7. Capital Budgeting


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7. Capital Budgeting

  1. 1. Capital Budgets Andrew Graham School of Policy Studies Queens University
  2. 2. Capital Budgeting <ul><li>Capital Budgeting is a process used to evaluate investments </li></ul><ul><li>in long-term or capital assets. </li></ul><ul><li>Capital Assets </li></ul><ul><ul><li>have useful lives of more than one year; </li></ul></ul><ul><ul><li>analysis requires focus on the life of the asset; </li></ul></ul><ul><ul><li>low-cost, long-lived assets are not usually subjected to the </li></ul></ul><ul><ul><li>Capital Budgeting process; </li></ul></ul><ul><ul><li>cost often makes it necessary for the organization to </li></ul></ul><ul><ul><li>finance the asset using long-term financing from capital </li></ul></ul><ul><ul><li>campaigns, mortgages, long-term loans, leases, and equity </li></ul></ul><ul><ul><li>offerings. </li></ul></ul>
  3. 3. What are capital assets? <ul><li>They are used in the production or supply of goods and services (productivity criterion), </li></ul><ul><li>Their life extends beyond a fiscal year (longevity criterion) </li></ul><ul><li>they are not intended for resale in the ordinary course of operations </li></ul><ul><li>Their treatment as a capital assets is of value (materiality principle) </li></ul>
  4. 4. Types of Capital Budget Actions Capital Acquisitions Capital Improvements Maintenance
  5. 5. Capital budgeting: Analyzing alternative long- term investments and deciding which assets to acquire, eliminate or renovate Risk in Capital Investment Decisions Outcome is uncertain. Large amounts of money are usually involved. Investment involves a long-term commitment . Decision may be difficult or impossible to reverse.
  6. 6. Why Prepare a Capital Budget? <ul><li>Since the investments are large, mistakes can be costly. </li></ul><ul><li>Since capital acquisitions lock the organization in for many </li></ul><ul><li>years, bad investments can hamper the organization for </li></ul><ul><li>many years. </li></ul><ul><li>Since capital assets have long lives, they must be looked </li></ul><ul><li>at over their lives. Operating budgets do not do that. Value of accrual basis here. </li></ul><ul><li>Since the cash the organization uses to buy the capital </li></ul><ul><li>asset is not free, managers must include the cost of that </li></ul><ul><li>money in their analysis. </li></ul>
  7. 7. Some uniquely public sector issues in capital funding <ul><li>Social/economic goals versus monetary – regional distribution, make-work projects </li></ul><ul><li>Depreciation and replacement </li></ul><ul><li>The border-line between capital and operational budgets and its impact on financial reporting of deficits, etc. </li></ul><ul><li>Asset valuation and management </li></ul><ul><li>Investment strategies – debt, current funds, other party investment </li></ul>
  8. 8. Capital assets age and break-down!
  9. 11. Steps in the Development of a Capital Budget <ul><li>Inventory of Capital Assets </li></ul><ul><li>Development of a Capital Investment Plan </li></ul><ul><li>Development of a Time-Sensitive CIP – multi-year projection </li></ul><ul><li>Development of a Financing Plan </li></ul><ul><li>Approvals, consultations, winning support, and implementation </li></ul>
  10. 12. Inventory of Capital Assets <ul><li>Life cycle assessments – replacement plans </li></ul><ul><li>Depreciation schedules: accrued value or replacement value </li></ul><ul><li>Provides information on the capacity of the infrastructure in place </li></ul>
  11. 13. Capital Investment Plan <ul><li>Primarily a planning document – not necessarily fully funded </li></ul><ul><li>Relating it to the agency’s or government’s overall objectives and priorities </li></ul><ul><li>Danger of ‘hidden’ capital costs not attracting public or political attention: replacing computers, buildings, sewers </li></ul><ul><li>Danger in ‘all to obvious’ capital renewal costs getting priorities: potholes </li></ul>
  12. 14. Developing a Multi-Year Plan <ul><li>Reinforces the cyclical nature of capital costs – recurring expenses </li></ul><ul><li>Permits inclusion of maintenance and preventive costs of capital </li></ul><ul><li>Permits some entities to consider various longer-term funding strategies </li></ul>
  13. 15. Development of a Financing Plan <ul><li>Complexity varies dramatically </li></ul><ul><li>Ranges from drawing on appropriated funds completely right through to public-private partnerships, bonds issues, specialized financing strategies such as user fees (airports) </li></ul><ul><li>Increasing trend to look at creative options </li></ul>
