Methods of Financing Capital Facilities

A sound fiscal policy will seek to develop an appropriate mix among the three basic methods of financing capital improvements: (1) from current tax revenues; (2) by building a reserve fund; and (3) through the issuance of municipal bonds or other forms of borrowing. Few local governments have the capability to finance vital public facilities strictly from current revenues, either on a "pay-as-you-go" basis or by setting aside funds to build a capital reserve. Therefore, the power to borrow is one of the most important assets of government.

Three Basic Methods

Supporting capital improvements from current revenues is less costly than borrowing because it avoids the added cost of interest payments. It may be argued, however, that most public projects provide services over many years and therefore, should be paid for by people according to their use or benefit--that is, should be financed on a "pay-as-you-use" basis.

Financing capital improvements through a reserve fund (sometimes called capital reserve) involves setting aside a portion of current revenues to be invested each year in order to accumulate sufficient funds to initiate a project at some future date. The amount (S) of a reserve fund generated by an 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

Thus, an annual investment of $10,000 for ten years at 6 percent interest will yield a reserve fund of $131,800.

Local governments often borrow to finance major facilities on the assumption that future economic and population growth will make the debt service payments (principal and interest) more feasible. Jurisdictions also may borrow on the assumption that as inflation erodes the real value of the dollar, the actual burden of debt declines, making repayment easier. Future events may or may not prove these assumptions correct.

In general, long-term borrowing is appropriate under the following conditions: (1) where the project 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. 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..

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. Although referred to as "municipal bonds," this broad invest-ment 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. In addition to their tax-exempt status, municipal bonds possess three significant features:

(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.

Various categories of municipal bonds are identified in Exhibit 5. Two basic types of serial bonds, with interest calculated over ten years at 6 percent, are shown in Exhibit 6. As this comparison illustrates, the total debt service cost of the straight serial bonds is less than that of the annuity serial bonds, given comparable interest rates.

Exhibit 5. Categories of Municipal Bonds

Exhibit 6. Debt Service Charges on $1 Million for Ten Years

Straight Serial Bonds (6 percent on Declining Principal)

Annuity Serial Bonds (6 percent on Outstanding Principal)

New Fiduciary and Fiscal Instruments

Faced with reduced profit margins in the late 1970s, many institutional investors that traditionally have supported the municipal bond curtailed their bond buying. Tax-exempt bond yields were forced to unprecedented highs, and as a consequence, a number of new fiduciary and fiscal instruments were devised.

Zero coupon bonds, for example, take advantage of federal tax laws which entitle bondholders who forego tax-free income over the life of their investment in order to receive tax-exempt capital gains when the bonds reach 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 value of $1,000 because they pay no interest. By paying the full face value upon maturity, however, they offer capital gains that may be as much as 25 times the original investment, depending on the length of time until the issue matures.

The interest rates on stepped coupon bonds start at lower levels and progressively increase to higher levels as the time to maturity increases. All bonds in the issue are sold at the full face value. The substantial increase in coupon payments each year is intended to provide a hedge against inflation and thus make the bonds more marketable.

Compound interest bonds return to the investor at maturity the principal plus interest compounded at a specified rate. 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. An investor knows exactly what the total return will be--the rate of return is guaranteed for 15 to 20 years.

The yield (interest paid by the issuer) on a flexible interest bond changes over the life of the bond, based on some interest index printed on the bond itself. The interest index most often used is the average weekly rate of Treasury bills or bonds issued during the preceding interest period.

A tender option bond offers the investor the option of submitting the bond for redemption before it reaches maturity (in order to take advantage of other investment options). Investors usually may "tender their option" to redeem 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 interest rate.

Under tax-exempt leveraged lease (or TELL) financing, a private investment in a public facility is "leveraged" by the municipality leasing back the facility at subsidized rates. The sale is financed through tax-exempt revenue bonds, sharply reducing financing costs for the investor. A new pool of unrestricted funds for capital improvements is created from the proceeds of the sale, and greater financial flexibility is provided to the borrowers.

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.

These more innovative approaches stem from the willingness of government officials to deal with the uncertainty of future markets for financing capital facilities. Careful application of these new financing techniques may provide capital resources that otherwise would be unavailable to localities. More conventional approaches to the financing of capital facilities should not be abandoned, however, unless officials are satisfied that sufficient benefits will accrue compared to the risks.

Funding Capital Facilities as a Development Cost

In the past, the private sector often was involved in the design, construction, and financing major capital improvements, such as water systems, roads, or mass transit systems. This practice has largely been abandoned in recent years. However, 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 recent trend has been to require private developers to finance more of the "off-site" capital costs that can be shown to be "reasonably related" to the public capital costs attributable to development.

An "equity charge" to new subscribers to fund expanded sewer and water services to meet increased demands has been upheld by the courts, for example, as long a linkage between the expansion and the requirements of new development can be demonstrated. This charge relieved older subscribers from having to pay the cost of system expansion.

