Transcript Capital Budgets - POST: Faculty/Staff Connectivity at Queen's

Capital Budgets
Andrew Graham
School of Policy Studies
Queens University
Capital Budgeting
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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;
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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.
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)
•
Types of Capital Budget Actions
Capital
Acquisitions
Capital
Improvements
Maintenance
Risk in Capital Investment Decisions
Outcome
is uncertain.
Investment involves a
long-term commitment.
Capital budgeting:
Analyzing alternative longterm investments and deciding
which assets to acquire, eliminate or renovate
Decision may be
difficult or impossible
to reverse.
Large amounts of
money are usually
involved.
Why Prepare a Capital Budget?
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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.
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
Capital assets age and break-down!
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
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
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
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
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
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
Continuum of Options, Risk and Delivery Tools
Source: British Columbia, “Capital Asset Management Framework”,
http://www.fin.gov.bc.ca/TBS/CAMF_Guidelines.pdf
Other Important Concepts for
Budgets and Planning
• Costing and costing issues –
discussed last lecture.
• Cost/Benefit Analysis
• Time Value of Money
To be dealt
with in this
lecture
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
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
The Process of Cost/Benefit Analysis
Calculate the
costs
Calculate the
Benefits
•One time
costs
•One time
benefits
•Ongoing or
Repeated
Costs
•Ongoing or
Benefits
•Opportunity
costs
•Savings
•Improved
Services
Calculate the
Return on
Investment =
ROI
Benefits/Costs
× 100% = ROI
Cost/Benefit Analysis: A Simple Example: A
City Camp: Operate or Rent?
Benefits
Rental Fees
Costs
Repairs
Supervision and
Maintenance
Net Benefit
Rent to Outside
Group
$100,000
Fix up &
Operate
$200,000
0
$50,000
$75,000
$100,000
$50,000
$25,000
Time Value of Money
• Previous example ignores the
role of time in deciding on
alternatives
• More complex issues seldom
play out in one year
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
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.
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
Time Value of Money
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
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
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
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
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
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.= PV Inflows – PV Outflows
NPV
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.
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
Queens Stadium Net Present Value Analysis
Vending mach.
Year(s) Cash Flow PV factor
PV
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.
Queen’s Stadium Net Present Value Analysis
Vending mach.
Annual inflow
Year(s) Cash Flow PV factor
PV
Now $ (75,000)
1.000 $ (75,000)
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
Queen’s Stadium Net Present Value Analysis
Vending mach.
Annual inflow
Salvage
Year(s) Cash Flow PV factor
PV
Now $ (75,000)
1.000 $ (75,000)
1-5
24,000
3.352
80,448
5
5,000
0.497
2,485
Present value of $1
factor for 5 years at 15%.
Queen’s Stadium Net Present Value Analysis
Vending mach.
Annual inflow
Salvage
NPV
Year(s) Cash Flow PV factor
PV
Now $ (75,000)
1.000 $ (75,000)
1-5
24,000
3.352
80,448
5
5,000
0.497
2,485
Now
7,933
Since the NPV is positive, we know the rate of return is
greater than the 15 percent discount rate.
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
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
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
of the risk is known or capable of projection.
Risk Management in a Public Sector
Context
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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
Other Risks
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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.
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.
How Do You Measure It?
• Probability and Intensity
• Not all risks are equal,
not all risks require
action – this is about
priority setting
Typical Risk Map
Typical Risk Map
Example of a Risk Management Model for DecisionMaking
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
LIKELIHOOD
HIGH
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
A Risk Continuum in Systems Acquisition – An Example
Concept
Definition
Acquisition
Strategy
Package
Development
Mission
Integration
Operations &
Support
Operational Risk Management
Concept &
Technology
Development
FRP
System Development
& Demonstration
Decision &
Production
Review
OT&E
Deployment
Operations &
Support
Acquisition Risk Management
Pre - Systems
Acquisition
Systems Acquisition
(Engineering and Manufacturing
Development, Demonstration, &
Production)
Sustained
Operations