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VI. CAPITAL BUDGETING AND DEBT ADMINISTRATION
Two fundamental responsibilities stem from the broad objectives to "promote the general health, safety, morals, and public welfare":
(1) Regulation of individual actions to ensure that they will not be detrimental to the general public; and
(2) Provision of public services and facilities for the mutual benefit of all or a majority of citizens.
Capital facilities represent very large investments of public resources, usually exert their effects over period of many decades, and are not easy to modify once built.
COMPONENTS OF CAPITAL FACILITIES PLANNING
Capital facilities involve expenditures of a non-recurring nature, designed to provide new or expanded government capacity for the delivery of public services.
The Planning Phase
The following elements should be included in the planning framework:
(1) External factors. Shifts in demographic characteristics, changes in economic activities, social trends, scientific and technological change, emerging land use patterns, and so forth, that may influence the service programs of the community or organization
(2) Total service demands. Assumptions, standards, and criteria used to quantify and project facility and service needs must be identified and tested against available trend analyses.
(3) Service delivery responsibilities. Present and future roles of various levels of government, as well as private enterprise, in the provision of facilities and services must be examined and recommendations made regarding the elimination of overlapping responsibilities through coordination or realignment.
It is important to understand the current demographic composition of the community in order to identify any unique characteristics that may influence future population structure.
o Demographic projections are often based on an age-cohort survival model.
o Population is analyzed by narrow age categories (cohorts) according to vital statistics on births, deaths, and net migration patterns (inflows or outflows of population).
Economic indicators--including data on employment, cost of living, disposable income, building activity, and bank deposits--can be used to analyze trends and to suggest the future revenue capacity of the community.
Economic base studies, widely applied in capital facilities planning, divide the local economy into two broad categories:
(1) Basic or export industries--those industries producing goods and services (and capital) for distribution to markets outside a defined local economic area; and
(2) Nonbasic or service industries--those producing goods and services that are consumed within the local economic area.
A distinction is made between economic activities that bring new money into the community (basic industries) and those that result in the recirculation of money (service industries). 
Land use studies are important for identifying land suitable for various types of capital facilities and for estimating the cost of such public improvements--the cost of sewers, roads, and other facilities can be greatly influenced by topography, subsoil conditions, and the like.
Financial Planning and Fiscal Policy
In economic terms, local government revenues are relatively inelastic--that is, most local sources of revenues are not particularly responsive to changes in the overall economy.
o Property taxes have proven to be relatively unresponsive in meeting increasing demands for public services and facilities.
o Unilateral taxation of income, sales, or business by local governments often results in a shrinkage of the local tax base.
Government services often are labor intensive and not readily amenable to the substitution of capital for labor.
While there have been massive increases in productivity in manufacturing, transportation, and agriculture, increases in public sector productivity have been much less significant.
Revenue and Expenditure Analyses
Revenue analysis separate sources of revenue into appropriate categories and projects these categories over a number of years.
Expenditure analyses also require disaggregation of data into major expenditure categories in order to compute multipliers for each expenditure category.
A sound revenue policy must be based on the basis of a thorough assessment of public service and capital facilities needs, including an analysis of the revenues to be collected if existing fiscal policies are maintained.
Capital Costs and Debt Burden
The annual cost of any improvement program is determined by the planning, scheduling, and methods of financing, together with the projected operating costs.
The tax burden is determined by annual capital costs, measured against tax resources and available subsidies.
The overall debt burden is determined by the total capital costs, together with the schedule and financing methods.
Standards of service should represent actual performance or benefits and be flexible enough to permit adjustments to meet changing conditions.
The Programming Phase
Procedures must be developed for the continuous evaluation of services and facilities, including the following key elements:
o A basic inventory and a set of indicators for measuring and assessing the condition of the infrastructure systems of the community.
o Determination of current conditions and range of potential improvement needs.
o Analyses of the maintenance, repair, and replacement options for different infra-structure improvement proposals (including the "do-nothing" option).
o Analyses of the risks and uncertainties associated with the various investment choices.
o Evaluation of financing options.
o Selection, programming, budgeting, and scheduling of specific improvement projects.
Estimation of Current Infrastructure Conditions
Corrective action must be based on an assessment of major components of the local infra-structure--monitored over time and compared to benchmark data where possible.
