7 capital budgeting 3604
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Capital Budgets
Andrew GrahamSchool of Policy StudiesQueens University
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Capital Budgeting Capital Budgeting is a process used to evaluate investments
in long-term or capital assets.
Capital Assets
have useful lives of more than one year; analysis requires focus on the life of the asset;
low-cost, long-lived assets are not usually subjected to theCapital Budgeting process;
cost often makes it necessary for the organization tofinance the asset using long-term financing from capitalcampaigns, mortgages, long-term loans, leases, and equityofferings.
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What are capital assets?
They are used in theproduction or supply of goodsand services (productivity
criterion), Their life extends beyond a
fiscal year (longevity criterion) they are not intended for resale
in the ordinary course ofoperations Their treatment as a capital
assets is of value (materialityprinciple)
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Types of Capital Budget Actions
CapitalAcquisitions
CapitalImprovements
Maintenance
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Capital budgeting:Analyzing alternative long-
term investments and decidingwhich assets to acquire, eliminate or renovate
Outcomeis uncertain.
Large amounts ofmoney are usually
involved.
Investment involves along-term commitment.
Decision may bedifficult or impossible
to reverse.
Risk in Capital Investment Decisions
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Why Prepare a Capital Budget?
Since the investments are large, mistakes can be costly. Since capital acquisitions lock the organization in for
many
years, bad investments can hamper the organization formany years.
Since capital assets have long lives, they must belookedat over their lives. Operating budgets do not do that.Value of accrual basis here.
Since the cash the organization uses to buy the capitalasset is not free, managers must include the cost of thatmoney in their analysis.
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Some uniquely public sector issues in
capital funding Social/economic goals versus monetary
regional distribution, make-work projects
Depreciation and replacement The border-line between capital and
operational budgets and its impact onfinancial reporting of deficits, etc.
Asset valuation and management
Investment strategies debt, currentfunds, other party investment
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Capital assets age and break-down!
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Steps in the Development of a CapitalBudget
Inventory of Capital Assets
Development of a Capital InvestmentPlan
Development of a Time-Sensitive CIP multi-year projection
Development of a Financing Plan
Approvals, consultations, winningsupport, and implementation
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Inventory of Capital Assets
Life cycle assessmentsreplacement plans
Depreciation schedules: accruedvalue or replacement value
Provides information on the capacity
of the infrastructure in place
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Capital Investment Plan
Primarily a planning document notnecessarily fully funded
Relating it to the agencys orgovernments overall objectives andpriorities
Danger of hidden capital costs not
attracting public or political attention:replacing computers, buildings,sewers
Danger in all to obvious capital
renewal costs getting priorities:
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Developing a Multi-Year Plan
Reinforces the cyclical nature of
capital costs recurringexpenses
Permits inclusion ofmaintenance and preventivecosts of capital
Permits some entities toconsider various longer-termfundin strate ies
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Development of a Financing Plan
Complexity varies dramatically
Ranges from drawing onappropriated funds completelyright through to public-privatepartnerships, bonds issues,
specialized financing strategiessuch as user fees (airports)
Increasing trend to look atcreative options
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Capital Funding Alternatives
Internal Funds DEVELOPMENT CHARGES
OPERATING FUNDS SPECIAL RESERVES CAPITAL DEVELOPMENT REPAIR AND MAINTENANCE LIFECYCLE REPLACEMENT THINK SYSTEMS
EXTERNAL FUNDING LEVIES SPECIAL CHARGES AIRPORT TAX PRIVATE FUNDING - PPPs DEBT
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Continuum of Options, Risk and DeliveryTools
Source: British Columbia, Capital Asset Management Framework,
http://www.fin.gov.bc.ca/TBS/CAMF_Guidelines.pdf
http://www.fin.gov.bc.ca/TBS/CAMF_Guidelines.pdfhttp://www.fin.gov.bc.ca/TBS/CAMF_Guidelines.pdf -
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Cost/Benefit Analysis
Uses: Comparing benefits and costs of a particular
project to see if benefits exceed costs
Comparing costs of two or more products todetermine lowest cost
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Cost/Benefit Analysis
Comparing the net benefits of two or moreprojects to decide which will generatemaximum benefit
Can be as simple or as complex as the situationdemands
At its heart, it is a simple process of quantifyingcosts and benefits
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The Process of Cost/Benefit Analysis
Calculate thecosts
One time
costsOngoing or
RepeatedCosts
Opportunitycosts
Calculate theBenefits
One time
benefitsOngoing or
Benefits
Savings
ImprovedServices
Calculate theReturn on
Investment =ROI
Benefits/Costs 100% = ROI
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Cost/Benefit Analysis: A Simple Example: ACity Camp: Operate or Rent?
