1. Capital Budgets
Andrew Graham
School of Policy Studies
Queens University

2. 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 the
Capital Budgeting process;
cost often makes it necessary for the organization to
finance the asset using long-term financing from capital
campaigns, mortgages, long-term loans, leases, and equity
offerings.

3. 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)

4. Types of Capital Budget Actions
Capital Capital
Maintenance
Acquisitions Improvements

5. Risk in Capital Investment Decisions
Outcome Investment involves a
is uncertain. long-term commitment.
Capital budgeting:
Analyzing alternative long-
term investments and deciding
which assets to acquire, eliminate or renovate
Decision may be Large amounts of
difficult or impossible money are usually
to reverse. involved.

6. 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.

7. 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 on
financial reporting of deficits, etc.
• Asset valuation and management
• Investment strategies – debt, current
funds, other party investment

8. Capital assets age and break-down!

11. Steps in the Development of a Capital Budget
• 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

12. Inventory 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

13. Capital 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

14. Developing 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

15. Development 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

16. 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

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

18. Other Important Concepts for
Budgets and Planning
• Costing and costing issues –
To be dealt
discussed last lecture. with in this
lecture
• Cost/Benefit Analysis
• Time Value of Money

24. 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 to
determine lowest cost

25. Cost/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

26. The Process of Cost/Benefit Analysis
Calculate the Calculate the
costs Benefits Calculate the
•One time •One time Return on
costs benefits Investment =
ROI
•Ongoing or •Ongoing or
Repeated Benefits Benefits/Costs
Costs × 100% = ROI
•Savings
•Opportunity
•Improved
costs
Services

27. Cost/Benefit Analysis: A Simple Example: A
City Camp: Operate or Rent?
Rent to Outside Fix up &
Group Operate
Benefits $100,000 $200,000
Rental Fees
Costs
Repairs 0 $75,000
Supervision and $50,000 $100,000
Maintenance
Net Benefit $50,000 $25,000

28. Time Value of Money
• Previous example ignores the
role of time in deciding on
alternatives
• More complex issues seldom
play out in one year

29. Time 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

30. Time 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.

31. Time 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

32. Time Value of Money

33. As a formula, Present Value looks like
this
PV = FV [ 1 / (1 + i)n ]
PV = Present Value
FV = Future Value
i = Interest Rate Per Period
n = Number of Compounding Periods

34. Time Value of Money: measuring
present value
• Common unit of measure is ‘year
zero dollars’ = the present value of
funds received or spent in the
future

35. Time Value of Money: measuring
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

36. Time Value of Money: measuring present
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

37. Time Value of Money: measuring present
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

38. Net 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

39. General decision rule in applying NPV. . .
If the Net Present
Value is . . . Then the Project is . . .
Acceptable, since it promises a
Positive . . . return greater than the required
rate of return.
Acceptable, since it promises a
Zero . . . return equal to the required rate
of return.
Not acceptable, since it
Negative . . . promises a return less than the
required rate of return.

40. Evaluating Capital Investment Proposals: An Illustration
Queen’s Stadium is considering purchasing
vending machines with a 5-year life.
Cost and revenue information
Cost 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

41. Queens Stadium Net Present Value Analysis
Year(s) Cash Flow PV factor PV
Vending 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.

42. Queen’s Stadium Net Present Value Analysis
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 $1
factor for 5 years at 15%.
$24,000 × 3.352 = $80,448

43. Queen’s Stadium Net Present Value Analysis
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 $1
factor for 5 years at 15%.

44. Queen’s Stadium Net Present Value Analysis
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
Since the NPV is positive, we know the rate of return is
greater than the 15 percent discount rate.

45. Risk Assessment in Capital Spending
• 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

46. 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

47. Key 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

48. Risk Management in a Public Sector
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

49. Other Risks
• Policy risks
• Public interest risks
• Management or organizational risks
• Project risks
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.

50. 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 little
syndrome.

51. How Do You Measure It?
• Probability and Intensity
• Not all risks are equal,
not all risks require
action – this is about
priority setting

52. Typical Risk Map

53. Typical Risk Map

55. Example of a Risk Management Model for Decision-
Making
IMPACT POTENTIAL RISK MANAGEMENT ACTIONS
Considerable Extensive
Must manage and
Significant management management
monitor risks
required essential
Risks may be worth
Moderate Management effort Management effort
accepting with
worthwhile required
monitoring
Minor Accept risks Accept, but monitor Manage and
risks monitor risks
g LOW MEDIUM HIGH
in n t
as e
cre em
In nag us
LIKELIHOOD
c
Ma Fo

56. The Process of Risk Management
SCANNING
Form Risk Assessment Team / Linkages
•identify & involve other affected areas of the OPP & relevant experts
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

57. A Risk Continuum in Systems Acquisition – An Example
Concept Acquisition Package Mission Operations &
Definition Strategy Development Integration Support
Operational Risk Management
FRP
Concept & Production &
Decision
Review
System Development OT&E
Deployment Operations &
Technology
& Demonstration Support
Development
Acquisition Risk Management
Pre - Systems Systems Acquisition Sustained
Acquisition (Engineering and Manufacturing Operations
Development, Demonstration, &
Production)