Impact fee systems have been approved in some localities, covering the additional costs for roads, parks, and schools generated by new development. Each new subdivision is charged according to its anticipated use of the expanded or extended capacity of public improvements. The developers know from the outset how much they will have to pay for a given type and scale of project. The locality achieves the necessary expansion of capital facilities without having to finance from local tax revenues.

Public Investment Strategies

Local governments often may be able to meet current obligations and, at the same time, have some uncommitted cash left over to invest. An investment portfolio that is well-managed can be an important source of additional revenue that does not involve tax increases or assumption of additional debt.

In selecting an investment, the principal factors to be considered 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 criteria must be compromised.

The majority of states allow local governments to invest in a variety of securities (see Exhibit 7). Federal obligations, such as T-bills and federal agency securities, are practically riskless, since they are backed by the full faith and credit of the federal government. Other securities carry varying degrees of risk and, therefore, must offer higher interest rates. In many states, however, local governments are prohibited from investing in banker's acceptances and commercial paper which generally earn higher rates of return.

Exhibit 7. Investment Instruments Used by Local Governments

Derivatives, one of the most complicated securities yet invented, have received considerable coverage in the media in recent months, largely stemming from the fiscal crises that some local governments must face as a result of the these investments. Derivatives were devised in the mid-eighties to help large corporations guard against sudden shifts in global financial markets. In the early ninties, Wall Street found a new market for these complex securities--local finance officers with little formal education in finance but millions of dollars in taxpayers' funds to invest. Since derivatives offer above-average returns when short-term interest rates are low, many localities responded to the aggressive sales tactics of brokers and invested in securities--in some cases, with disasterous consequences.

Debt Administration

The greater diversity of bond offerings currently available to local governments has resulted in increased complexity and responsibility for the administration of public debt. Debt administration involves the management of the resources required for the acquisition or construction of a capital facility and the servicing of the debt obligations that may result from the issuance of bonds to finance these improvements.

Tracking the Funds for Capital Improvements

Resources derived from the issuance of bonds or other long-term obligations, from intergovernmental grants, or as transfers from other funds are initially recorded in a capital project funds account. Since the proceeds from bond sales or transfers from state or federal grants often are received before these resources are needed to acquire the capital asset, they should be invested and the investment revenue transferred to the debt service fund to partially offset to the amount needed from the general fund for the first interest payment. 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. Since the principal and interest on serial bonds are serviced annually, no resources are accumulated on which interest can be earned. However, resources to service the principal on term bonds can be invested since these funds are not needed until the debt matures.

A sinking fund is used to spread the cost of repayment over the duration of the term bond issue. The management of a sinking fund is a complex task, however, that should not be undertaken without adequately trained personnel and proper safeguards to protect the integrity of the funds. Local governments in most states are restricted as to the types of sinking fund investments that can be made--usually being limited to federal, state, and municipal bonds. An annual independent audit should be made of all sinking fund transactions.

Accurate debt records--including auditable ledgers as to the identity, purpose, and amount of debt commitment 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.

Financial Reporting

Accurate and complete reporting on public debt develops confidence on the part of investors and the general public as to the fiscal management of a jurisdiction or public organization. Annual financial reports should list all outstanding debt by type of issue (general obligation, special assessment, or revenue bonds) and provide a computation of the jurisdiction's legal borrowing status.

Prompt payment of all principal and interest requirement is the most direct evidence of sound debt administration. A bond and interest register and the ledgers for bonded debt and interest form a ready basis for the development of a payment calendar. The funds for principal and interest payments must be allotted in a timely manner to provide the cash when it is needed. 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 substantially higher interest rates than are currently available. Five elements need to be considered in refunding: (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. Refunding generally involves the exercise of a call provision included in the original issue to permit the bonds to be refunded at lower rates, if the market changes or the locality's credit rating improves.

The refunding of the outstanding debt may also be appropriate in order to eliminate or modify restrictive covenants. Refunding mature or maturing bonds should be avoided if at all possible, however, and if necessary, should be undertaken with great discretion. A municipality may find it necessary to refund outstanding debts to avoid default or serious disruption of fiscal operations. Such emergencies should be anticipated and the necessary steps taken 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. 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 revenue declines, 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 most serious defaults involve 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.

Faced with a default, a local jurisdiction should take the initiative in planning and implementing a refunding plan to demonstrates good faith and competence and to gain the necessary cooperation from investors. Attempting to cover up the fiscal state of the local government merely exacerbates the uncertainty, increases expenses, and ultimately may result in the municipality being placed in receivership.

The refunding plan must provide: (1) mechanisms to release current accounts from all accumulated deficiencies; and (2) financing procedures that will maintain balanced operations. Most states have adopted legislative measures to circumvent the financial catastrophe that were faced by many governments during the Great Depression. The ultimate responsibility, however, still rests with local officials to adopt debt administrative procedures that will protect their community from "mortgaging its future."

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. 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] 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] 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.

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