Rent toOutside Group
Fix up &Operate
Benefits
Rental Fees
$100,000 $200,000
CostsRepairs
SupervisionandMaintenance
0
$50,000
$75,000
$100,000
Net Benefit $50,000 $25,000
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Time Value of Money
Previous example ignores therole of time in deciding on
alternatives More complex issues seldom
play out in one year
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Time Value of Money
Often costs and benefitsdistribute themselves unevenly
over time: long term gain versusshort term pain
When money is received canoften be as important as how
much is received Particularly with capital
investments focus ontechnology
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Time Value of Money
Two important corollaries:1. Firms or governments offering to
capitalize (pay for) long term capitalexpenditure will factor in the cost of
the money they pay up front andgovernment will pay for that.
2. Deferred benefits are costed atcurrent rates means that you have
to restate the value of such benefitsinto a common unit of measurement.That is Net Present Value
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Time Value of Money
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As a formula, Present Value looks likethis
PV = FV [ 1 / (1 + i)n ]
PV = Present Value
FV = Future Valuei = Interest Rate Per Periodn = Number of Compounding Periods
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Time Value of Money: measuringpresent value
Common unit of measure is year
zero dollars = the present valueof funds received or spent in thefuture
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Time Value of Money: measuring
present value
Uses a factor, usually a discountrate, to restate the funds to their
present value
Example: if 90.0 cents wereinvested at 10% interest today
(show me where) it would beworth $1.00 a year from now
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Time Value of Money: measuring presentvalue
For decision making purposes,stating a future flow of $1 meanscommitting 90.0 cents today
TVM is critical for accrual-basedorganizations that have major capitalcosts or make multi-year
commitments for which a cash flow isneeded less so for cash-based
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Time Value of Money: measuring presentvalue
Major impact on intergenerationalequity issues
Where it really matters for the publicsector is in its use in forward costingand cost benefit analysis of projectsthat derive actual costs and benefits
of a project Also, how cash will flow becomes
crucial in terms of final value
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Net Present Value
Net Present Value (NPV) is a means to calculatewhether the public sector organization will bebetter or worse off if it make a capital
investment. It does so by adding the presentvalue of outflows and the present value ofinflows. It shows the value of a stream of futurecash flows discounted back to the present bysome percentage that represents the minimum
desired rate of return, often called the cost ofcapital.NPV = PV Inflows PV Outflows
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General decision rule in applying NPV. . .
If the Net Present
Value is . . . Then the Project is . . .
Positive . . .
Acceptable, since it promises a
return greater than the requiredrate of return.
Zero . . .Acceptable, since it promises a
return equal to the required rate
of return.
Negative . . .Not acceptable, since it
promises a return less than the
required rate of return.
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Queens Stadium is considering purchasingvending machines with a 5-year life.
Cost and revenue information
Cost of vending machines $ 75,000Revenue 84,375$
Cost of goods sold 50,625
Gross profit 33,750$
Cash operating costs 3,350$
Depreciation 14,000 17,350
Pretax income 16,400$
Income tax 6,400
After-tax income 10,000$
($75,000 - $5,000) 5 years
Evaluating Capital Investment Proposals: An Illustration
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Year(s) Cash Flow PV factor PV
Vending mach. Now (75,000)$ 1.000 (75,000)$Annual inflow 1 - 5 24,000 3.352 80,448
Present value of an annuity of $1factor for 5 years at 15%.
