Methods of Financing

The options for financing public facilities are similar to those available to any individual or family: (a) pay cash, (b) save money for future acquisitions, or (c) borrow on anticipated earning power. A sound, long-range revenue program will seek to develop an appropriate mix among these three methods of financing capital improvements.

Pay-As-You-Go Financing

Financing capital improvements on a "pay-as-you-go" basis from current revenues encourages government to "live within its income." It minimizes premature commitments of funds and conserves credit for times of emergency when ample credit may be vital. Pay-as-you-go financing avoids the added cost of interest payments and therefore, is less costly than borrowing.

On the other hand, the pay-as-you-go approach may result in an undue burden being placed on present taxpayers to finance some future need from which they may not fully benefit. Achieving user-benefit equity--if that is an important goal--may require financing a facility so that the burden is spread over the life of the improvement. Thus, it may be argued that public projects providing services over many years should be paid for by people according to their use or benefit--that is, should be financed on a "pay-as-you-use" basis.

Excessive commitment to pay-as-you-go may prevent a locality from doing things that really need to be done because the projects are too costly to be carried out using only annual operating funds. In point of fact, few governments today have the capability to finance vital public facilities strictly on a "pay-as-you-go" basis. Therefore, the power to borrow is one of the most important assets of government.

Reserve Funds

Financing capital facilities through a reserve fund (sometimes called a capital reserve) can be thought of as the opposite of borrowing in that the timetable is reversed. A 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:

Thus, an investment of $10,000 each year for ten years at 6 percent interest will yield a reserve fund of $131,808.

S = $10,000 x [(1.06)^10 - 1]/ 0.06 = $10,000 x [(1.7908477) - 1] / 0.06 = $10,000 x [0.7908477]/0.06 = $131,808

Conversely, the amount (N) that must be placed annually at compound interest (r) for a term of n years to create a reserve fund (S) can be calculated by means of the following formula:

Should the objective be to develop a reserve fund of $2 million at the end of ten years, an investment of $151,736 per year at 6 percent would be required.

N = $2,000,000 x 0.06/[(1.06)^10 - 1] = $2,000,000 x 0.06/[1.7908477 - 1] = $2,000,000 x 0.07586796 = $151,736

Simple computational routines using these basic formula can test various assumptions as to appropriate investment periods under different interest rates.

Exhibit 6. Cost Analysis of Funding Alternatives

Alternatives Duration
(1) Fund the project from General Tax Revenue Over a period of four years, with site preparation in year 1, construction in years 2 and 3, and equipment acquisition in year 4.
(2) Build a Capital Reserve Fund Over four years until the total project costs have been accumulated at which time the project can be constructed.
(3) Establish a Capital Reserve Fund With annual payments made from this fund to cover the project schedule outlined under Alternative 1.

Alternative 1. "Pay-As-You-Go" Financing from General Revenues

Year Project Phase Cost Calculations
1 Site Preparation = $75,000
2 Construction: 1st Phase $500,000 (1.08) = $540,000
3 Construction: 2nd Phase $500,000 (1.1664) = $583,200
4 Equipment Acquisitions $300,000 (1.331) = $399,300
Total Cost $1,597,500

Alternative 2. Capital Reserve Fund (6% Annual Interest)

Project Phase Cost Calculations Cost
Site Preparation $50,000 (1.3605) = $ 102,037
Construction $500,000 (1.3605) = $1,360,489
Equipment Acquisition $150,000 (1.4641) = $439,230
Total Reserve Required $1,901,756
Annual Payments $434,725
Total Cost $434.725 x 4 = $1,738,901

Alternative 3.Capital Reserve Fund with Annual Funding of Project

Year Carry Forward Payment to Reserve Cost Reserve Balance
1 $369,535 (1.06) = $391,707 $75,000 $316,707
2 $316,707 (1.06) = $335,710 $369,535 (1.06) = $391,707 $540,000 $187,417
3 $187,417(1.06) = $198,662 $369,535 (1.06) = $391,707 $583,200 $ 7,169
4 $7,169(1.06) = $7,599 $369,535 (1.06) = $391,707 $399,300 $6
Total Cost $369,535 x 4 = $1,478,140

To illustrate this point, assume that a municipality is considering a major addition to its community health center. Construction costs are estimated to be $1,000,000 (in current dollars), with an additional $75,000 for site preparation and $300,000 for equipment. Construction costs are increasing at a rate of 8 percent a year, and the cost of equipment is estimated to be increasing 10 percent a year. In other words, if construction is deferred for one year, the cost would increase to $1, 080,000; if deferred for two years, the cost of construction would increase to $1,166,400, and so forth. Three different financing approaches that the municipality might consider are outlined in Exhibit 6.

