Module 6 – Capital Budgeting; Debt Financing



Module 6 – Capital Budgeting; Debt Financing



[SLIDE 2] Agenda

  • Capital Improvement Financing
  • Capital Budgeting
  • Debt Administration
  • Debt Capacity Analysis
  • Review of Literature:
    • Waste in the Sewer


[SLIDE 3] Public Budgeting Stages & Public Finance Administration Techniques

In terms of public finance administration stages, capital budgeting falls in the preparation stage.

Module 6 – Capital Budgeting; Debt Financing

[SLIDE 4] Capital Budgeting

The efforts by public agencies to develop a financial plan of action directed at the funding of land, improvements, facilities, and equipment for use in the immediate, intermediate and long-term future.


Closely tied to:

Debt administration

Assessing financial conditions

Economic development

Module 6 – Capital Budgeting; Debt Financing

[SLIDE 5] Characteristics of capital budgeting

Relative expensiveness

Elongated life cycles

Affects multiple funding cycles


High impact


Capital items include:

  • Land
  • Physical assets with extended utility (Buildings, roads, vehicles and other equipment)


Expenditures may be authorized simultaneously for operating and capital budgets, or counter-cyclical.


Most capital budgets rely upon a capital improvement program/plan (CIP).


Elements of CB include:


Cost analysis











[SLIDE 6] Why prepare Capital budgets?

  • Because the investments are large, mistakes can be costly.
  • Because capital acquisitions lock the organization in for many years, bad investments can hamper the organization for many years.
  • Because capital assets have long lives, they must be looked at over their lives. Operating budgets do not do that.
  • Because the cash the organization uses to buy the capital

asset is not free, managers or policy makers must include

the cost of that money in their analysis.


[SLIDE 7] Time value of money

  • The Time Value of Money says a dollar that you get at some point in the future is worth less than a dollar you get today.


[SLIDE 8] Simple & Compound Interest

  • Simple Interest is the basis for all time value of money

calculations. It is the interest that one earns in each period on the original amount of an investment.

  • Compound Interest includes simple interest (the interest     on the amount of the original investment) but it adds to that amount interest on all intervening interest payments.
  • The calculation of compound interest requires that you know the interest rate being paid and the frequency of interest payments.


[SLIDE 9] – Compounding & discounting

  • Compounding finds the value at some point in the future of a dollar invested today at some specified rate of interest.
  • Discounting is the reverse of Compounding. Discounting tells you what a dollar at some point in the future is worth today.


Take a look at the table at the bottom of slide 9.


[SLIDE 10] The Power of Compounding

  • Suppose, in 1626, the Native American inhabitants of Manhattan Island had invested the $24 they received for the sale of Manhattan Island at 8% interest per annum. Here’s what they would have in 2014! (Current U.S. total GDP is roughly $15 trillion.)



[SLIDE 11] Planning & Strategy Capital Budgets


Planning Capital Budgets

  • Inventory of existing capital assets
  • Review of constituent demands for goods and services in the future
  • Review of replacement needs of existing capital assets


Strategy for establishing capital budgets

  • Executive assessment
  • Project criticality or weighted rankings
  • Elected policy-maker direction



Module 6 – Capital Budgeting; Debt Financing


[SLIDE 12] Capital Asset Inventory List

The Capital Asset Inventory List will help the organization develop a “Needs Analysis.”


The needs analysis should also include a review of shifting external & internal changes.


  • External – population shifts


  • Internal – Retirement, policies (ADA requirements, use of ICTs)


Capital Asset Inventory List should include the following:Module 6 – Capital Budgeting; Debt Financing


  • Type of facility or equipment asset
  • Date asset was acquired
  • Initial cost of asset
  • Any improvements that have been made
  • Existing condition of asset
  • Level of utilization of land, facility or equipment
  • Depreciated value
  • Replacement cost
  • Anticipated end of usefulness


[SLIDE 13] Capital Budget – Analysis

In terms of assessing expenditure decisions, the public managers should evaluate:


  • Economy or conduct an economic analysis
  • Assess the political need
  • Determine the project’s fairness – Will certain populations or groups be adversely affected? And if so, how?
  • Evaluate the visibility of the project


[SLIDE 14] Capital Budget – Analysis

How then can the public manager evaluate the economy and assess the political need, etc?


Well she or he can systematically :


  • Assess the costs of the project relative to competing costs
  • Conduct a cost benefit analysis
  • Determine the relationship of the proposed purchased asset to the goals of the organization
  • Determine the capital costs relative to maintenance costs
  • Finally, an overall financial impact of the project should occur











[SLIDE 15] Financing Capital Expenditures



  • The expenditure of funds for a capital item does not occur until the money is in hand.
  • Debt is not incurred to fund all or any part of the capital item.



  • Financing of project is done as the asset is used.



  • Combination of Pay as you go & Pay as you use


[SLIDE 16] Slide 16 displays a chart where you can see the benefits and drawbacks to pay-as-you go and pay-as-you use financing.