Queens Stadium Net Present Value Analysis
$24,000 3.352 = $80,448
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Year(s) Cash Flow PV factor PV
Vending mach. Now (75,000)$ 1.000 (75,000)$Annual inflow 1 - 5 24,000 3.352 80,448
Salvage 5 5,000 0.497 2,485
Present value of $1factor for 5 years at 15%.
Queens Stadium Net Present Value Analysis
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Since the NPV is positive, we know the rate of return isgreater than the 15 percent discount rate.
Year(s) Cash Flow PV factor PV
Vending mach. Now (75,000)$ 1.000 (75,000)$Annual inflow 1 - 5 24,000 3.352 80,448
Salvage 5 5,000 0.497 2,485
NPV Now 7,933
Queens Stadium Net Present Value Analysis
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Risk Assessment in Capital Spending
NPV and other tools are a means totry to quantify some risks associated
with long term capital investments They provide a level analytical
playing field
Risk analysis is much morecomprehensive than this
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What is Risk?
The possibility that the goals of theproject will not be met.
That includes costs, timing,objectives and policy intent.
It also includes failures inmethodology: Cost estimations and potential overruns
Project management
Even technology chosen a bridge too
far, a submarine too old
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Key Attributes of Risk
Time horizon is the future which alwaysinvolves uncertainty.
Since future events can be either positive or
negative, risks can be either threats oropportunities.
Risk is measured by likelihood and impact.
Risk appetite and tolerance vary over time, byindividual, and by organization.
Risks have a cost stream potential if the natureof the risk is known or capable of projection.
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Risk Management in a Public SectorContext
A changing landscape
Increased transparency
Increased exposure to the private sector
Greater citizen expectations Stronger inspection of services
More performance indicators
More choice?Reputation becomes more tangible
managing reputation becomes vitalaspect of strategic risk management in the
public sector
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Other Risks
Policy risks
Public interest risks
Management or organizational risks
Project risksThere is now a good body of public sector experience that shows thatthere is a need for systematic risk management of major capital
ventures, regardless of how they are financed and delivered. There isalso ample evidence of internal project management risk managementpractices being sound, but being generally ignored by decision makersdue to the overriding political benefits or ideological imperativesassociated with them.
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Other Risks
External capacities of designers,expert advisors, funders, co-funders
General financing issues Poor fit to operations risks
A general assortment of risk that
might attract a chicken littlesyndrome.
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How Do You Measure It?
Probability and Intensity
Not all risks are equal,not all risks requireaction this is about
priority setting
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Typical Risk Map
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Typical Risk Map
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Example of a Risk Management Model forDecision-Making
IMPACT POTENTIAL RISK MANAGEMENT ACTIONS
Significant
Considerablemanagement
required
Must manage andmonitor risks
Extensivemanagement
essential
Moderate Risks may be worthaccepting withmonitoring
Management effortworthwhile
Management effortrequired
Minor Accept risks Accept, but monitorrisks
Manage andmonitor risks
LOW MEDIUM HIGH
LIKELIHOOD
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Form Risk Assessment Team / Linkagesidentify & involve other affected areas of the OPP & relevant experts
The Process of Risk Management
SCANNING
Risk AssessmentWhat is the risk? What can get in the way of achieving objectives?What controls/systems are currently in place to manage the risk?
Are these systems up to date, understood & implemented?What could still go wrong (short & long run)? Can the current system be improved?
Identify & evaluate the options
Corrective Action Planplan developed to reduce likelihood or impact of occurrence; avoid activity
Evaluate the Outcome
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Systems Acquisition(Engineering and ManufacturingDevelopment, Demonstration, &
Production)
ConceptDefinition
AcquisitionStrategy
PackageDevelopment
MissionIntegration
Operations &Support
OT&E
FRPDecisionReviewConcept &
TechnologyDevelopment
System Development& Demonstration
Production &Deployment Operations &
Support
Pre - SystemsAcquisition
SustainedOperations
A Risk Continuum in Systems Acquisition An Example
Operational Risk Management
Acquisition Risk Management