Given the cost assumptions, the third alternative--building a capital reserve while funding the project from this reserve--is the "least cost" approach in terms of the municipality's investment. Achieving the least cost, however, is not necessarily the only consideration, for there are pros and cons to any financing strategy.

Borrowing

Like all governmental powers, the capacity to borrow must be used with critical regard for its justifiable purposes and with a clear understanding of its safe and reasonable limits. A sound borrowing policy is one that seeks to conserve rather than exhaust credit. The ability to borrow when necessary on the most favorable market terms is an objective that applies to governments just as it does in business and industry.

Local governments often borrow to finance major facilities on the assumption that future economic and population growth will make the payment of debt service (principal and interest) more feasible. Future events may or may not prove this assumption correct. Jurisdictions also may borrow on the assumption that inflation will make repayment easier. As inflation erodes the real value of the dollar, the actual burden of a given dollar of debt declines. A municipality which issued 30-year bonds in 1965 was paying debt service in 1995 with dollars worth perhaps one-third their initial value. However, unless one's crystal ball is unfailingly accurate, relying on inflation to lift the burden of debt can be a high risk strategy.

States often impose borrowing limits on local governments. These limits typically are cast in terms of dollars of outstanding debt as a percentage of the jurisdiction's real property tax base. Beyond any state imposed limits on borrowing, municipalities are restrained by the fact that this year's borrowing must be paid back from revenues in subsequent years. When the debt service burden of a municipality becomes overly large in comparison to its the tax base, the bond rating of the municipality may be lowered and the cost of borrowing may increase. Companies that rate municipal bonds (and thereby, influence the interest rate that must be offered to place such bonds) emphasize the importance of "good fiscal stewardship" in this regard.

Government loans are marketed with maturities ranging from a few days to several decades. For purposes of discussion, it is possible to divide government borrowing practices into three categories: (1) short-term loans with maturities of a year or less, (2) intermediate loans with maturities over one year but not more than five years, and (3) long-term loans with maturities of over five years. While the latter category is most commonly associated with long-range financing of capital projects, each may have a role in the financial planning of a municipality or county.

Short-term borrowing takes various forms--bills, certificates, or notes sold to banks or other investors, bank loans, warrants paid out in lieu of cash, and unpaid bills and claims. Short-term borrowing is most frequently used to smooth out irregularities between expenditure and income flows and to temporarily finance governmental operations during periods when tax receipts fall off unexpectedly.

Municipal notes are short-term, interest-bearing securities used to assist to help manage cash flow or to assist in financing a capital project. Bond Anticipation Notes (BANs) are issued for immediate financing of projects that eventually will be financed through long-term bonds. Notes may also be issued to finance municipal operations in anticipation of future tax receipts (TANs), future revenues (RANs), or with the expectation of receiving grants from the state or federal government (GANs). Standard and Poor's and Moody's have issue rating for municipal notes as well as fixed income securities.

Intermediate borrowing has limited but definite uses. A city whose outstanding debt is primarily in the form of callable-term bonds (bonds which may be called in and the principal paid in full after a specified period) may discover favorable opportunities to convert a portion of such debt by floating a new intermediate loan at a lower rate of interest. Cities operating largely on a pay-as-you-go basis may resort to loans of intermediate maturities when exceptional expenditures cannot be met from current revenues.

In general, long-term borrowing is appropriate under the following conditions: (1) where the project is of a type that will not require replacement for many years, such as a city hall, auditorium, major health facility, or sewage disposal plant; (2) where the project can be financed by service charges to pay off the bond commitments; (3) where needs are urgent for public health and safety purposes or other emergency reasons; (4) where special assessment bonds are the only feasible means of financing improvements in the absence of subdivision regulations or other controls; (5) where intergovernmental revenues may be available on a continuous basis to guarantee the security of the bonds; and (6) for financing projects in newly annexed areas or areas of rapid expansion where the demands on local tax resources are comparatively large and unforeseen.

Bonding Strategies

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. Thus, a 10-year bond for $2 million with a 7 percent interest rate will pay the bondholders $140,000 in interest each year (usually in semiannual installments), and at the end of 10 years, the $2 million will be repaid. Although referred to as "municipal bonds," this broad investment category includes bonds issued by any political subdivision--cities, counties, school districts, or special purpose districts--public agency, authority, or commission, or by a state, territory, or possession of the United States.

