7 capital budgeting 3604

8/3/2019 7 Capital Budgeting 3604

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Capital Budgets

Andrew GrahamSchool of Policy StudiesQueens University


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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 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?

They are used in theproduction or supply of goodsand services (productivity

criterion), Their life extends beyond a

fiscal year (longevity criterion) they are not intended for resale

in the ordinary course ofoperations Their treatment as a capital

assets is of value (materialityprinciple)


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Types of Capital Budget Actions

CapitalAcquisitions

CapitalImprovements

Maintenance


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Capital budgeting:Analyzing alternative long-

term investments and decidingwhich 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?

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 formany years.

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

Since the cash the organization uses to buy the capitalasset is not free, managers must include the cost of thatmoney in their analysis.


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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 onfinancial reporting of deficits, etc.

Asset valuation and management

Investment strategies debt, currentfunds, other party investment


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Capital assets age and break-down!


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Steps in the Development of a CapitalBudget

Inventory of Capital Assets

Development of a Capital InvestmentPlan

Development of a Time-Sensitive CIP multi-year projection

Development of a Financing Plan

Approvals, consultations, winningsupport, and implementation


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Inventory of Capital Assets

Life cycle assessmentsreplacement plans

Depreciation schedules: accruedvalue or replacement value

Provides information on the capacity

of the infrastructure in place


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Capital Investment Plan

Primarily a planning document notnecessarily fully funded

Relating it to the agencys orgovernments overall objectives andpriorities

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:


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Developing a Multi-Year Plan

Reinforces the cyclical nature of

capital costs recurringexpenses

Permits inclusion ofmaintenance and preventivecosts of capital

Permits some entities toconsider various longer-termfundin strate ies


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Development of a Financing Plan

Complexity varies dramatically

Ranges from drawing onappropriated funds completelyright through to public-privatepartnerships, bonds issues,

specialized financing strategiessuch as user fees (airports)

Increasing trend to look atcreative options


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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


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Continuum of Options, Risk and DeliveryTools

Source: British Columbia, Capital Asset Management Framework,

http://www.fin.gov.bc.ca/TBS/CAMF_Guidelines.pdf
http://www.fin.gov.bc.ca/TBS/CAMF_Guidelines.pdfhttp://www.fin.gov.bc.ca/TBS/CAMF_Guidelines.pdf


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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 todetermine lowest cost


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Cost/Benefit Analysis

Comparing the net benefits of two or moreprojects to decide which will generatemaximum benefit

Can be as simple or as complex as the situationdemands

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


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The Process of Cost/Benefit Analysis

Calculate thecosts

One time

costsOngoing or

RepeatedCosts

Opportunitycosts

Calculate theBenefits

One time

benefitsOngoing or

Benefits

Savings

ImprovedServices

Calculate theReturn on

Investment =ROI

Benefits/Costs 100% = ROI


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

Rent toOutside Group

Fix up &Operate

Benefits

Rental Fees

$100,000 $200,000

CostsRepairs

SupervisionandMaintenance

0

$50,000

$75,000

$100,000

Net Benefit $50,000 $25,000


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Time Value of Money

Previous example ignores therole of time in deciding on

alternatives More complex issues seldom

play out in one year


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Time Value of Money

Often costs and benefitsdistribute themselves unevenly

over time: long term gain versusshort term pain

When money is received canoften be as important as how

much is received Particularly with capital

investments focus ontechnology


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Time Value of Money

Two important corollaries:1. Firms or governments offering to

capitalize (pay for) long term capitalexpenditure will factor in the cost of

the money they pay up front andgovernment will pay for that.

2. Deferred benefits are costed atcurrent rates means that you have

to restate the value of such benefitsinto a common unit of measurement.That is Net Present Value


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Time Value of Money


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As a formula, Present Value looks likethis

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

PV = Present Value

FV = Future Valuei = Interest Rate Per Periodn = Number of Compounding Periods


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Time Value of Money: measuringpresent value

Common unit of measure is year

zero dollars = the present valueof funds received or spent in thefuture


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Time Value of Money: measuring

present value

Uses a factor, usually a discountrate, to restate the funds to their

present value

Example: if 90.0 cents wereinvested at 10% interest today

(show me where) it would beworth $1.00 a year from now


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Time Value of Money: measuring presentvalue

For decision making purposes,stating a future flow of $1 meanscommitting 90.0 cents today

TVM is critical for accrual-basedorganizations that have major capitalcosts or make multi-year

commitments for which a cash flow isneeded less so for cash-based


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Time Value of Money: measuring presentvalue

Major impact on intergenerationalequity issues

Where it really matters for the publicsector is in its use in forward costingand cost benefit analysis of projectsthat 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 Value

Net Present Value (NPV) is a means to calculatewhether the public sector organization will bebetter or worse off if it make a capital

investment. It does so by adding the presentvalue of outflows and the present value ofinflows. It shows the value of a stream of futurecash flows discounted back to the present bysome percentage that represents the minimum

desired rate of return, often called the cost ofcapital.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 requiredrate 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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Queens Stadium is considering purchasingvending machines with a 5-year life.

Cost and revenue information

Cost of vending machines $ 75,000Revenue 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 Illustration


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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 $1factor for 5 years at 15%.

Queens Stadium Net Present Value Analysis

$24,000 3.352 = $80,448


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Salvage 5 5,000 0.497 2,485

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



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



Salvage 5 5,000 0.497 2,485

NPV Now 7,933



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Risk Assessment in Capital Spending

NPV and other tools are a means totry to quantify some risks associated

with long term capital investments They provide a level analytical

playing field

Risk analysis is much morecomprehensive than this


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What is Risk?

The possibility that the goals of theproject will not be met.

That includes costs, timing,objectives and policy intent.

It also includes failures inmethodology: 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 Risk

Time horizon is the future which alwaysinvolves uncertainty.

Since future events can be either positive or

negative, risks can be either threats oropportunities.

Risk is measured by likelihood and impact.

Risk appetite and tolerance vary over time, byindividual, and by organization.

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


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Risk Management in a Public SectorContext

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 vitalaspect of strategic risk management in the

public sector


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Other Risks

Policy risks

Public interest risks

Management or organizational risks

Project risksThere is now a good body of public sector experience that shows thatthere is a need for systematic risk management of major capital

ventures, regardless of how they are financed and delivered. There isalso ample evidence of internal project management risk managementpractices being sound, but being generally ignored by decision makersdue to the overriding political benefits or ideological imperativesassociated with them.


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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 littlesyndrome.


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How Do You Measure It?

Probability and Intensity

Not all risks are equal,not all risks requireaction this is about

priority setting


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Typical Risk Map


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Typical Risk Map


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Example of a Risk Management Model forDecision-Making

IMPACT POTENTIAL RISK MANAGEMENT ACTIONS

Significant

Considerablemanagement

required

Must manage andmonitor risks

Extensivemanagement

essential

Moderate Risks may be worthaccepting withmonitoring

Management effortworthwhile

Management effortrequired

Minor Accept risks Accept, but monitorrisks

Manage andmonitor risks

LOW MEDIUM HIGH

LIKELIHOOD


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Form Risk Assessment Team / Linkagesidentify & involve other affected areas of the OPP & relevant experts

The Process of Risk Management

SCANNING

Risk AssessmentWhat 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 Planplan 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

7 capital budgeting 3604

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