Three categories of indicators should be considered:
(1) Engineering-type assessments such as measures of water pipe capacity loss, bridge condition ratings, etc.;
(2) Performance measures such as number of sewer line stoppages, frequency of bus breakdowns; service calls for water line repairs, etc.; and
(3) Service impact indicators such as numbers of citizen complaints and losses arising from system failures (e.g., water main breaks, basement flooding incidents from sewer back-ups).
Appropriate indicators should be drawn from a wide variety of sources, including engineering practices and federal and state rating schemes.
The product of these analyses should be a description of appropriate condition indicators and procedures for obtaining indicator information on a regular (e.g., annual) basis.
Local governments have four options: (1) replace the facility or equipment; (2) rehabilitate or under take a major overhaul; (3) continue to provide current maintenance with emergency repairs as required; or (4) cut back maintenance spending and defer repairs.
Replacement analysis makes an assessment of the trade-offs among the options by providing information on the likely costs, impacts on service levels, and risks of the choices involved.
Depreciation curves show the rate of deterioration as a function of such factors as age, original construction material, climate, intensity of use, and the like.
Equipment replacement models seek to minimize future net costs by estimating the time for replacement in terms of the time at which operating and maintenance costs (plus loss of resale value) exceed the cost (annualized) of replacement plus the operating and maintenance cost of the replacement equipment.
Ranking Capital Project Requests
Decisions regarding capital project requests should be based measurable and defensible criteria which establish priorities among needs.
Systems for assigning priorities can be divided into two approaches: (1) those that stress intangible values, and (2) those that seek to quantify various criteria to develop a numerical scoring system.
Under a numerical priority system, the criterion judged to be most important or most significant is given the highest score, with other factors then ranked in relation to this score.
The priority system--whether developed on a more subjective, intangible basis or on a numerical system--must be tailored to the particular goals and objectives of the individual jurisdiction.
In government, "the actual choice and establishment of final priorities are still accompanied by the political process of compromise, a give-and-take between all groups concerned." 
Capital Improvements Program
Governments have found with experience that six years is a convenient period for the detail programming of capital expenditures, permitting sufficient lead time for the design and other preliminary work required by such projects.
When adopted, the CIP should be made available in report form to civic groups and interested citizens, in addition to being distributed to the operating departments.
The capital program report should cover three main topics:
(1) Explanation of the various legal requirements, magnitude of projected capital needs, fiscal resources of the jurisdiction, etc. that bear on the development of priorities.
(2) Listing of major projects under construction or for which funds have been appropriated.
(3) Description of the capital improvements program and budget for (a) the next fiscal year and (b) the following five years, with listing of projects by agency and by priority.
Capital costs, operating costs, source of funds, method of financing, and financing schedule should be set forth in the report for each project.
Gaining Political Support
A financing plan has a far better chance of success if it has political support from the outset.
Local governments have not been particularly successful in promoting bond referenda.
The local business community seldom has been enlisted as an effective partner in generating public support for the capital plan.
Methods of Financing
Pay-as-you-go financing encourages government to "live within its income," minimizes premature commitments of funds, and conserves credit for times of emergency.
o Achieving user-benefit equity may require financing a facility so that the burden is spread over the life of the improvement.
o Few governments today have the capability to finance vital public facilities strictly on a "pay-as-you-go" basis.
Reserve funds (sometimes called a capital reserve) can be thought of as the opposite of borrowing in that the timetable is reversed--portion of current revenue is invested each year in order to accumulate sufficient funds to initiate some project in the future.
The amount (S) of a reserve fund that is generated by a fixed investment (N) placed annually at compound interest (r) for a term of n years can be expressed by the following formula:
S = [N (1 + r)^n - 1]/r
Government borrowing can be divided into three categories:
o Short-term borrowing takes various forms--bills, certificates, or notes sold to banks or other investors, bank loans, warrants paid in lieu of cash, and unpaid bills and claims--and is used to smooth out irregularities between expenditure and income and to temporarily finance governmental operations when tax receipts fall off unexpectedly.
o Cities operating largely on a pay-as-you-go basis may resort to loans of intermediate maturities (1 to 5 years) when exceptional expenditures cannot be met from current revenues.
o Long-term borrowing is appropriate where the project: (1) will not require replacement for many years; (2) can be financed by service charges to pay off the bond commitments; (3) involves urgent needs for public health and safety purposes or other emergency reasons; or (4) places comparatively large and unforeseen demands on local tax resources.