The price of a bond is usually quoted as a percentage of its face value (sometimes referred to as the "clean price"). The face value is the amount that the issuer of the bond pays the bond holder at maturity. Most municipal bonds are issued with a face value of $1,000. Municipal bonds may be sold at discount or at a premium. For example, the quoted price of a bond selling at a 5% discount would be 95 (i.e., 95% of $1,000 or $950). The quoted price of a bond selling at a 3% premium would be 103 (i.e., 103% of $1,000 or $1,030). The actual payment exchanged between two parties, however, may be different from the quoted price. Bonds purchased between coupon payments, for example, accrue interest that is proportional to the coupon period. Therefore, the buyer must pay the seller the quoted price plus any accrued interest. This sum is known as the invoice price of the bond.

The coupon rate is the annual rate of interest on the face value of the bond that the issuer agrees to pay the bond holder until maturity. The term "coupon" comes from the manner by which bonds were redeemed historically. A series of coupons were attached to the bond certificate, one coupon for each interest payment stipulated in the bond's indenture. At each coupon payment date, the bond holder (bearer) would clip the appropriate coupon, and present it for payment. Bearer bonds are rarely issued in this hi-tech era when registering bonds is no longer the time-consuming, labor-intensive task it once was.

In 1983, Congress required municipal bonds to be in registered or book entry form for the interest income to be exempt from federal income taxes. A registered bond certificate contains the name and address of the bondholder (or his/her agent), and all payments and notices are sent to the holder of record (there are no coupons to clip and present for payment). The holder of record can transfer the bond to a new owner by endorsing it (similar to endorsing a personal check). Book entry bonds do not have certificates. Instead, records of ownership are kept by a depository for its members--brokerage houses, banks, and other financial institutions. All new issues of municipal bonds (with minor exceptions) are assigned a CUSIP number, which provide a unique identification of the security. [4] Transferring the ownership of a bond is accomplished by changing the records on the books of the depository and its members to reflect the bond trade.

Interest earned on municipal bonds is exempt from federal taxation, and usually from state taxes in the state in which the bond is issued. As a consequence, municipal bonds carry lower interest rates than taxable corporate bonds. This tax exemption is, in effect, a federal subsidy that reduces borrowing (debt service) costs for local governments. In April, 1988, the Supreme Court overruled a major 1895 precedent, by holding that the Constitution does not protect state and local governments against federal taxation of the interest received by holders of their bonds. However, the chairmen of the Senate and House tax-writing committees immediately went on record that the decision was not expected to prompt Congress to impose any new taxes on such bonds.

The Tax Reform Act of 1986 did subject some municipal bond interest to possible income tax--the federal Alternative Minimum Tax. Under this Act, municipal bonds issued after August 15, 1986 fall into one of three categories, depending on their purpose:

o Public purpose bonds, used for traditional municipal projects that are clearly the responsibility of government, are tax-exempt.

o Private activity bonds issued by state or local governments supply funds for "private" projects, such as sports arenas, civic centers, or even shopping malls, and are subject to federal taxatrion, but may be exempt from state or local taxes in the states in which they are issued.

o Nongovernmental purpose bonds that support "nongovernmental" (but not "private") projects, such as public housing or student loans, are tax-exempt, but the amount of such bonds that may be issued is capped and the income is treated as a perference items for the purposes of the alternative minimum tax.

Any profit from the purchase or sale of a municipal bond is subject to tax regulations regarding capital gains.

Municipal bonds possess three significant features in addition to their tax-exempt status:

(1) The security of municipal bonds is generally considered second only to that of federal government bonds.

(2) Municipal bonds have high marketability, assuring that investors can always sell them if they wish to do so.

(3) The diversity of municipal bonds enables investors to obtain bonds in geographic areas and at maturities of their preference.

Types of Bonds

General obligation bonds are backed by the "full faith, credit, and taxing power" of the issuing locality. For many investors, general obligation bonds are seen as the most secure of the municipal issues, since the issuing authority must have the power to levy taxes at a level necessary to meet debt service requirements. The levy of taxes has practical limits, however. In effect, the security of general obligation bonds is based upon the economic resources of taxpayers in the issuing jurisdiction. Defaults are rare, and principal and interest are paid on schedule.

Special Tax or Special Assessment Bonds are payable only from the proceeds derives from a special tax (such as highway bonds payable from a gasoline tax) or from a special assessment levies against those who benefit from the facilities constructed (e.g., special assessments for curbs and gutters in certain residential areas). Special benefit assessments place a major share of the burden of financing on those individuals or properties receiving the greatest benefits from the improvements. The rising cost of special assessment bonds in recent years has resulted in a large majority additionally being secured by a pledge of full faith and credit, making them general obligation bonds. Sometimes referred to as limited tax bonds, these general obligation bonds often are secured by a specified maximum tax rate within the taxing power of the issuing authority.

