Capital BudgetsCapital Budgets

Andrew GrahamAndrew GrahamSchool of Policy StudiesSchool of Policy Studies

Queens UniversityQueens University

Capital BudgetingCapital 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.

What are capital assets?What are capital assets?

• They are used in the production or supply of goods and services (productivity criterion),

• Their life extends beyond a fiscal year (longevity criterion)

• they are not intended for resale in the ordinary course of operations

• Their treatment as a capital assets is of value (materiality principle)

Types of Capital Budget Actions

CapitalAcquisitions

CapitalImprovements

Maintenance

Capital budgeting:Analyzing alternative long-

term investments and deciding which 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

Why Prepare a Capital Budget?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 for many years.

Since capital assets have long lives, they must be looked at over their lives. Operating budgets do not do that.Value of accrual basis here.

Since the cash the organization uses to buy the capital asset is not free, managers must include the cost of that money in their analysis.

Some uniquely public sector Some uniquely public sector issues in capital fundingissues 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 on financial reporting of deficits, etc.

• Asset valuation and management• Investment strategies – debt, current

funds, other party investment

Capital assets age and break-Capital assets age and break-down!down!

Steps in the Development of a Capital Steps in the Development of a Capital BudgetBudget

• Inventory of Capital Assets• Development of a Capital Investment

Plan • Development of a Time-Sensitive CIP –

multi-year projection• Development of a Financing Plan • Approvals, consultations, winning

support, and implementation

Inventory of Capital AssetsInventory of Capital Assets

• Life cycle assessments – replacement plans

• Depreciation schedules: accrued value or replacement value

• Provides information on the capacity of the infrastructure in place

Capital Investment PlanCapital Investment Plan

• Primarily a planning document – not necessarily fully funded

• Relating it to the agency’s or government’s overall objectives and priorities

• 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: potholes

Developing a Multi-Year PlanDeveloping a Multi-Year Plan

• Reinforces the cyclical nature of capital costs – recurring expenses

• Permits inclusion of maintenance and preventive costs of capital

• Permits some entities to consider various longer-term funding strategies

Development of a Financing PlanDevelopment of a Financing Plan

• Complexity varies dramatically • Ranges from drawing on

appropriated funds completely right through to public-private partnerships, bonds issues, specialized financing strategies such as user fees (airports)

• Increasing trend to look at creative options

Capital Funding AlternativesCapital 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

Continuum of Options, Risk and Continuum of Options, Risk and Delivery ToolsDelivery Tools

Source: British Columbia, “Capital Asset Management Framework”, http://www.fin.gov.bc.ca/TBS/CAMF_Guidelines.pdf

Other Important Concepts for Other Important Concepts for Budgets and PlanningBudgets and Planning

•Costing and costing issues – discussed last lecture.

•Cost/Benefit Analysis•Time Value of Money

To be dealt with in this

lecture

Cost/Benefit AnalysisCost/Benefit Analysis

Uses: • Comparing benefits and costs of a

particular project to see if benefits exceed costs

• Comparing costs of two or more products to determine lowest cost

Cost/Benefit AnalysisCost/Benefit Analysis

• Comparing the net benefits of two or more projects to decide which will generate maximum benefit

Can be as simple or as complex as the situation demands

At its heart, it is a simple process of quantifying costs and benefits

The Process of Cost/Benefit The Process of Cost/Benefit AnalysisAnalysis

Calculate the costs

•One time costs

•Ongoing or Repeated

Costs

•Opportunity costs

Calculate the Benefits

•One time benefits

•Ongoing or Benefits

•Savings

•Improved Services

Calculate the Return on

Investment = ROI

Benefits/Costs × 100% = ROI

Cost/Benefit Analysis: A Simple Cost/Benefit Analysis: A Simple Example: A City Camp: Operate or Example: A City Camp: Operate or Rent?Rent?

Rent to Outside Group

Fix up & Operate

BenefitsRental Fees

$100,000 $200,000

CostsRepairsSupervision and Maintenance

0$50,000

$75,000$100,000

Net Benefit $50,000 $25,000

Time Value of MoneyTime Value of Money

• Previous example ignores the role of time in deciding on alternatives

• More complex issues seldom play out in one year

Time Value of MoneyTime Value of Money

• Often costs and benefits distribute themselves unevenly over time: long term gain versus short term pain

• When money is received can often be as important as how much is received

• Particularly with capital investments – focus on technology

Time Value of Money PrincipleTime Value of Money Principle

Money in hand now is worth more than the right to

receive money in the future because money in hand now

can be invested to earn interest.

Time Value of MoneyTime Value of Money

Two important corollaries: 1. Firms or governments offering to

capitalize (pay for) long term capital expenditure will factor in the cost of the money they pay up front and government will pay for that.