A bond is a promissory note ensuring that the lender will receive periodic payments of interest (at some predetermined rate) and at maturity (the due date), repayment of the original sum (principal) invested.
o Interest earned on municipal bonds is exempt from federal taxation, and usually from state taxes in the state in which the bond is issued.
o The security of municipal bonds is considered second only to that of federal bonds.
o Municipal bonds have high marketability, assuring that investors can always sell them.
o The diversity of municipal bonds enables investors to obtain bonds in geographic areas and at maturities of their preference.
Three basic types of bonds based on security that backs them:
(1) General obligation bonds are backed by the "full faith, credit, and taxing power" of the issuing locality.
(2) Special Tax or Special Assessment Bonds are payable only from the proceeds of a special tax or from a special assessment levied against those who benefit from the improvement.
(3) Revenue bond are backed by a pledge of the revenues generated by the facility being financed and do not have any claim on the general credit or taxing power of the governmental unit that issues them.
Municipal bonds can also be classified according to the method of redemption.:
Term bonds become due in a lump sum at the end of the term of the loan.
o All of the bonds in the issue reach maturity and must be paid off at the same time.
o The lump-sum principal payment on term bonds is met by making annual payments to a sinking fund.
Serial bonds are retired by annual installments directly from tax revenues, or in the case of revenue bonds, from earned income.
o Annuity serial bonds. The debt service payment is approximately the same each year (as with a home mortgage); the portion of the annual payment devoted to interest is higher in the early years of the issue but declines as payments toward principal are made (as the outstanding principal is retired).
o Straight serial bonds. Annual payments of principal of approximately equal amounts; interest payments are large in the early years and decline gradually as the outstanding bonds approach maturity.
Callable bonds are issued with the provision that they can be paid off prior to maturity date so as to avoid overly rigid fiscal responsibilities, while at the same time permitting more rapid retirement if the project's revenue capacity expands.
New Fiduciary and Fiscal Instruments
Stepped coupon bonds use a serial maturity schedule, with coupon rates that start at lower levels and progressively increase to higher levels, even though all the bonds in the issue are sold at par.
Zero coupon bonds sell at a discount and take advantage of federal tax laws which entitle bondholders who forego tax-free income over the life of their investment to receive tax-exempt capital gains upon maturity.
Compound interest bonds return to the investor at maturity the principal plus interest compounded at a specified rate.
Tender option bond offer the investor the option of submitting the bond for redemption before maturity. Investors usually may redeem a bond (or "tender their option") five years after the date of issue or on any anniversary date thereafter.
The yield of a floating interest rate changes over the life of the bond, based on some interest index printed on the bond itself--most often used is the average weekly rate of Treasury bills or bonds issued during the preceding interest period.
Flexible interest bonds usually have call and/or put features, specifying the earliest dates at which the bondholder can get his/her money back at par.
The most common variable rate demand bond is the "lower floater," in which the interest rate is adjusted weekly relative to a specified index.
A warrant gives the holder the right to purchase more of the same securities to which the warrant is attached at the same price and rate of return as the original bond.
Private activity bonds are used either entirely or partially for private purposes and must meet the test of qualification outlined within federal tax law to obtain tax-exempt status.
Buyers of inflation protection bonds accept a lower stated rate of return in exchange for a guarantee that the principal amount will be adjusted for inflation--measured by the Consumer Price Index--while the interest rate remains fixed.
Under tax-exempt leveraged lease (or TELL) financing, jurisdictions generate capital funds by selling public facilities.
o A private investor buys a public facility by making a down payment and, over a five-year period, contributing equity equal to 25 to 30 percent of the sales price.
o The sale is financed through tax-exempt revenue bonds, and the private investment is "leveraged" by the municipality leasing back the facility at subsidized rates.
In a lease-purchase agreement, a government acquires an asset by making a series of lease payments considered to be installments toward the purchase of the asset.
Certificates of participation (COPs) are a widely used type of lease-purchase financing mechanism, whereby individual investors purchase fractional interests in a particular lease.
