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I. GOVERNMENT RESPONSIBILITY FOR CAPITAL FACILITIES

Broad objectives of government to "promote the general health, safety, morals, and public welfare" give rise to:

(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 benefit of all or a majority of citizens.

Significant economies can be derived from government activities--economies that could not be achieved if each citizen had to provide for these facilities and services on an individual basis.

Components of Capital Facilities Planning

Capital facilities involve non-recurring expenditures, designed to provide new or expanded capacity for the delivery of public services.

o Capital facilities represent large commitments of public resources, which exert their effects over many decades and are not easy to modify once investments have been made.

o Effective procedures for providing/maintaining capital facilities must involve planning, programming, financing, and debt administration.

The Planning Phase

Capital facilities planning provides a framework to:

(1) Extent the time available for the design of facilities, resulting in a number of economies

(2) Develop justification for advance acquisition of improvements, thereby taking advantage of lower market prices.

(3) Identify the need for bond issues or other revenue-producing measures and to take action before emergency financing measures are required;

Forecasting Community Growth and Change

Current demographic composition must be examined to identify characteristics that may influence future population structure.

Demographic projections often are based on an age-cohort survival model which analyzes the population by narrow age categories (cohorts) according to vital statistics on births, deaths, and net migration patterns (inflows or outflows of population).

Assumptions concerning population growth or decline are based, in part, on economic activities.

Economic indicators--including data on employment, cost of living, disposable income, building activity, and bank deposits--can be used to analyze growth trends and to suggest the future revenue capacity of the community.

Economic base studies 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.

Economic base multipliers include: (1) employment data, (2) payroll data, (3) value added, (4) value of production, (5) physical production, and (6) dollar income and expenditure accounts. [1]

Land use studies are important to identify areas suitable for various types of capital facilities and to estimate the cost of such public improvements.

Revenue and Expenditure Analyses

Most local sources of revenues are not responsive to changes in the overall economy.

o Property taxes are relatively inelastic 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.

While taxpayers demand good schools, adequate police and fire protection, and other public services, at the same time, they resist any increases in local taxes to pay for these services.

A sound fiscal policy must be based on a thorough assessment of public service and capital facilities needs.

o Estimates should include an analysis of the revenues to be collected if existing fiscal policies are maintained.

o Estimates must also be made of the revenues needed to meet expanded expenditure requirements.

Programming Capital Facilities

Programming provides effective mechanisms for the continuous control of capital facilities.

The Local Infrastructure

An ongoing evaluation of facilities and services should include the following key elements:

o A basic inventory and a set of indicators to assess the infrastructure systems.

o Determination of current conditions and range of infrastructure improvement needs.

o Analyses of maintenance, repair, and replacement options for different infrastructure improvements.

o Analyses of the risks and uncertainties associated with various investment options.

o Evaluation of financing options and ranking of investment proposals.

o Selection, programming, budgeting, and scheduling of specific improvement projects.

Project Planning and Operations Scheduling

Three elements must be coordinated in a project plan and operations schedule:

(1) Operations: the things that must be done (activities or jobs), each with a sequential relation to other operations and each requiring resources for some time period.

(2) Resources: the things utilized in a project, including personnel, equipment, materials, and time.

(3) Constraints: conditions imposed by outside factors, such as budgetary limits, completion deadlines, availability of resources, inputs from other units, and so forth.

Project planning provides a blueprint for project implementation and should include: (1) an identification of project tasks and activities; (2) specifications of performance requirements and functional plans related to organizational responsibilities; and (3) the development of cost estimates and budgets

Operations scheduling (1) must reflect the total resource capacity assigned to the project; (2) must take into account the availability of resources, the sequence of activities or jobs, the resource requirements, and possible starting times for each activity; and (3) must level the use of resources to avoid dramatic shifts in resource requirements (particularly personnel).

Use of Network Analysis to Program Capital Projects

Network analysis (1) identifies/displays the tasks to be performed; (2) determines the order (sequence or priority) in which tasks should be undertaken; and (3) establishes critical linkages among tasks.

Program Evaluation and Review Technique (PERT) and the Critical Path Method (CPM): (1) facilitate the selection of a "best route" to reach project objectives; (2) identify potential delays and obstacles to successful project implementation; (3) show interrelation-ships of all activities in a project or program; and (4) indicate where responsibilities for supervision and management should be assigned.

The Computer in Capital Facilities Planning

The computer makes it possible to maintain large data sets on the current inventory of capital facilities and to carry out calculations that otherwise might be too time-consuming to undertake.

