Speaking Notes

PADM 5301

March 30, 2010

Dr. Neubauer

WHERE WE ARE

I plan to cover chapters 12, 13 and 14 prior to the in class final on April 20.
The final will be comprehensive.
You should study the midterm.
I will prepare study suggestions soon.

CHAPTER 12

As usual, this chapter seems to have two major parts . . .

what one would expect to find as an explanation of capital budgeting
a long section of quantitative methods for evaluating capital projects

The federal government of the United States does not have a capital budget.

This tends to make the debt look larger than it would otherwise appear.

Despite the absence of capital budgeting, reports are made available related to capital expenditures.

This is not a chapter about HUMAN CAPITAL. This is about things like sewer systems and buildings

STATE AND LOCAL GOVERNMENTS "DO" CAPITAL BUDGETING.

It involves PLANNING.
The line between what to include in an OPERATING BUDGET and a CAPITAL BUDGET can depend upon the size and nature of the jurisdiction. A large city might consider police cars to be part of the operating budget because they replace them so often.
It SHOULD involve quantitative analysis (although political realities usually rule the day).

Capital budgets get VERY TANGLED UP WITH annual OPERATING BUDGETS.

The purchase itself is likely to be financed, so the PRESENT DECISION affects future operating budgets.
Assets have a COST OF OWNERSHIP including utilities, security, maintenance, and insurance.
Most capital assets owned by state and local governments do not generate revenues -- they are used to provide services.
The inventory of existing assets should be maintained and they should be kept in good repair. OTHERWISE, the BOND RATING of the government may go down, resulting in a higher cost of borrowing in the future.

In terms of accounting, CAPITAL ASSETS should be DEPRECIATED over the useful lifetime of the asset, even if they are paid for in some other way.

Capital projects are often paid for by borrowing (or through issuance of bonds) and the principle and interest is usually paid in annual installments.

Used government assets often have limited resale value. It may be necessary to factor into calculations of costs the future cost of demolition.

Most state and local governments have a separate CAPITAL BUDGET and a separate OPERATING BUDGET.

The capital budget includes LARGE COST expenditures with a life expectancy of at least one year. Many of these items constitute INFRASTRUCTURE and have very long expected lives.

Different jurisdictions may have different definitions of what constitutes a capital expenditure. A small town probably considers a new police vehicle a capital expenditure. A large city may consider it part of the operating budget.

Capital budgets do impact operating budgets. A capital expenditure may either create a need for MAINTENANCE that will be reflected in future operating budgets. It may also create SAVINGS that also affect future operating budgets.

There are usually a long list of needed capital improvements. Not all of them can be done soon. It is necessary to select what is possible, given the level of financial resources and/or the ability to borrow money.

The list is likely to include a variety of types of projects as follows.

Repair or renovation of existing facilities/infrastucture.
Replacement of existing major resources.
Construction or initiation of new capital projects.

Part of a CIP

http://www.nashville.gov/finance/Management_and_Budget/CB2003/downloads/CIB2004R.pdf

When I was teaching in Nebraska, the renovation of our building was on "the list" for a number years until it finally rose to the top and was actually done. Here the new Ray Charles building may be a similar situation.

In a small city, decisions about capital expenditures have consequences in elections.

Whether the city council members serve districts or serve "at large" has consequence for how decisions about capital expenditures are made.

CRITERIA FOR THE ORDER OF THE LIST

Is there a PRESSING NEED such as a major public health consequence?
Is the need POLITICALLY SALIENT? (Do citizens know and care?)
Does the need have a CONSTITUENCY that can speak for it effectively?
Is the need HIGHLY VISIBLE? Is there a prospect for an elected person being remembered for this project?
Are the benefits likely to be evident and realized quickly?
Are there direct or indirect consequences in terms of local ECONOMIC DEVELOPMENT? (airport construction)
Is it necessary to do one thing before another (replace old sewer system before repaving streets)?

QUANTITATIVE ASSESSMENT OF PROPOSED PROJECTS

Payback period -- will the cost be recovered by lower maintenance expenses, and if so, how soon?
Are the financial benefits (adjusted for time value of money) greater than the costs?
What are the risks of failure?
Will the adoption of this project leverage additional money from outside the jurisdiction?
In terms of ROI, would we be better off just putting money into some kind of a safe investment? Would the money be better as part of a "rainy day" fund?

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Project 1

Cost: $100,000

Benefit:

$15,000

Cost:

$0.00

Benefit:

$20,000

Cost: $0.00

Benefit:

$20,000

Cost: $0.00

Benefit:

$20,000

Cost: $0.00

Benefit:

$20,000

Cost: $0.00

Benefit:

$20,000

Cost: $0.00

Benefit:

$20,000

Project 2

Cost: $40,000

Benefit:

$0.00

Cost: $30,000

Benefit:

$0.00

Cost: $30,000

Benefit:

$0.00

Cost: $0.00

Benefit:

$10,000

Cost: $0.00

Benefit:

$10,000

Cost: $0.00

Benefit:

$50,000

Cost: $0,000

Benefit:

$50,000

Financially only, which is the better investment?

	Project 1		Project 2
	Costs	Benefits	Costs	Benefits
Year 1	PV of $100,000	PV of $15,000	PV of $40,000	PV of $0
Year 2	PV of $0	PV of $20,000	PV of $30,000	PV of $0
Year 3	PV of $0	PV of $20,000	PV of $30,000	PV of $0
Year 4	PV of $0	PV of $20,000	PV of $0	PV of $10,000
Year 5	PV of $0	PV of $20,000	PV of $0	PV of $10,000
Year 6	PV of $0	PV of $20,000	PV of $0	PV of $50,000
Year 7	PV of $0	PV of $20,000	PV of $0	PV of $50,000
	PV of total costs	PV of total benefits	PV of total costs	PV of total benefits

The TIME VALUE OF MONEY says that a dollar today is worth more than a dollar you have to wait for in the future. For each of the two projects you can compute the anticipated PV of both costs and benefits.

For either project, if PV of total costs is greater than PV of total benefits, perhaps this project should not be done.
If for both projects, the PV of benefits is greater than the PV of costs, then perhaps the BETTER PROJECT IS THE ONE WITH THE LARGER NET PRESENT BENEFIT, assuming that there is not enough money available to do both projects.

The Government Accounting Standards Board (GASP) has Statement 34 that requires a MORE EXPLICIT acknowledgement of the government's infrastructure in the budgetary process.

In the ACCOUNTING DOCUMENTS capital assets are to be DEPRECIATED over time.
Many cities are still using capital assets that should have been fully depreciated many years ago. To continue to use these things rather than replace them may constitute a FALSE ECONOMY.
CITIZENS should know.
The BOND RATING AGENCIES take this information into consideration. Governments with a lot of very old assets and a lot of DEFERRED MAINTENANCE are higher risk. It is often more costly to pick up the pieces after something breaks than to maintain or replace it in the first place. Consider, for example, the high cost of driving an old car that is probably beyond its useful life.