these two assertions imply that all

capital budgeting decisions should be

governed by cost-benefit analysis, which says:

do it whenever benefits exceed costs

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As Practical Matters• Some projects have greater

value when deferred than at present

• State and Local Governments are often Liquidity constrained (as are many of their citizens), which means that they may have to make tradeoffs

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CONVERTING FUTURE VALUE TO PRESENT VALUEMaking decisions having

significant future benefits or costs means looking at consequences from where we are right now: converting future benefit/cost flows to

PRESENT VALUES

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DiscountingFuture values are converted to

present values by means of a discount rate.

That is, future nominal benefits are worth less than present benefits of equal magnitude -- the WIMPY principal• Inflation• Markets tell us that people

demand compensation for forgoing current consumption

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Mechanics of Discounting I

PV = FV in year t / [1+r]^t

Where PV = Present ValueFV = Future Value (real or

nominal)

t = Yearr = Discount Rate (real or nominal)

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Mechanics of Discounting IIFor a Stream of Benefits from

year 1 to year t, SUM [add up] all the present values for

all net future valuesWhere t = 3

PV = (FV in year 1 / [1+r]^1) + (FV in year 2 / [1+r]^2) + (FV in

year 3 / [1+r]^3)

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Three Ways to Find PVs

• Solve the equation with a regular calculator (or use FV tables from an accounting text).

• Use a financial calculator.• Use a spreadsheet.

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10%

What’s the PV of $100 due in 3 years if i = 10%?

Finding PVs is discounting; it’s the reverse of compounding.

100

0 1 2 3

PV = ?

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( )PV =

FV

1+ i = FV

11+ i

nn n

n⎛⎝⎜

⎞⎠⎟

PV = $1001

1.10

= $100 0.7513 = $75.13.

3

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Spreadsheet Solution

• Use the PV function: see spreadsheet. = PV(Rate, Nper, Pmt, FV)

= PV(0.10, 3, 0, -100) = 75.13

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What is the PV of this uneven benefit stream?

0

100

1

300

2

300

310%

-50

4

90.91247.93225.39-34.15

530.08 = PV

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Spreadsheet Solution

Excel Formula in cell A3:

=NPV(10%,B2:E2)

A B C D E

1 0 1 2 3 4

2 100 300 300 -50

3 530.09

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Perpetuities

PV = NBF / rWhere NBF = a specified

annual net-benefit flow

For example:

$186k / .03 = $6.2m

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Alternative Discount Rates

• Market rate = r + i + b + y

Where r = real, risk-free ratei = the expected rate of inflation

b = project specific (nondiversifiable) risk

y = income tax adjustment

• Nominal risk-free rate [n] = r + i

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Use of Alternative Discount Rates• Use real rate [r] with real FVs

• For example, where you are using current costs to estimate future costs

• Use nominal rate [n] with nominal FVs• For example, where you are making

identical nominal principal and interest payments each year

WHAT NOMINAL RATE SHOULD YOU USE?

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Use of Alternative Discount Rates• Use real rate [r] with real FVs

• For example, where you are using current costs to estimate future costs

• Use nominal rate [n] with nominal FVs• For example, where you are making identical

nominal principal and interest payments each year

Borrowing rate on tax-exempt, general-purpose bonds of similarMaturities.

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Annualizing Capital Costs

• Since US government budget is formulated one year at a time, the budget tends to be biased against delivery methods requiring up-front investments

• The proper solution is converting everything to PV

• However, there is a reasonable alternative, which is the annualizing capital costs

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Mechanics of AnnualizingAnnual Cost of a Capital Asset

= P [r + d - a]

Where P = Purchase Price [replacement cost]

d = Depreciation rate

[wear and tear + obsolescence]

a = Appreciation rate

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Borrowing Cost as a Proxy for Capital Consumption

• Principal plus interest• Simplify by laying out an

amortization schedule• Charge that amount to programs• Sock it way to replace asset