Under a master lease-purchase program individual lease purchases are consolidated into a single lease-purchase program in order to achieve lower interest rates, tighter controls, and lower administrative costs.
More conventional approaches to financial capital facilities should not be abandoned unless public officials are satisfied that sufficient benefits will accrue compared to the risks.
Funding Capital Facilities as a Development Cost
Developers of new subdivisions and some commercial or industrial projects may be required to pay the infrastructure costs created by their developments.
This shift to private sector financing has been most pronounced in high-growth states and especially those faced with strict limitations on public bonding or taxes.
The courts generally have upheld off-site dedications that can be shown to be "reasonably related" to the public capital costs attributable to development.
More diverse bond offerings have resulted in increased responsibilities for the administration of public debt.
Marketing Municipal Bonds
Some form of popular referendum is required for the authorization of general obligation bonds.
Bond ordinances or resolutions should be drawn with precision, setting forth the nature and limits of the security offered.
An official notice of sale should be published at least two weeks in advance of the date set for opening bids.
If the enabling legislation permits, the best practice is to allow the rates of interest to be fixed by the bidding underwriters.
Availability of all essential facts concerning the financial condition of the municipality is fully as important as any other factor in the successful marketing of municipal bond.
Municipal bonds must be in registered or book entry form for the interest income to be exempt from federal income taxes.
o Book entry bonds do not have certificates; records of ownership are kept by a depository for its members.
o Transferring the ownership is accomplished by changing the records on the books of the depository to reflect the bond trade.
The cost of borrowing also involves the costs incurred in readying bonds for market and their actual delivery to the initial investors.
Bond ratings appraise two basic credit risk factors: (1) the risk that bond quality will be diluted by an inordinate increase in debt, and (2) the risk that ability to meet principal and interest payments may be impaired under depressed economic conditions.
All bids should be received and opened in public by the governing body at the designated hour, with the bonds awarded to the bidder on the basis of the lowest net interest cost.
Bonds should be delivered at the earliest practical date after the sale (no later than thirty days). --the winning bidder usually has the option to cancel the obligation if delivery is not made on or before the date specified in the contract.
Capital Project Funds
Capital project funds account for the resources which come from the issuance of bonds or other long-term obligations, from intergovernmental grants, or as transfers from other public funds.
These resource should be invested and the investment revenue transferred to the debt service fund for payment of the principal or interest.
When a project is completed, the accounting results are transferred to the debt service fund which tracks the payment of interest and principal on each capital project.
Debt Service Funds
Debt service funds are account for: (1) the accumulation of resources to pay the principal and interest on long-term debt and (2) the investment and expenditure of those resources.
Accrued interest received on the sale of the bonds must be transferred to the debt service fund to partially offset to the amount needed from the general fund for the first interest payment.
When bonds are sold at a premium, the difference is usually transferred to the debt service fund and used with other resources to pay off the bonds.
Several debt issues should be accounted for in a single fund--the fewer the number of funds, the less complicated the accounting for long-term debt.
Resources to service the principal on term bonds are not needed until the debt matures and, therefore, can be invested.
A sinking fund accumulates the assets and fund balance annually to eventually be used for payment of the debt.
Annual payments to the sinking fund are determined by: (1) the dollar value of the bonds to be retired, (2) the number of payments to be made into the account, and (3) the anticipated rate of earnings on the invested funds.
An independent audit of the sinking fund should be made annually in addition to regular auditing by the controller of all sinking fund transactions.
Long-Term Debt Control
Accurate debt records--including auditable ledgers as to the identity, purpose, and amount of debt commitments associated with capital projects--are vital to short-term and long-term fiscal operations.
The general fixed assets account group records all fixed assets purchased, constructed or obtained by contract.
The long-term debt account group is used to maintain records of long-term liabilities, such as serial bonds, long-term notes, and long-term commitments arising from lease or purchase agreements.
Annual financial reports should list all outstanding debt by type of issue (general obligation, special assessment, or revenue bonds).
o Information should be presented as to the annual schedule of debt service, including interest, amortization requirements, and total debt service requirements.
o The portion of the debt of the school district, county, township, or special districts payable from taxes levied by the reporting jurisdiction should be included.
o The jurisdiction's legal borrowing status should be determined.
o If term bonds are outstanding, a sinking fund balance sheet should record the relation of sinking funds to actuarial requirements and a listing of current holdings.
o The level of unfunded debt--short-term borrowing that constitutes an obligation payable out of current revenues--should also be identified.
o Debt arising from the issuance of revenue bonds in proprietary funds must also be shown, including complete information on the facilities that support such debt.