Revenue bonds are obligations issued by an agency, commission, or authority to finance a revenue-producing enterprise--such as the construction of a toll road or bridge, parking structure, sewage treatment plant, and other facility that has fairly predictable revenue generating capacities. Both the principal and interest of such bonds are paid exclusively from the earnings of the enterprise. As a general rule, such issues do not have any claim on the general credit or taxing power of the governmental unit that issues them. A system of sinking funds and operating controls typically is established to assure investors that the financial affairs of the project will be maintained in good order and all commitments will be honored. Government with the power to tax also may issue revenue bonds, but restricts the debt service payments to only those funds from the enterprise which generates these revenues and does not pledge its own credit to pay the bonds.

Revenue bond financing is best suited to projects that (1) can operate on a service charge or user-fee basis; (2) have the potential to be self-supporting, previously demonstrated under public or private operation; and (3) can produce sufficient revenue without jeopardizing other important economic or social objectives of the community. Problems of social equity may arise when traditionally tax-supported functions are placed on a service charge basis. Facilities supported by service charges also frequently produce benefits to individuals who do not pay for them--for example, an enhancement in land values that may accrue to speculative holders of unimproved real estate.

Many local capital improvements can only be financed through the issuance of tax-supported general obligation bonds to provide full project funding or the local match. Faced with increasing rehabilitation needs, spiraling construction costs, and limited bonding authority, many cities may need to consider alternative financing arrangements for projects traditionally funded through general obligation bonds. For example, local governments are exploring increased use of revenue bond financing for projects with identifiable revenues that can be pledged to debt repayment.

Local governments have many possibilities for combining and substituting funding sources. The use of revenue bonds to finance capital construction in one area--such as a water system--may free up funds to support general obligation bonds for financing other portions of the capital plant--such as streets--where service pricing is not feasible. Restricted funds may be used to free up block grants for other capital purposes. These financing alternatives should be made explicit in the initial evaluation and ranking of capital investment projects.

Method of Redemption

Municipal bonds can also be classified into two general types according to the method of redemption. Term bonds all mature on the same date and must be redeemed by a lump sum principal payment which accrues by making annual payments to a sinking fund. When invested at compound interest, these annual payments should produce the amount of principal required at maturity. Frequent actuarial computations are required to determine the adequacy of sinking funds to meet principal payments at maturity. Some states do not permit the issuance of bonds for which the principal is funded solely through a sinking fund. With proper investment safeguards, however, term bonds do offer some advantages. Term bonds may serve to finance public utilities and other enterprises that do not have established earning records.

Serial bonds are retired by annual installments directly from tax revenues, or in the case of revenue bonds, from earned income. Serial bonds have simpler retirement requirements and offer greater flexibility in marketing and in arranging the debt structure of the jurisdiction or public organization. There are two types of serial bonds: annuity serials and straight serials.

With annuity serial bonds, the debt service payments are approxmately 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).

Straight serial bonds require annual payments of principal of approximately equal amounts. Interest payments are large in the early years and decline gradually as the bonds approach maturity. A payment schedule for straight serial bonds, with interest calculated over ten years at 6 percent on a declining principal, is shown in Exhibit 7. Also shown in this exhibit is the payment schedule for an annuity serial bond, with interest calculated at 6 percent on the outstanding principal for the life of the loan. Note that the total debt service cost of the straight serial is less than that of the annuity serial.

Callable bonds are issued with the provision that they can be paid off--"called in" for payment--prior to their maturity date. The call provision normally is exercised with appropriate notice only on interest payment dates. Callable bonds can afford greater flexibility in the jurisdiction's debt structure. Bonds may be recalled and refunded at more favorable terms if (1) the market or the jurisdiction's credit rating improves, (2) the initial retirement schedule proves too rapid, or (3) a period of declining revenue is encountered. The callable feature can be used to avoid overly rigid fiscal responsibilities, while at the same time permitting more rapid retirement if the project's revenue capacity expands. Since most investors insist on a premium for callable bonds, the resultant savings must be carefully considered. A common call feature in the mid-1009s was callable in 10 years at 102 (providing a 2% premium), in 11 years at 101, and in 12 years or more at 100. If the entire issue is not called, a partial call may be made in inverse order of maturity; that is, the longest maturities are called first.