2. Deferred benefits are costed at current rates – means that you have to restate the value of such benefits into a common unit of measurement. That is Net Present Value

Time Value of MoneyTime Value of Money

As a formula, Present Value As a formula, Present Value looks like thislooks like this

PV = FV [ 1 / (1 + i)n ]

PV = Present ValueFV = Future Valuei = Interest Rate Per Periodn = Number of Compounding Periods

Time Value of Money: Time Value of Money: measuring present valuemeasuring present value

• Common unit of measure is ‘year zero dollars’ = the present value of funds received or spent in the future

Time Value of Money: Time Value of Money: measuring present valuemeasuring present value

• Uses a factor, usually a discount rate, to restate the funds to their present value

• Example: if 90.0 cents were invested at 10% interest today (show me where) it would be worth $1.00 a year from now

Time Value of Money: measuring Time Value of Money: measuring present valuepresent value

• For decision making purposes, stating a future flow of $1 means committing 90.0 cents today

• TVM is critical for accrual-based organizations that have major capital costs or make multi-year commitments for which a cash flow is needed – less so for cash-based

Time Value of Money: measuring Time Value of Money: measuring present valuepresent value

• Major impact on intergenerational equity issues

• Where it really matters for the public sector is in its use in forward costing and cost benefit analysis of projects that derive actual costs and benefits of a project

• Also, how cash will flow becomes crucial in terms of final value

Net Present ValueNet Present Value

Net Present Value (NPV) is a means to calculate whether the public sector organization will be better or worse off if it make a capital investment. It does so by adding the present value of outflows and the present value of inflows. It shows the value of a stream of future cash flows discounted back to the present by some percentage that represents the minimum desired rate of return, often called the cost of capital.

NPV = PV Inflows – PV Outflows

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 required

rate 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.

Queen’s Stadium is considering purchasingvending machines with a 5-year life.

Cost and revenue informationCost of vending machines $ 75,000

Revenue 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 Evaluating Capital Investment Proposals: An IllustrationIllustration

Queens Stadium Net Present Value Analysis

Year(s) Cash Flow PV factor PVVending mach. Now (75,000)$ 1.000 (75,000)$

Queens uses a 15% discount rate.

Term for the annual growth rate of an investment, used when a future value is assumed and you are trying to find the required present value. Also called the internal rate of return.

Year(s) Cash Flow PV factor PVVending mach. Now (75,000)$ 1.000 (75,000)$ Annual inflow 1 - 5 24,000 3.352 80,448

Present value of an annuity of $1 factor for 5 years at 15%.

Queen’s Stadium Net Present Value Analysis

$24,000 × 3.352 = $80,448

Year(s) Cash Flow PV factor PVVending 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 $1 factor for 5 years at 15%.

Queen’s Stadium Net Present Value Analysis

Since the NPV is positive, we know the rate of return is greater than the 15 percent discount rate.

Year(s) Cash Flow PV factor PVVending 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

Queen’s Stadium Net Present Value Analysis

Risk Assessment in Capital Risk Assessment in Capital SpendingSpending

• NPV and other tools are a means to try to quantify some risks associated with long term capital investments

• They provide a level analytical playing field

• Risk analysis is much more comprehensive than this

What is Risk?What is Risk?

• The possibility that the goals of the project will not be met.

• That includes costs, timing, objectives and policy intent.

• It also includes failures in methodology: – Cost estimations and potential overruns– Project management– Even technology chosen – a bridge too

far, a submarine too old

Key Attributes of RiskKey Attributes of Risk

• Time horizon is the future which always involves uncertainty.

• Since future events can be either positive or negative, risks can be either threats or opportunities.

• Risk is measured by likelihood and impact.

• Risk appetite and tolerance vary over time, by individual, and by organization.

• Risks have a cost stream potential if the nature of the risk is known or capable of projection.

Risk Management in a Public Risk Management in a Public Sector ContextSector Context

• 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 vital

aspect of strategic risk management in the public sector

Other RisksOther Risks

• Policy risks• Public interest risks• Management or organizational

risks• Project risksThere is now a good body of public sector experience that shows that

there is a need for systematic risk management of major capital ventures, regardless of how they are financed and delivered. There is also ample evidence of internal project management risk management practices being sound, but being generally ignored by decision makers due to the overriding political benefits or ideological imperatives associated with them.

Other RisksOther 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 little syndrome.

How Do You Measure It?How Do You Measure It?

•Probability and Intensity

•Not all risks are equal, not all risks require action – this is about priority setting

Typical Risk MapTypical Risk Map

Typical Risk MapTypical Risk Map

Example of a Risk Management Model for Example of a Risk Management Model for Decision-MakingDecision-Making

IMPACT POTENTIAL RISK MANAGEMENT ACTIONS

Significant Considerable management

required

Must manage and monitor risks

Extensive management

essential

Moderate

Risks may be worth accepting with

monitoring

Management effort worthwhile

Management effort required

Minor Accept risks

Accept, but monitor

risks Manage and monitor risks

LOW MEDIUM HIGH

LIKELIHOOD Increasing

Management

Focus

Form Risk Assessment Team / Linkages•identify & involve other affected areas of the OPP & relevant

experts

The Process of Risk ManagementSCANNING

Risk Assessment•What 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 Plan• plan developed to reduce likelihood or impact of occurrence; avoid

activity…

Evaluate the Outcome

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