Capital Budgeting, Public Infrastructure Investment, and

Project EvaluationTroy 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 theCapital 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 Moneyr = interest rate (usually a decimal…6% = .06)FV = future valuePV = present valuen = 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))2n

Time Value of Moneyr = interest rate (usually a decimal…6% = .06)FV = future valuePV = present valuen = number of years

p.260 discounting example:

PV = FV1

(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 semi-annually?

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 semi-annually?

$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 ofCost-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.