As you can see, the benefits of pay as you go include:

  • Conservative approach
  • Org. does not incur debt/interest charges
  • Org. is viewed as financially responsible


The drawbacks, on the other hand include:

  • Decreased number of capital assets acquired
  • Creates greater fluctuations in year-to-year expenditures
  • Intergenerational equity is violated



Intergenerational equity refers to the belief that those who benefit from a service should be those who actually pay for it. In this case of pay-as-you go,


Take for example, if the city of San Bernardino decided to build a new basketball arena. In this case they have decided to use pay as you go and the project will be paid by assessing a higher sales tax for one year, increasing property taxes for one year and increasing user fees for one year. They believe that these revenues, along with what is currently in their unreserved unrestricted fund will pay for the project. While there isn’t any debt incurred, it is likely that you along with your children, and perhaps your grandchildren will be benefit from watching games there. Unlike you, however, they will not have an increase in sales & property taxes, and user fees to pay for the arena.


One may argue, however, that intergenerational equity is violated in any case where a person or family moves to a new community and receives the benefits of projects paid for prior to their relocation.


The benefits of Pay as you Use, on the other hand are:

  • Spread costs over several years
  • Avoids fluctuations in expenditures & revenues
  • Provides intergenerational equity


While the drawbacks are:

  • Financing of project may exceed its usefulness
  • Requires CIP & Needs Assessment
  • Changes in (political, social & economic) priorities


Module 6 – Capital Budgeting; Debt Financing

[SLIDE 17] Problems of Capital Budgeting

  • Cost escalation
  • Assumption of continuous cycle of evaluation
  • Funding/priority distortion
  • Treatment questions
  • Capital budgeting can unduly favor debt financing
  • Designated reserves


[SLIDE 18] Debt Administration

Debt is a liability, an obligation.


Four common purposes of public debt are:

  1. Managing the national economy
  2. Making expenditures that exceed revenues over a long term period
  3. Making expenditures that exceed revenues over a short term period (paid back within 1 year; erratic revenues; larger than anticipated expenditures)
  4. Financing specific large (capital) expenditures over a period of time


Reasons for government debt include:

  • To cover deficits
  • Annual expenditures are greater than revenues
  • To finance capital projects
  • Construction
  • To cover cash flow issues
  • Bills exceed cash on hand


[SLIDE 19] Largest Users of Government Debt (in order)

  1. Cities and counties
  2. Special districts
  3. School districts


The federal gov’ts debt is the result of:

  • Wars
  • Attempts to stabilize the national economy (unemployment, recession)


  • Deficit refers to the annual amount of gov’t borrowing
  • Debt refers to the cumulative amount of outstanding borrowing from the public over the nation’s history


Characteristics of debt include:

  • Debt must be repaid with interest


  • Commits future budgets


  • Requires careful management







[SLIDE 20] Debt Obligation Bases

  • Debt contracts are also referred to as instruments or securities


  • Security – repayment is secured by the debt contract.


  • Securing repayment is done by specifying the obligation the debtor has to the debt holder in legally valid terms.


General obligation

  • Refers to a government with taxing powers has pledged its full faith, credit and unlimited obligation to repay the debt from its general revenues


Limited liability obligation

  • Revenue source of debt repayment is specified


Moral obligation

  • Explicit of implied promise to repay debt without a legally binding obligation. Typically used by the federal government to states.


No obligation debt

  • State & local gov’ts lend their names and legal authority to a debt issue for which the true debtor is one or more private parties who are obliged to repay the debt.


  • Gov’t involvement secures a preferred federal income tax status for the debt holders which lowers the cost of the debt.




























[SLIDE 21] Waste in the Sewer: The Collapse of Accountability & Transparency in Public Finance in Jefferson County, Alabama


Roots of the crises:


  • County sewer system was regularly discharging large amounts of raw, untreated sewage into 2 major river systems.
  • Violation of Clean Water Act
  • Consent decree that required an overhaul of the county’s sewer system
  • County consolidation of sewer system of over 20 municipalities under a single system


How were they planning to pay for the new consolidated sewer system?

  • Issuance of debt


1995 – $280 million in outstanding sewer debt/warrants


How much debt had accumulated by 2007?

  • Just under $3 billion resulting in a sewer debt of $3,260,895,000
  • Represents a 1,075% increase from 1997


Why did it cost so much?

  1. Consolidation of muni’s made it difficult to assess cost per city
  2. Rising costs of sewer improvement projects
  3. Lack of county oversight in bidding and awarding of contracts
  4. Corruption


Compounding problems was risky refinancing-module 6 – Capital Budgeting; Debt Financing


Interest-rate swaps: An agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the swap.


Overall, pressure from the public and risky interest swap agreements were some of the reasons that led Jefferson County to create some of the risky refinancing they undertook.


  1. What alternatives did the county have?
  2. What strategies would you have implemented to avoid the complex issues they currently face?


Please take a look at the videos for more information on this case: