Chapter seven

Capital Budgeting

Capital budgeting or capital expenditure budget is a process of making decisions regarding investments in
fixed assets such as land, building, machinery or furniture. The word investment refers to the expenditure
which is required to be made in connection with the acquisition and the development of long-term
facilities including fixed assets. It refers to process by which management selects those investment
proposals which are worthwhile for investing available funds. For this purpose, management is to decide
whether or not to acquire, or add to or replace fixed assets in the light of overall objectives of the
organization.

7.1. Capital Improvements Program (CIP)

A capital improvements program is a blueprint for planning a community's capital projects. A CIP is a
multiyear planning instrument used by governments to identify needed capital projects (the maintenance,
repair and rehabilitation of existing infrastructure as well as the construction of buildings, utility systems,
roadways, bridges, parks, landfills and heavy equipment which have a high cost and a useful life of
several years); the project appropriations or spending that must be incurred to make those needs a reality;
the sources of financing for the projects; and the impact of the projects on future operating budgets. A
CIP is not a static document. It should be reviewed every year to reflect changing priorities, unexpected
events and opportunities.

Purpose of Capital Improvements Program (CIP)

A. Mechanism for formal decision making

A CIP provides government with a process for the planning and budgeting of capital needs. A CIP
answers such questions as what to buy, build, or repair and when to buy or build. It is a useful tool for
prioritizing of capital projects.

B. A link to long range plans

A CIP serves as a link to the planning process and should be developed with the land use plan, strategic
plan and other long range plans. When determining whether or not new infrastructure should be
constructed or existing infrastructure should be replaced, it is important to consider changing
demographics and land use patterns.

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 C. Financial management tool

A CIP is used to prioritize current and future needs to fit within the anticipated level of financial
resources. When looking at capital projects, it is important to consider the operating and maintenance
costs that will be incurred with the construction or replacement of infrastructure. A CIP will allow for
better financial planning and will smooth the need for sharp increases in tax rates or user fees to cover
unexpected repairs, replacements or construction of capital assets.

D. Reporting document

A CIP presents a description of proposed projects that will be undertaken over the planning period. The
CIP is used to communicate to citizens the government unit’s capital priorities and plans for
implementing projects. It also includes the expected source of funding for projects.

7.2 Capital Budget

Capital Budget is also known as "Investment Decision Making or Capital Expenditure Decisions" or
"Planning Capital Expenditure" etc. Normally such decisions where investment of money and expected
benefits arising there from are spread over more than one year, it includes both raising of long-term funds
as well as their utilization.

Capital budgets in governments have multiple roles: as instrument of fiscal policy and to improve the net
worth of government, and particularly in the area of economic infrastructure as vehicles for economic
development. Governments have introduced capital budgets to serve all these objectives, singly or
collectively, depending on the context.

Budgeting for capital items is most often associated with longevity, high cost, and major impact. Items
that have a useful life extending beyond a single year are considered to have longevity and are candidates
for capital budgeting. Such items become fixed assets. Also, high-cost physical items that make a
substantial impact on an annual budget if funded in anyone year are candidates for capital budgeting.
Finally, items expected to have a significant impact that are not easily changed are often included within a
capital budget. Examples of capital items are land, public buildings, large and expensive equipment, and
public improvements, such as streets and sewer, are all items that should be included in a capital budget.

Capital budgeting is the process of identifying and selecting investments in long-

lived assets, or assets expected to produce benefits over more than one year.
Moreover, capital budgeting is concerned with the firm's formal process for the acquisition and

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investment of capital. Due to these concepts, capital budgeting is important because of the following
reasons:

 Capital budgeting decisions involve long-term implication for the firm.

 Capital budgeting involves commitment of large amount of funds.
 Capital decisions are required to assessment of future events which are uncertain.
 In most cases, capital budgeting decisions are irreversible. This is because it is very difficult to
find a market for the capital goods. The only alternative available is to scrap the asset, and incur
heavy loss.
 Capital budgeting ensures the selection of right source of finance at the right time.
 Wrong sale forecast; may lead to over or under investment of resources.

7.2.1. Elements of Capital Budgeting

Three major elements exist within a capita1 budget process: (1) planning, (2) cost analysis and
(3) financing. Each requires a certain amount of research capability, staffing (either external or
internal), organizational capacity, and expertise.

1. Planning

Effective capital budgeting requires a comprehensive planning effort. This effort includes a
number of elements: (1) an inventory of existing capital assets, (2) a review of constituent
demands for goods and services in the future, and (3) a review of replacement needs of existing
capital assets.

Surprisingly, most public and nonprofit agencies lack a comprehensive inventory of their capital
assets. Depending on the size and holdings of the public agency, such a list can be relatively easy
to produce or can represent an enormous undertaking. Such an inventory can include some of the
following elements: the type of facility or equipment asset; the date the asset was acquired; the
initial cost of the asset; any improvements that have been made; the existing condition of the
asset; the level of utilization of that land, facility, or equipment; its depreciated value;
replacement cost; and the anticipated end of its useful life or replacement date. This inventory
can be used as the first step in a risk management program as well as a capital budgeting
program.

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Perhaps one of the most difficult parts of a capital budget planning effort is, to develop a clearly
defined needs analysis to help the organization determine future demands for capital assets.
Information on current and future needs guides where public resources should be directed in
acquiring capital asset. Such analysis requires the incorporation of existing replacement needs, a
review of shifting external changes, and any anticipated internal changes that affect the need or
demand for such capital assets.

An analysis is used most commonly for major capital improvement projects such as buildings,
streets, sewers, and large equipment. In some cases, the approach is similar to the environmental
scan elements of strategic planning. The agency should consider factors, both internally and
externally, that affect the need associated with capital acquisition. Several factors are
incorporated into such analysis. Shifts in population size and location provide indications of
where new facilities may be required. This is very common with public school systems, where
changes in the number of elementary school children and corresponding changes in the number
of high school students may require acquiring some new buildings and closing others. Changes
in facility use can also occur.

Demographic and cultural changes of the existing constituent base and changes in legal
requirements can portend increasing demands for services. Changes in federal and state laws
affecting health care benefits for the poor and elderly have increased demands for facilities and
services, particularly at the state level.

Planning includes a systematic review of the replacement needs of existing facilities and
equipment. Most facilities and equipment have an expected useful life span, which may range
from a few years to as many as 40 years. Replacement periods can be based on both wear and
tear and usage or on technological obsolescence. Streets, sewers, and front-end loaders are
examples of the former, whereas computers, telecommunications equipment, and other
electronics equipment exemplify the latter.

Technological obsolescence does not mean that facilities or equipment do not work or require
increased maintenance. It simply means that more recent advances in technology have made the
facilities or equipment less useful than new facilities or equipment to meet current and future

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demands. This is a very different situation from one in which equipment, because of wear and
tear, has increasing downtime when it is unavailable or where the maintenance and replacement
part costs begin to exceed the actual depreciated value of the equipment itself. Streets that are
constantly under repair or buildings with major structural and mechanical problems are
recommended strongly as candidates for replacement.

Replacement schedules should be developed when facilities and equipment are acquired. This
allows a public agency to plan years in advance of the actual need for the replacement. This
information can also be placed on a capital budgeting calendar so that replacement decisions can
be contrasted with decisions for acquisition of new capital assets.

These replacement schedules should be based on useful life, with a clear understanding of the
trade-offs between replacement relative to repair or maintenance and between replacement and
modernization. Replacement schedules-which are forecasts, after all-should be adjusted yearly to
account for factors that have changed since that schedule was developed. For example, street
replacement may be based on assumptions about level of usage. If the usage or wear and tear is
greater than originally thought, the replacement schedule should be adjusted to reflect such a
change.

2. Cost analysis- Evaluating Expenditure Decisions

Perhaps the most difficult decision faced by policymakers and administrators is choosing which
capital assets to acquire or replace. Most public organizations have limited resources and face
legal as well as political restrictions on their ability to raise revenue. For these reasons, a limited
number of capital items can be acquired during any one time period. Priorities must be set to
fund those that are considered the most important. Importance can be determined by some form
of economic analysis or by other concerns (political need, fairness, or visibility). Assuming,
however, that some form of systematic analysis is useful, most finance professionals suggest
using a systematic method to evaluate the importance of various capital acquisitions. These
methods involve numerous criteria-quantitative, qualitative, and political. The key is to match
available revenue sources with a wide-ranging set of expenditure options and to match

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expenditure options to revenue availability. Criteria can be developed that are simple or
complex. Among the most common are the following.

