7. capital budgeting
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Capital BudgetsCapital Budgets
Andrew GrahamAndrew GrahamSchool of Policy StudiesSchool of Policy Studies
Queens UniversityQueens University
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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.
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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)
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Types of Capital Budget Actions
CapitalAcquisitions
CapitalImprovements
Maintenance
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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
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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.
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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
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Capital assets age and break-Capital assets age and break-down!down!
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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.
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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
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Time Value of MoneyTime Value of Money
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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
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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
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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
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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
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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
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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
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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 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.
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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 - $5,000) ÷ 5 years
Evaluating Capital Investment Proposals: An Evaluating Capital Investment Proposals: An IllustrationIllustration
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Queens Stadium Net Present Value Analysis
Year(s) Cash Flow PV factor PVVending mach. Now (75,000)$ 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.
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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 = $80,448
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Year(s) Cash Flow PV factor PVVending mach. Now (75,000)$ 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 $1 factor for 5 years at 15%.
Queen’s Stadium Net Present Value Analysis
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Since the NPV is positive, we know the rate of return is greater than the 15 percent discount rate.
Year(s) Cash Flow PV factor PVVending mach. Now (75,000)$ 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
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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
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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
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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.
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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
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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.
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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.
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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
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Typical Risk MapTypical Risk Map
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Typical Risk MapTypical Risk Map
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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
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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
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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