Distribution of Revenues and Issuance of Additional Bonds
A reserve fund receives the income derived from the operation of a self-supporting project.
Sufficient leeway should be provided in the bond indenture or resolution to permit the issuance of additional bonds.
Debt Service and Retirement
Well-defined administrative procedures--including advanced planning of the payment calendar and sound management of sinking funds and capital reserves--are essential to ensure regularity in the payment of interest and redemption of principal.
Allotments for principal and interest payments must be timed to provide cash when needed.
Funds are deposited with the paying agent in advance of interest (and principal) due dates, and the coupons and matured bonds are paid as they are submitted.
Recording and canceling of coupons and bonds that have been paid is the final step in servicing a municipal debt.
Many commercial banks and trust companies that serve as paying agents for municipal bonds include as part of their services all phases of recording and cancellation.
Refunding, Conversions, and Defaults
Refunding is the process of issuing new bonds to retire outstanding bonds and is generally developed through the exercise of the call provision incorporated into the original bond issue.
The refunding analysis should include a determination of:
(1) The probable interest rate on the refunding bonds if offered in the prevailing market;
(2) The gross amount of interest to be saved in terms of: (a) current dollars payable in the years in which the savings will occur; and (b) present worth of dollars to be saved at future dates; and
(3) The cost of refunding--the call premiums payable and the costs incident to the issuance of refunding bonds.
A municipality may find it necessary to refund outstanding debts to avoid default or serious disruption of fiscal operations.
Five elements of refunding need to be considered: (1) the timing of the sale, (2) the maturity schedule of the refunding bonds, (3) the time of settlement on the new bonds, (4) the refunding costs, and (5) the redemption provisions for the refunding bonds.
By far the largest number and most severe municipal defaults took place during the depression era from 1929 through 1938, when approximately $5.5 billion, or 30% of the average net municipal debt outstanding, was in default.
Defaults fall into three general classifications:
o Minor or temporary defaults involve failure to meet the maturity payment of a single security or temporary postponement of interest payments as a result of unanticipated declines in revenue collections, the shutting off of normal lines of bank credit, and/or a temporary inability to market refunded bonds.
o A second, more serious class of defaults involves municipalities that have encountered such fiscal problems as peak debt service in period of low-paying capacity, serious breakdowns in the local economic base, and/or abnormally high tax delinquency.
o The third class of debt involves situations in which the jurisdiction is confronted by abnormally high debt, severely curtailed revenues, and significant accumulation of operating deficits, with little or no prospect for correction except through a comprehensive refunding plan.
A comprehensive refunding plan usually involves the scaling of debt --a reduction in the jurisdiction's overall commitments because the total obligation is beyond its capacity to pay.
The refunding plan must provide: (1) mechanisms to release current accounts from all accumulated deficiencies; and (2) financing procedures that will maintain balanced operations.
SUMMARY AND CONCLUSIONS
Capital facilities planning involves a unified series of steps to carry out the policy aims of government.
It must recognize the interrelated character of all expenditures, whether for new or existing programs or capital outlays, and must provide for their joint evaluation in arriving at expenditure decisions.
Capital facilities planning provides a coordinative mechanism for all phases of capital construction--estimation, submission, approval, execution, and post audit.
Most decisions relating to capital investments are political decisions.
Ultimately, the efficiency and effectiveness of the capital facilities plan is measured by the results of executive and legislative action.
 Richard D. Andrews, "Mechanics of the Urban Economic Base," Land Economics (November 1953), pp. 344-49; "Urban Economics: An Appraisal of Progress," Land Economics (August 1961), pp. 223-225; "Economic Planning for Small Areas: An Analytical System," Land Economics (May 1963), pp. 145-155; ""Economic Planning for Small Areas: The Planning Process," Land Economics (August 1963), pp. 253-264.
 Harry P. Hatry, Annie P. Millar, and James H. Evans, "Guide to Setting Priorities for Capital Investment," Guides to Managing Urban Capital (Washington, DC: Urban Institute Press, 1984).
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