 Costs of any particular project, facility, or equipment relative to competing projects,

facilities, or equipment
 Costs relative to benefits for competing projects, facilities, or equipment
 Relationship of the capital asset to the specific goals and objectives of the organization.
 Financial impact of the project on defined beneficiaries
 Capital costs relative to operating and maintenance costs
 Spin-off benefits of the capital asset to other public and private activities
 Effect on improved efficiency of organizational activities
 Political costs and benefits of the project
 Legal mandate of a project or activity mandated by law
 Chances for external funding
 Relationship to future needs and demands

Although this list is not exhaustive, it does provide a wide range of criteria to consider when
developing an evaluation system. The major focus is deciding which capital assets to fund lies in
the area of cost.

Cost-effectiveness and cost-benefit analysis can be used to compare capital expenditure items.
Not all capital expenditures are associated with their cost relative to their benefits; however,
many decisions are made on other bases. Other decisions are made on the grounds of equity
rather than cost. Providing mass transit facilities in low use areas may make little economic
sense. If these areas are also populated by low-income citizens, however, eliminating such
facilities simply because they are not economical is often rejected by public agencies responsible
for such facilities on the basis of equity.

Another example pertains to disabled access to public facilities. Retrofitting public buildings or
transportation equipment and facilities to allow for disabled access is not the most cost-effective
way to ensure particular outcomes; however, it does serve social and political objectives or meet
legal requirements that make such expenditures necessary.

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There are many different ways to evaluate capital expenditures. Various factors can be weighted
in level of importance and then ranked according to a quantitative system. Opinion surveys can
be used along with qualitative analysis to determine level of support for various projects. This is
especially helpful if a project or facility is potentially controversial among elected officials or
citizens affected.

3. Financing

No matter how various projects are ranked, rated, or prioritized, the funding of capital items is
contingent on adequate revenue. Revenue sources should suffice to encompass both the capital
expenditure and the operating or maintenance costs associated with that expenditure. It makes
little sense to purchase a piece of equipment if an organization cannot afford to maintain or
repair it.

Two major modes of financing capital projects are pay-as-you-go and pay-as-you-use. The most
conservative financing approach is pay-as-you-go. This simply means that the expenditure of
funds for a capital item does not occur until the money is in hand. Debt is not incurred to fund all
or a part of the capital item. On the other hand, pay-as-you-use proponents argue that financing
should occur as the capital asset is used. Incurring debt to fund such an item is logical because
the debt can be paid throughout the item's useful life.

Both approaches may be appropriate, depending on the particular situation facing the
organization. Both have inherent strengths and weaknesses. Pay-as-you-go ensures that an
organization does not borrow money to finance capital assets. Interest charges are a measure of
opportunity cost. Public organizations must choose between more expenditure to have more
capital facilities and equipment, which means more revenues, and less expenditure, fewer capital
items, and fewer revenues. Unfortunately, fewer expenditures and revenues and more capital
items is not possible. If concern exists about borrowing money and incurring debt to obtain
capital facilities, the pay-as-you-go approach may be the more acceptable action.

The disadvantage of pay-as-you-go can be substantial. Many capital items would never be
acquired or replaced because funding is simply not available within existing resources of an
organization. In this sense, pay-as-you-go discriminates against larger expenditures. In small

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organizations or where the capital item is expensive, the pay-as-you-go approach can create
much greater fluctuations in the budget expenditures from year to year and can also create
fluctuations in the revenue load of the organization's supporters. This is not a particular problem
for the national government, which has such an enormous budget that anyone capital expenditure
is unlikely to have a substantial impact.

