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CAPITAL BUDGETINGInfrastructure & Project Evaluation
Making decisions having significant future net benefits or costs
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JUSTIFYING PUBLIC SPENDING• Spending/Proposing agencies
are responsible for justifying their proposals (I.e., presenting the case for spending in ABC terms)
• Budget analysts are supposed to guarantee that the proper justification has been provided
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Exercise 3.7Questions:
What are: new social procedures, valid test results and scores, sociological
recommendations, evaluation professionals, specialty counselors,
maximum effectiveness, and success factor? Don't use possibly empty
jargon.
What actually is being requested? What makes up a "counselor team" and
where will the "teams" be located?
How did the case service funds for abused children get included in this
request?
What is the advantage of bringing together battered spouses? Explain.
And why does this apparent objective require testing and special training?
Is this really a workload change--or a program improvement?
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An illustrative rewrite:
Program Improvement--2002-03 Biennial Cost: $184,300
Counseling programs for battered spouses have the objective of protecting
battered spouses and, eventually, allowing them to continue life without
outside assistance. This request would provide two part-time
psychologist/ counselors trained in abuse management in each of the
following state mental health centers: Baileyville, Roberts, Needmore, and
Trevlac. Each team would counsel clients and refer them to other state and
local social programs. (Then: separate Workload Change request for child
abuse.)
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As a Practical MatterIf this proposal were consistent
with executive priorities, we would stop here:• The dollar values are small• The activities are more or less
reversible• Estimating program benefits
would be prohibitively costly
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ButThe following is also true:
• Present Value of the workforce commitment is approximately $6million, excluding hiring and training costs
• Overheads are probably of roughly the same magnitude
• Some benefits can be estimated • e.g., savings to state from reductions in future
assistance. If teams would counsel 4000 battered spouses a year,
they would pay for themselves if they reduced future assistance by $100 on average.
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Public Sector Project Assessment should take all benefits and costs to public
into account Federal Gov. treats consequences to
itself as costsConsequences for citizens as benefits
Hence, revenues are negative costs and payments by citizens negative benefits
REVENUE TO GOVERNMENT ≤ COST TO CITIZENS
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TWO ASSUMPTIONS
The welfare of an entity's stakeholders will be maximized by the implementation of all policy choices that generate positive net-present values.
Timing of benefits or costs accruing from a policy choice is generally of no importance -- so long as benefits/ costs are properly discounted.
The source of financing does not matter -- shouldn’t influence capital budgeting decisions, value will be the same regardless of whether an activity is financed with debt, fund balances, or taxes
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Together these two assertions imply that all
capital budgeting decisions should be
governed by cost-benefit analysis, which says:
do it whenever benefits exceed costs
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As Practical Matters• Some projects have greater
value when deferred than at present
• State and Local Governments are often Liquidity constrained (as are many of their citizens), which means that they may have to make tradeoffs
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CONVERTING FUTURE VALUE TO PRESENT VALUEMaking decisions having
significant future benefits or costs means looking at consequences from where we are right now: converting future benefit/cost flows to
PRESENT VALUES
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DiscountingFuture values are converted to
present values by means of a discount rate.
That is, future nominal benefits are worth less than present benefits of equal magnitude -- the WIMPY principal• Inflation• Markets tell us that people
demand compensation for forgoing current consumption
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Mechanics of Discounting I
PV = FV in year t / [1+r]^t
Where PV = Present ValueFV = Future Value (real or
nominal)
t = Yearr = Discount Rate (real or nominal)
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Mechanics of Discounting IIFor a Stream of Benefits from
year 1 to year t, SUM [add up] all the present values for
all net future valuesWhere t = 3
PV = (FV in year 1 / [1+r]^1) + (FV in year 2 / [1+r]^2) + (FV in
year 3 / [1+r]^3)
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Three Ways to Find PVs
• Solve the equation with a regular calculator (or use FV tables from an accounting text).
• Use a financial calculator.• Use a spreadsheet.
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10%
What’s the PV of $100 due in 3 years if i = 10%?
Finding PVs is discounting; it’s the reverse of compounding.
100
0 1 2 3
PV = ?
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( )PV =
FV
1+ i = FV
11+ i
nn n
n⎛⎝⎜
⎞⎠⎟
PV = $1001
1.10
= $100 0.7513 = $75.13.
3
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Spreadsheet Solution
• Use the PV function: see spreadsheet. = PV(Rate, Nper, Pmt, FV)
= PV(0.10, 3, 0, -100) = 75.13
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What is the PV of this uneven benefit stream?
0
100
1
300
2
300
310%
-50
4
90.91247.93225.39-34.15
530.08 = PV
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Spreadsheet Solution
Excel Formula in cell A3:
=NPV(10%,B2:E2)
A B C D E
1 0 1 2 3 4
2 100 300 300 -50
3 530.09
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Perpetuities
PV = NBF / rWhere NBF = a specified
annual net-benefit flow
For example:
$186k / .03 = $6.2m
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Alternative Discount Rates
• Market rate = r + i + b + y
Where r = real, risk-free ratei = the expected rate of inflation
b = project specific (nondiversifiable) risk
y = income tax adjustment
• Nominal risk-free rate [n] = r + i
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Use of Alternative Discount Rates• Use real rate [r] with real FVs
• For example, where you are using current costs to estimate future costs
• Use nominal rate [n] with nominal FVs• For example, where you are making
identical nominal principal and interest payments each year
WHAT NOMINAL RATE SHOULD YOU USE?
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Use of Alternative Discount Rates• Use real rate [r] with real FVs
• For example, where you are using current costs to estimate future costs
• Use nominal rate [n] with nominal FVs• For example, where you are making identical
nominal principal and interest payments each year
Borrowing rate on tax-exempt, general-purpose bonds of similarMaturities.
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Annualizing Capital Costs
• Since US government budget is formulated one year at a time, the budget tends to be biased against delivery methods requiring up-front investments
• The proper solution is converting everything to PV
• However, there is a reasonable alternative, which is the annualizing capital costs
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Mechanics of AnnualizingAnnual Cost of a Capital Asset
= P [r + d - a]
Where P = Purchase Price [replacement cost]
d = Depreciation rate
[wear and tear + obsolescence]
a = Appreciation rate