  14. 16. Capital Funding Alternatives <ul><li>Internal Funds </li></ul><ul><ul><li>DEVELOPMENT CHARGES </li></ul></ul><ul><ul><li>OPERATING FUNDS </li></ul></ul><ul><ul><li>SPECIAL RESERVES </li></ul></ul><ul><ul><ul><li>CAPITAL DEVELOPMENT </li></ul></ul></ul><ul><ul><ul><li>REPAIR AND MAINTENANCE </li></ul></ul></ul><ul><ul><ul><li>LIFECYCLE REPLACEMENT – THINK SYSTEMS </li></ul></ul></ul><ul><li>EXTERNAL FUNDING </li></ul><ul><ul><ul><li>LEVIES </li></ul></ul></ul><ul><ul><ul><li>SPECIAL CHARGES – AIRPORT TAX </li></ul></ul></ul><ul><ul><ul><li>PRIVATE FUNDING - PPPs </li></ul></ul></ul><ul><ul><ul><li>DEBT </li></ul></ul></ul>
  15. 17. Continuum of Options, Risk and Delivery Tools Source: British Columbia, “Capital Asset Management Framework”, http:// www.fin.gov.bc.ca/TBS/CAMF_Guidelines.pdf
  16. 18. Other Important Concepts for Budgets and Planning <ul><li>Costing and costing issues – discussed last lecture. </li></ul><ul><li>Cost/Benefit Analysis </li></ul><ul><li>Time Value of Money </li></ul>To be dealt with in this lecture
  17. 24. Cost/Benefit Analysis <ul><li>Uses: </li></ul><ul><li>Comparing benefits and costs of a particular project to see if benefits exceed costs </li></ul><ul><li>Comparing costs of two or more products to determine lowest cost </li></ul>
  18. 25. Cost/Benefit Analysis <ul><li>Comparing the net benefits of two or more projects to decide which will generate maximum benefit </li></ul><ul><li>Can be as simple or as complex as the situation demands </li></ul><ul><li>At its heart, it is a simple process of quantifying costs and benefits </li></ul>
  19. 26. The Process of Cost/Benefit Analysis <ul><li>Calculate the costs </li></ul><ul><li>One time costs </li></ul><ul><li>Ongoing or Repeated Costs </li></ul><ul><li>Opportunity costs </li></ul><ul><li>Calculate the Benefits </li></ul><ul><li>One time benefits </li></ul><ul><li>Ongoing or Benefits </li></ul><ul><li>Savings </li></ul><ul><li>Improved Services </li></ul>Calculate the Return on Investment = ROI Benefits /Costs × 100% = ROI
  20. 27. Cost/Benefit Analysis: A Simple Example: A City Camp: Operate or Rent? $25,000 $50,000 Net Benefit $75,000 $100,000 0 $50,000 Costs Repairs Supervision and Maintenance $200,000 $100,000 Benefits Rental Fees Fix up & Operate Rent to Outside Group
  21. 28. Time Value of Money <ul><li>Previous example ignores the role of time in deciding on alternatives </li></ul><ul><li>More complex issues seldom play out in one year </li></ul>
  22. 29. Time Value of Money <ul><li>Often costs and benefits distribute themselves unevenly over time: long term gain versus short term pain </li></ul><ul><li>When money is received can often be as important as how much is received </li></ul><ul><li>Particularly with capital investments – focus on technology </li></ul>
  23. 30. Time Value of Money Principle <ul><li>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. </li></ul>
  24. 31. Time Value of Money <ul><li>Two important corollaries: </li></ul><ul><li>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. </li></ul><ul><li>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 </li></ul>
  25. 32. Time Value of Money
  26. 33. As a formula, Present Value looks like this PV = Present Value FV = Future Value i = Interest Rate Per Period n = Number of Compounding Periods PV = FV [ 1 / (1 + i) n ]
  27. 34. Time Value of Money: measuring present value <ul><li>Common unit of measure is ‘year zero dollars’ = the present value of funds received or spent in the future </li></ul>
  28. 35. Time Value of Money: measuring present value <ul><li>Uses a factor, usually a discount rate , to restate the funds to their present value </li></ul><ul><li>Example: if 90.0 cents were invested at 10% interest today (show me where) it would be worth $1.00 a year from now </li></ul>
  29. 36. Time Value of Money: measuring present value <ul><li>For decision making purposes, stating a future flow of $1 means committing 90.0 cents today </li></ul><ul><li>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 </li></ul>
  30. 37. Time Value of Money: measuring present value <ul><li>Major impact on intergenerational equity issues </li></ul><ul><li>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 </li></ul><ul><li>Also, how cash will flow becomes crucial in terms of final value </li></ul>
  31. 38. Net Present Value <ul><li>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. </li></ul>NPV = PV Inflows – PV Outflows
  32. 39. General decision rule in applying NPV. . .