In a small town, however, building a new fire station or paving a street can have a substantial
impact. In addition, the concept of intergenerational equity is violated with a Pay-as-you-go
approach. This means that those who benefit from the item are not necessarily the ones who
finance the asset. For example, if taxpayers in a community use money that had been saved over
a period of years to build a recreational center, the beneficiaries of the center may not be the
same as those who put their tax dollars toward building it. Some may move away or die. Then,
they will have helped pay for a facility that they never have a chance to use. This is considered
inequitable.
Pay-as-you-use financing is beneficial for a number of reasons. First, it helps spread the costs of
the capital asset over a number of years, thus making acquisition or more feasible in many cases.
It avoids great fluctuations in expenditures and revenues. Second, it provides for
intergenerational equity by allowing those paying taxes or user fees for a particular capital
expenditure to have access to that item.

There are dangers associated with the pay-as-you-use approach. The greatest concern is that
financing of capital items might exceed the useful life of that asset. In other words, a public
agency should not finance a piece of equipment for 10 years if it is likely that the equipment will
need to be replaced in 5 years. Such borrowing can place the agency in a financially precarious
situation, where it is using current revenues to pay for capital assets that no longer exist.

Several options exist for public agencies that do not wish to rely exclusively on either pay-as-
you-go or pay-as-you-use. One approach would be to use a substantial down payment for a
capital expenditure and to finance the remainder through borrowing. In this way the amount
financed through debt can be reduced, yet intergenerational equity can be partially protected. A
similar approach is to shorten the maturity date of the debt that is issued to finance capital

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acquisition so that debt costs are minimized and items are funded before the end of their useful
lives.

Another option is to set up a sinking fund that can cover costs associated with replacing a capital
item. Money is put into the fund yearly. This is similar to debt in extended funding and is used
extensively in replacing equipment and other short- or intermediate-lived capital items. The
money can be invested in interest-bearing accounts, and the principal and interest can accumulate
at the rate such that at the time a capital asset must be replaced, funding necessary to pay for that
replacement is readily available. It is extremely important that when such funds are created, they
are maintained separate and distinct from other funds. It is often tempting to raid these funds to
help cover the costs of other operating items within the budget or to deal with other concerns,
such as revenue shortfalls.

Under certain circumstances, leasing provides an attractive alternative to either financing

approach. This is a variant of pay-as-you-use, because ownership is not involved. When a capital
asset is likely to have a very short useful life, as is the case with certain kinds of equipment
(automobiles and computers and so forth), or whether the financing costs (both for incurring debt
and for servicing and maintenance) will be clearly lower, leasing is an alternative to acquisition.
In many instances, a public agency can obtain title to the capital asset at the end of a lease at a
minimal cost. The disadvantage to this, however, is that the asset may have reached the end of its
useful life at the end of this period.

7.2.2. Administration of the Capital Budgeting Process

Administration of the capital budgeting process is often shared among operating, planning, and
finance officials. Each group has an important role to play. Operating departments within public
organizations funnel requests for capital items to their financial officials. Those responsible for
planning within the public organization review trends and developments as they affect the need
for various capital projects, facilities, and equipment and submit this information along with the
various requests that are made. The finance officials must provide a critical review of each
request, provide evaluative criteria for ranking the relative importance of each, and determine a
financing system to fund the most important items.

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In most instances, a 5-to-l0-year capital improvement plan is submitted to the policy board of an
agency for its review and approval. This multiyear plan includes all major capital construction
and acquisition projects scheduled during that time. The capital budget includes the revenue and
expenditure amounts for capital items that are to be constructed or acquired during the coming
year. In most instances, a capital improvement plan is revised and approved each year along with
a capital budget.

A major problem of capital budgeting is that some perceive it as a static process. Once a five-
year capital budget plan is adopted, some in the agency assume that they do not have to deal with
it again for another five years. In fact, the capital budgeting process is a dynamic one. As an
organization's financial situation changes and as environmental factors change, it is important
that the capital budget plan reflects these changes. At a minimum, the plan must be updated
annually to reflect shifting priorities and concerns.

Another problem is that many public agencies treat the capital budgeting process as a paper
exercise and often ignore it during the annual budget process. This is often the case for local
government officials when state or federal law mandates some type of capital budgeting process
but elected officials are not convinced of its appropriateness and do not participate in the
development of the capital budget themselves. This is especially evident when the later years of a
capital budget are populated with the same proposals as in the initial year, none of them either
chosen or dropped. The key can be to link some form of strategic planning to the agency's budget
process, including the capital budgeting process.

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