Exhibit 7. Debt Service Charges on $1 Million

Ten-Year Straight Serial Bond (6% Interest)

Year Outstanding

Principal

Principal

Payment

Interest

Payment

Total

Debt Service

1st $1,000,000 $100,000 $60,000 $160,000
2nd $900,000 $100,000 $54,000 $154,000
3rd $800,000 $100,000 $48,000 $148,000
4th $700,000 $100,000 $42,000 $142,000
5th $600,000 $100,000 $36,000 $136,000
6th $500,000 $100,000 $30,000 $130,000
7th $400,000 $100,000 $24,000 $124,000
8th $300,000 $100,000 $18,000 $118,000
9th $200,000 $100,000 $12,000 $112,000
10th $100,000 $100,000 $6,000 $106,000
Total $1,000,000 $330,000 $1,330,000

Ten-Year Annuity Serial Bond (6% Interest)

Year Outstanding

Principal

Principal

Payment

Interest

Payment

Total

Debt Service

1st $1,000,000 $75,868 $60,000 $135,868
2nd $924,132 $80,420 $55,448 $135,868
3rd $843,712 $85,245 $50,623 $135,868
4th $758,712 $90,360 $45,508 $135,868
5th $668,107 $95,782 $40,086 $135,868
6th $572,325 $101,528 $34,340 $135,868
7th $470,797 $107,620 $28,248 $135,868
8th $363,177 $114,077 $21,791 $135,868
9th $249,100 $120,922 $14,946 $135,868
10th $128,178 $128,178 $7,690 $135,868
Total $1,000,000 $358,680 $1,358,680

New Fiduciary and Fiscal Instruments

The municipal bond market traditionally has been supported by large institutional investors, such as fire and casualty insurance companies. Faced with reduced profit margins in the late 1970s, many of these institutions curtailed their municipal bond buying, forcing tax-exempt bond yields to unprecedented highs. Interest costs increased significantly as bond issuers were forced to make yields more attractive to buyers. Investors were unwilling to lock into fixed returns, feeling uncertain about inflation, tax liabilities, and yield curves. As a consequence, a number of new fiduciary and fiscal instruments were devised.

In traditional serial bonds, each maturity has a single coupon rate payable over the life of the bond. Stepped coupon bonds, on the other hand, 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. The substantial increase in coupon payments each year is intended to provide a hedge against inflation and thus make the bonds more marketable. From the perspective of the issuing government, more bonds may be scheduled to mature in early years because of the lower coupon rates, thereby lowering the average life of the issue.

Zero coupon bonds emerged in the late seventies to 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. The result is a sort of tax-free income, accrued annually from the time the bonds are first issued. Zero coupon bonds sell at substantial discounts from the face, or par, value of $1,000 because they pay no interest. By paying par upon maturity, however, they offer capital gains that may be as much as 25 times the original investment, depending on the length of the issue. Held to maturity, for example, a 17-year zero coupon bond purchased for $150 will provide a tax-free capital gain of $850; or, according to the IRS, $50 in tax-exempt income each year ($850 divided by 17 years). Zero-coupon bonds tend to outperform other fixed-income issues when the economy loses momentum and interest rates decline.

Compound interest bonds (also called capital appreciation bonds, accumulators, or municipal multiplier bonds) return to the investor at maturity the principal plus interest compounded at a specified rate. The interest component is held by the issuer and compounded at a stated rate so that the investor receives a lump sum, consisting of both the principal and interest, at the bonds' maturity. Unlike zero coupon bonds, which sell at a discount, these bonds sell at face value. However, an investor in compound interest bonds still pays much less for the bond than it would be worth at maturity. The main advantages of these bonds over regular coupon bonds is that an investor knows exactly what the total return on his or her investment will be. Compound interest bonds guarantee the current rate of return for the duration of the issue--as much as fifteen to twenty years. This type of bond combines the investment multiplying power of compound interest with the income sheltering feature of traditional tax-exempt bonds.

Payments to a sinking fund must be structured to earn a sufficient sum to cover the "appreciated capital." that is, the accumulated interest and principal costs. At some point during the term of the bond, the issuing jurisdiction may begin to make interest payments to the bond holders. The total annual payments are much higher, however, because interest must now be paid on the interest that has accumulated as additional capital (principal). It has been estimated that a capital appreciation bond can cost the municipality 2.5 times as much in annual sinking fund payments when compared to a more conventional term bond where only the principal payments are deferred (and paid in a lump sum when the bonds mature).