  33. 40. <ul><li>Queen’s Stadium is considering purchasing vending machines with a 5-year life. </li></ul>Evaluating Capital Investment Proposals: An Illustration ($75,000 - $5,000) ÷ 5 years
  34. 41. Queens Stadium Net Present Value Analysis 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.
  35. 42. 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
  36. 43. Present value of $1 factor for 5 years at 15%. Queen’s Stadium Net Present Value Analysis
  37. 44. Since the NPV is positive, we know the rate of return is greater than the 15 percent discount rate. Queen’s Stadium Net Present Value Analysis
  38. 45. Risk Assessment in Capital Spending <ul><li>NPV and other tools are a means to try to quantify some risks associated with long term capital investments </li></ul><ul><li>They provide a level analytical playing field </li></ul><ul><li>Risk analysis is much more comprehensive than this </li></ul>
  39. 46. What is Risk? <ul><li>The possibility that the goals of the project will not be met. </li></ul><ul><li>That includes costs, timing, objectives and policy intent. </li></ul><ul><li>It also includes failures in methodology: </li></ul><ul><ul><li>Cost estimations and potential overruns </li></ul></ul><ul><ul><li>Project management </li></ul></ul><ul><ul><li>Even technology chosen – a bridge too far, a submarine too old </li></ul></ul>
  40. 47. Key Attributes of Risk <ul><li>Time horizon is the future which always involves uncertainty. </li></ul><ul><li>Since future events can be either positive or negative, risks can be either threats or opportunities . </li></ul><ul><li>Risk is measured by likelihood and impact . </li></ul><ul><li>Risk appetite and tolerance vary over time, by individual, and by organization. </li></ul><ul><li>Risks have a cost stream potential if the nature of the risk is known or capable of projection. </li></ul>
  41. 48. Risk Management in a Public Sector Context <ul><li>A changing landscape </li></ul><ul><li>Increased transparency </li></ul><ul><li>Increased exposure to the private sector </li></ul><ul><li>Greater citizen expectations </li></ul><ul><li>Stronger inspection of services </li></ul><ul><li>More performance indicators </li></ul><ul><li>More choice? </li></ul><ul><li>‘ Reputation’ becomes more tangible – ‘managing reputation’ becomes vital aspect of strategic risk management in the public sector </li></ul>
  42. 49. Other Risks <ul><li>Policy risks </li></ul><ul><li>Public interest risks </li></ul><ul><li>Management or organizational risks </li></ul><ul><li>Project risks </li></ul>There 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.
  43. 50. Other Risks <ul><li>External capacities of designers, expert advisors, funders, co-funders </li></ul><ul><li>General financing issues </li></ul><ul><li>Poor fit to operations risks </li></ul><ul><li>A general assortment of risk that might attract a chicken little syndrome. </li></ul>
  44. 51. How Do You Measure It? <ul><li>Probability and Intensity </li></ul><ul><li>Not all risks are equal, not all risks require action – this is about priority setting </li></ul>
  45. 52. Typical Risk Map
  46. 53. Typical Risk Map
  47. 55. Example of a Risk Management Model for Decision-Making Increasing Management Focus
  48. 56. <ul><li>Form Risk Assessment Team / Linkages </li></ul><ul><li>identify & involve other affected areas of the OPP & relevant experts </li></ul>The Process of Risk Management SCANNING <ul><li>Risk Assessment </li></ul><ul><li>What is the risk? What can get in the way of achieving objectives? </li></ul><ul><li>What controls/systems are currently in place to manage the risk? </li></ul><ul><li>Are these systems up to date, understood & implemented? </li></ul><ul><li>What could still go wrong (short & long run)? Can the current system be improved? </li></ul><ul><li>Identify & evaluate the options </li></ul><ul><li>Corrective Action Plan </li></ul><ul><li>plan developed to reduce likelihood or impact of occurrence; avoid activity… </li></ul>Evaluate the Outcome
  49. 57. Systems Acquisition (Engineering and Manufacturing Development, Demonstration, & Production) Concept Definition Acquisition Strategy Package Development Mission Integration Operations & Support OT&E FRP Decision Review Pre - Systems Acquisition Sustained Operations A Risk Continuum in Systems Acquisition – An Example Concept & Technology Development System Development & Demonstration Production & Deployment Operations & Support Operational Risk Management Acquisition Risk Management