Geographic information systems (GIS) provide spatial data regarding the location, condition, and capacity of capital facilities.

Priority Classification Systems

A system of priorities should provide a basis to evaluate each proposed project against the total capital expenditure needs of government.

An intangible approach to the assignment of priorities is suggested in Exhibit 1, along with criteria for assigning capital projects to each of these categories.

Numerical priority systems involve weighted scores that reflect the relationship among the various "intangibles".

The criterion judged to be most important in establishing the priority of capital projects is given the highest score; other factors are then ranked in relation to this score.

Exhibit 1. General Criteria for Capital Facilities Priority System

Adopted from: Alan Walter Steiss, Local Government Finance: Capital Facilities Planning and Debt Administration (Lexington, Mass.: Lexington Books, 1978), p. 38.

Capital Improvements Program

A capital improvements program (CIP) usually spans a 5 to 6 year period and represents the more immediate and more detailed portions of the long-range capital facilities plan.

Projects should be arrayed according to their priority ranking.

When adopted, the CIP report should be made available to civic groups and interested citizens, in addition to being distributed to the operating departments.

Cost Analysis

Effective capital facilities planning requires analytical techniques to deal with the risk and uncertainty associated with future decisions regarding the commitment of scarce resources.

Future costs are influenced by: (1) scope and quality of services or products, (2) volume of activity, (3) methods, facilities, and organizational structure, (4) qualities and types of labor, materials, equipment, and other cost elements, and (5) price levels of various cost elements.

Discounted cash flow techniques apply the principles of compound interest to determine the differences in the worth of money over time and to examine the costs and benefits of particular investments.

Cost-benefit analysis requires that estimates of direct and indirect costs and tangible and intangible benefits be translated into a common measure, usually a monetary unit.

Cost-benefit analysis involves an identification of: (1) an objective function, (2) constraints, (3) externalities, (4) time dimensions, and (5) risk and uncertainty. [2]

Cost-effectiveness analysis seeks the preferred alternative which either (1) produces a desired level of performance at a minimum cost or (2) achieves the maximum level of performance possible for a given level of cost.

Costs can ordinarily be expressed in monetary terms; levels of performance usually are represented by nonmonetary indexes or measures of effectiveness.

Cost-benefit and cost-effectiveness analyses can be applied at two pivotal points: (1) in the planning stage, based on anticipated costs and benefits, and (2) after a project has been imple-mented to assess whether the costs are justified by the magnitude of net outcomes.

Methods of Financing Capital Facilities

"Pay-as-you-go" financing encourages government to "live within its income," minimizes premature commitments, and conserves credit for emergencies when ample credit may be vital.

o Achieving user-benefit equity may require that the burden be spread over the life of the improvement.

o Few governments have the capability to finance vital public facilities strictly on a "pay-as-you-go" basis.

A reserve fund (or capital reserve) requires that a portion of current revenue be invested each year in order to accumulate sufficient funds to initiate some project in the future.

The amount (S) in a reserve fund 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

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 bonds; (3) involves urgent needs for public health and safety or other emergency reasons; or (4) places large and unforeseen demands on local tax resources.

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.

Security of municipal bonds is considered second only to that of federal bonds.

High marketability of municipal bonds assure that investors can always sell them.

Their diversity enables investors to obtain municipal bonds in geographic areas and at maturities of their preference.

Interest earned on municipal bonds is exempt from federal taxation, and usually from state taxes in the state in which the bond is issued.

General obligation bonds are backed by the "full faith, credit, and taxing power" of the issuing locality.

Special Tax or Special Assessment Bonds are payable only from the proceeds of a special tax or special assessment levied against those who benefit from the improvement.

Revenue bonds are backed by a pledge of revenues generated by the facility being financed and do not have any claim on the general credit or taxing power of the unit that issues them.

Municipal bonds can also be classified according to the method of redemption.

(1) Term bonds reach maturity and must be paid off at the same time, with the lump-sum principal payment met by making annual payments to a sinking fund.

(2) Serial bonds are retired by annual installments directly from tax revenues, or in the case of revenue bonds, from earned income.