Tender option bonds, also known as put bonds, offer the investor the option of submitting the bond for redemption before maturity. Usually the investor may redeem or "put in" a bond five years after the date of issue or on any anniversary date thereafter. In return for this option, the investor accepts a lower yield. The issuer pays a lower rate of interest (usually about 1 percent less than for conventional bonds of the same maturity), and consequently, the jurisdiction's cost is lower. However, the bond returns more to the investor (about 0.75 percent) than conventional bonds that mature on the first prescribed put date.

Tender option bonds may also be issued with a simultaneous "call" date, on which the issuer can call in and pay off the bonds. Thus, the issuer and the bondholder have equal rights to cash in the bonds when market conditions and interest rates are favorable. If interest rates go down, a put bond will probably be called in by the issuing government. Conversely, if interest rates go up, the bondholder can "tender his option" to be paid at face value by the issuer.

The yield (interest paid by the issuer) on flexible interest bonds changes over the life of the bond, based on some interest index printed on the bond itself. This feature stands in contrast to the traditional fixed-rate bond for which the interest rate remains constant while the market value changes when interest rates rise or fall. The interest index most often used is the average weekly rate of Treasury bills or bonds issued during the preceding interest period. The floating rate for a short-term bond, for example, might be pegged at 67 percent of the average weekly T-bill quote, while the rate for a longer-term issue might be set at 75 percent of the average weekly quote on 30-year Treasury bonds. This approach provides stability for both the issuer and the bondholder throughout the life of the bonds, particularly during times of interest rate volatility. As with other municipal bonds, the maturities of flexible interest bonds vary. Such bonds usually have call and/or put features, specifying the earliest dates at which the bondholder can get his/her money back at par.

Interest rates on variable rate demand bonds are reset periodically based on a specified index. The demand feature allows the investors to require the issuer or a specified third party to purchase the bonds at specified times, such as when the interest rates are reset. The most common variable rate bond is the "lower floater" in which the interest rate is adjusted weekly relative to a specified index that reflects the current market. Holders of lower floater bonds can require redemption of the bonds after seven-days notice.

The structure of long-term, variable rate demand debt involves a rather complicated credit system. The issuer usually enters into an agreement with a credit facility, typically a commercial bank, which provides the debt issuer with a letter of credit. Should bondholders redeem the bonds before maturity, the issuer hires a remarketing agent. who resets the interest rate and then tries to remarket the bonds. If some bonds remain unsold, the issuer's remaining cash needs are met by the agreement with the credit facility.

A system of caps, floors, and collars has been developed to help mitigate the consequences of future increases in interest rates. Under an interest rate cap, also called a ceiling, an issuer enters into a contract with a counterparty who, upon receipt of a one-time premium from the bond issuer, agrees to pay the issuer if a specified interest rate index rises above a certain percentage rate, known as the cap or strike rate. If the floating interest rate remains below the strike rate for the duration of the contract, the cap purchaser receives no payments. In effect, the bond issuer is buying an insurance policy to protect against high interest rate payments on its variable rate bonds.

With a floor contract, the bond issuer receives an up-front fee from a counterparty. If the interest rate index falls below the floor or strike level, the issuer makes payments to the counterparty. Similar to a cap agreement, if the floating index rate does not fall below the strike level, the issuer pays nothing. In entering into a floor agreement, an issuer compares the up-front premium it receives with the payments it must make if the floating interest rate falls below the strike level. The issuer may bet that it can keep a premium without making any payments.

A collar is the simultaneous purchase of a cap and sale of a floor by the issuer. Under this contract, the government entity trades any benefits from a potential fall in the interest rate index for protection against excessive interest rates. Under a collar agreement, the issuer defines a specific range for its interest rate payments, eliminating some of the uncertainty associated with issuing variable rate debt. The closer the cap and floor strike rates are set, the more the bonds will resemble fixed rate obligations.

Detachable warrant bonds give the holder the right, at some future date, 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. In exchange for that right, the issuer pays a lower rate of interest (about one-half percent less) than offered on otherwise comparable securities. The marketability of such bonds depends on the opinion of prospective buyers as to anticipated fluctuations in interest rates. If interest rates rise, the savings to the issuer become real because of the initial lower interest cost. If the rates fall, the opposite is true.

Private activity bond are municipal bonds, used either entirely or partially for private purposes, which must meet the test of qualification outlined within federal tax law to obtain tax-exempt status. To qualify as a private activity, tax-exempt bond, the debt must fit into one of the seven categories, meet volume cap requirements, and satisfy several other requirements outlined in section 147 of the federal statutes. Tax-exempt bonds offer private entities lower interest rates than they would otherwise be able to obtain. A government can use private-activity bonds to give economic incentives to targeted activities or geographic areas. Some economists believe that the incentive given by tax-exempt status through private-activity bonds creates positive economic effects beyond the specific project or program that is being financed.