New Fiduciary and Fiscal Instruments

New fiduciary and fiscal instruments have been devised in response to changing conditions in the bond market, including:

o 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.

o Stepped coupon bonds use a serial maturity schedule, with coupon rates that start at lower levels and progressively increase to higher levels.

o Compound interest bonds return to the investor at maturity the principal plus interest compounded at a specified rate.

o The yield on a flexible interest bond changes over the life of the bond, based on some interest index printed on the bond itself.

o Tender option bonds offer investors the option of submitting the bond for redemption before maturity, usually five years after the date of issue or on any anniversary date thereafter.

o Inflation protection bonds exchange one kind of risk for another in that buyers accept a lower rate of return in exchange for a guarantee that their buying power will not be diminished by inflation.

Under tax-exempt leveraged lease (or TELL) financing, 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.

o 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.

o 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.

o Individual lease purchases can be consolidated into a single lease-purchase program in order to achieve lower interest rates, tighter controls, and lower administrative costs.

More conventional approaches 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.

The 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 requirements of private developers to finance "off-site" capital costs which can be shown to be "reasonably related" to their developments.

Public Investment Strategies

Local governments often are able to meet current obligations and have some uncommitted cash left over to invest to create additional revenue that does not involve increased taxation or additional debt.

The principal criteria to be considered in selecting a specific security are: (1) safety/risk, (2) price stability, (3) liquidity/marketability, (4) maturity, and (5) yield.

In general, securities with little risk, high liquidity, and short maturities also have low yields; for an investment to provide a high yield, one or more of the other relevant criteria must be compromised.

Debt Administration

Debt administration involves the management of resources required for the acquisition or construction of a capital facility and the servicing of the debt obligations resulting from the issuance of bonds to finance these improvements.

Tracking the Funds for Capital Improvements

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 funds and are to be used to build or buy capital facilities.

Debt service funds 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.

Debt records--including auditable ledgers that the identity, purpose, and amount of debt associated with capital projects--are vital to short-term and long-term fiscal operations.

o All fixed assets purchased, constructed, or obtained by contract are recorded at cost in the general fixed assets account group.

o 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.

Financial Reporting

Annual financial reports should list all outstanding debt by type of issue (general obligation, special assessment, or revenue bonds) and identify the jurisdiction's legal borrowing status.

The bond and interest register and the ledgers for bonded debt and interest form a ready basis for the development of a payment calendar.

A sufficient fund balance must be carried over from the previous fiscal year and/or provision must be made to generate adequate funds early in the new fiscal year.

The final step in servicing a municipal debt involves the recording and canceling of coupons and bonds that have been paid.

Many commercial banks and trust companies that serve as paying agents for municipal bonds include all phases of recording and cancellation as part of their services.

Refunding and Conversions

Refunding involves the issuance of new bonds to retire outstanding bonds which bear higher interest rates than are currently available.

Elements to be considered: (1) timing of the sale, (2) maturity schedule of the refunding bonds, (3) time of settlement on the new bonds, (4) refunding costs, and (5) redemption provisions for the refunding bonds.

Refunding is generally accomplished through the exercise of a call provision which permits bonds to be refunded at lower rates at some time during their term, if the market changes or the locality's credit rating improves.

Refunding mature or maturing bonds should be avoided if at all possible, and if necessary, should be undertaken with great discretion.

Refunding bonds avoid default or serious disruption of fiscal operations should be undertaken with sufficient lead time to resolve the problem in an orderly and businesslike manner.

Defaults

Defaults are likely to result in a sharp decline in the credit standing of the municipality, skepticism among lenders, and major difficulties in negotiating favorable interest rates on future bond issues.

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 Intermediate defaults involve 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 Serious defaults involve jurisdictions confronted by abnormally high debt, severely curtailed revenues, and significant accumulation of operating deficits, with little prospect for correction except through a comprehensive refunding plan. Faced with a default, a municipality should take the initiative in readjustments and in planning and implementing the refunding plan to demonstrates good faith and competence and to gain the necessary cooperation from investors.

Most states have adopted legislative measures to circumvent the financial catastrophe faced by many governments in the thirties.

Ultimate responsibility still rests with local officials to adopt debt administrative procedures that will protect their community from "mortgaging its future."

Summary and Conclusions

The provision of capital facilities involves a unified series of steps to carry out the policy aims of government. The interrelated character of all expenditures must be recognized, and specific provision made 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.

Capital budgeting is a political process, and most decisions relating to capital investments are policy decisions. Ultimately, the efficiency and effectiveness of the capital facilities plan is measured by the results of executive and legislative action.

Endnotes

[1] 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.

[2] Otto Eckstein, Water Resources Development (Cambridge, MA: Harvard University Press, 1958).