Buyers of inflation protection bonds accept a lower stated rate of return in exchange for a guarantee that their buying power will not be diminished by inflation alone. The principal amount of these so-called "bullet" instruments will be adjusted for inflation--measured by the Consumer Price Index--while the interest rate remains fixed. Since the adjustment for inflation at maturity is subject to capital gains, an investor could face adverse tax consequences should inflation surge. The break-even inflation rate for a taxpayer in the 28 percent bracket is 8.5 percent.

________________________________________________________________________

Exhibit 8. Structure for Tax-Exempt Leveraged Lease Financing

Under tax-exempt leveraged lease (or TELL) financing, local governments generate capital funds by selling public facilities (see Exhibit 8). A private investor (special purpose limited partnership) buys a public facility by making an appropriate down payment and, over a five-year period, contributing equity equal to 25 to 30 percent of the sales price. The balance of the sale is financed through tax-exempt revenue bonds issued on behalf of the partnership and loaned by a qualifying financing authority (such as a industrial development authority). The private investment is "leveraged" by the municipality leasing back the facility at subsidized rates. Underwriters arrange the tax-exempt bond financing, and the sale/leaseback transaction to meet the requirements of the bond market, the private investors, and the government. Financing costs are sharply reduced, a new pool of unrestricted funds for capital improvements is created (i.e., from the proceeds of the sale), and greater financial flexibility is provided to the borrowers.

Under the Internal Revenue Code, as amended by the Tax Reform Act of 1986, municipal bonds are not tax-exempt if (1) more than 10 percent of the proceeds from such bonds are used in support of private business activities and (2) more than 10 percent of the bond principal or interest is secured by bond-financed property or the income it generates. Bonds issued to finance property owned by an organization that is exempt under section (501)(c)(3) are tax-exempt provided that: (1) no more than five percent of the bond's net proceeds are used in private trade or business; and (2) no more than five percent of the bond's net proceeds are secured by facilities used in a private trade or business or by the income generated from such facilities. These are known as the "private use test" and the "private security or payment test."

Lease-purchase financing has become popular among state and local governments. Lease purchases have been used to finance the acquisition of equipment, such as computers and motor vehicles, and more recently, long-term projects, such as the acquisition of real property. In a lease-purchase agreement, a government acquires an asset by making a series of lease payments which are considered installments toward the purchase of the asset. The government may obtain title to the asset either at the beginning or at the end of the lease term. After arranging an agreement, the lessor often will assign the rights to the lease payments to a number of investors.

The non-appropriation clause of a lease-purchase agreement distinguishes it from general obligation tax-exempt debt. If the lessee government fails to make the specified lease payments, the agreement is terminated. Lease purchases can be entered into much more quickly than bonds, often within 60-90 days of initial authorization. Lease purchase financing avoids the commitment a large share of operating revenues to cash purchases of assets, preserves general obligation debt capacity, and avoids some of the referendum costs associated with general obligation bonds.

Certificates of participation (COPs) are a widely used type of lease-purchase financing mechanism, whereby individual investors purchase fractional interests in a particular lease. Certificates are generally issued in $5,000 denominations and can receive investment ratings from a rating agency. COPs can be traded in the secondary market, making them more marketable. Therefore, issuers are able to obtain a lower interest rate on COPs than on other types of lease-purchase financing.

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. Typically, a centralized governmental department issues tax-exempt debt to finance the purchase of various assets, such as vehicles, equipment, or computers, on behalf of other governmental departments. The centralized department then enters into a standardized lease-purchase contract with each of the other departments. The lease-purchase payments received from these departments is used to repay the debt.

In the dynamic and uncertain period of the 1980s, state and local governments have had to develop capital financing programs that are more responsive to their overall financial conditions and fiscal policies than traditional general obligation and revenue bonds. The emergence of more innovative approaches stems from the willingness of state and local governments to accept and deal with the uncertainty of future markets for financing capital facilities. More conventional approaches should not be abandoned, however, unless officials are satisfied that sufficient benefits will accrue compared to the risks. Practical concerns are also part of the equation, including the political acceptability of such approaches, the ability of government to structure and manage these creative financing mechanisms, and of course, the laws that govern capital financing. Interest payments are still the cost that governments must pay for the use of other people's money. Careful application of new financing techniques, however, may uncover some real opportunities or provide capital resources that otherwise would be unavailable.

Funding Capital Facilities as a Development Cost

The difficulties of obtaining public funds for capital improvements have induced many localities to look to the private sector for help. It was once common to rely on the private sector to design, construct, and finance major capital improvements, such as water systems, roads, or mass transit systems. While this practice has largely been abandoned in recent years, 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. It has been estimated, for example, that more than half of all state and local capital formation in California in the 1980's was financed by private developers, either by direct installation of capital facilities or by the payment of fees in lieu of facility dedication. The recent trend has been to require private developers to finance more and more of the "off-site" capital costs. Although each state has its own body of court rulings on these requirements, the courts generally have upheld off-site dedications that can be shown to be "reasonably related" to the public capital costs attributable to development.

In 1981, for example, the Suburban Sanitary Commission, which provides sewer and water services in northern Virginia, established a "system expansion offset charge" (SEOC), defined as an "equity charge" on new residential and commercial subscribers to fund new or expanded capital projects required to meet the increased service demands without making older system subscribers pay the cost. The SEOC is a lump sum, nondeferrable fee; it is in addition to water and sewer service connection charges. The legality of the fee differential of the SEOC, set at three times the fee paid by existing residents to finance new or expanded capital projects, was challenged. The court decision was in favor the Commission as long the linkage between the expansion and the requirements of new development can be demonstrated.

Developers contribute to infrastructure costs under the Adequate Public Facilities Ordinance in Montgomery County, Maryland. For example, each developer is assessed a proportional share of the cost of providing the additional capacity required to accommodate the trips generated by households and commercial activities in that developer's subdivision during the morning peak traffic hours.

The State of Texas requires developers outside areas currently serviced by sewer and water systems to establish a Municipal Utility District. The developer is responsible for installing all the capital facilities necessary to provide services. Once the system is built, the developer may operate it, sell it to the residents, or find another form of private management.

Broward County, Florida, has implemented one of the more innovative and sophisticated impact fee systems, covering additional road, park, and school costs generated by new development. The fees are adjusted annually to the GNP price deflator for the previous 12 months and are deposited in a non lapsing trust fund. Revenues for parks are set at a level equal to the assessed value of that would otherwise be dedicated or are calculated according to the type of residential unit in a development. School fees are determined in a similar fashion based on provisions in the county code for impacts generated by specific types of housing units and the number of bedrooms they contain. A computerized model is used to determine the proportional share of road capacity that the developer must finance. Each subdivision development is charged according to its share of use of expanded or extended network segments.

Notwithstanding early legal challenges, the system in Broward County appears to be working fairly effectively. Developers benefit by knowing beforehand how much they will have to pay for a given type and scale of project, and the county achieves the necessary capital facilities with a minimum processing time and negotiations and without having to finance them.

Summary and Conclusions

The early literature of public finance and administration reflected a concern for the honest administration of governmental resources. More recent studies have tended to emphasize the services provided through the allocation of limited public resources. This new focus reflects a shift in public budgeting procedures--from a concern for input and process to one of output and performance effectiveness

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. As a management tool, capital facilities planning provides a coordinative mechanism for all phases of capital construction --estimation, submission, approval, execution, and post audit.

Capital budgeting is a political process. While any budget contains some "automatic" decision, the important fact is that most decisions relating to capital investments are policy decisions. Economic and other criteria are employed in the capital facilities planning process, but they are defined within and conditioned by the broader political context. Ultimately, the efficiency and effectiveness of the capital facilities plan is measured by the results of executive and legislative action.

Endnotes

[1] Gregory Vaday, "Planning for Capital Improvements, MIS Report, Vol. 25, No. 10 (October, 1993).

[2] William B. Rogers, "Fiscal Planning and Capital Budgeting," Planning 1954 (Chicago, Ill.: American Society of Planning Officials, 1954), p. 96.

[3] Robert E. Coughlin, "The Capital Programming Problem," Journal of the American Institute of Planners, 26 (February 1970), p. 39.

[4] CUSIP numbers are named for the Committee for Uniform Securities Identification Procedure, which was to deal with the securities transfer problems that developed during the late 1960s. These numbers are assigned by the CUSIP Service Bureau, part of Standard and Poor's, under contract with the American Bankers Association. The first six numbers or letters of the CUSIP number identify the issuer of the security; the next two numbers or letters identify the particular security of the issuer; and the last number is a check digit, used for processing purposes to help ensure the accuracy of the first eight digits.

Continue Text

Return to Summary