Local Government Finance: Capital Facilities Planning and Debt Administration by Alan Walter Steiss

FINANCING CAPITAL FACILITIES

Methods of Financing

The options for financing public facilities are similar to those available to any individual or family: (a) pay cash out of current earnings, (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

Supporting 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:

S = N [(1 + r)^n - 1]/ r

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:

N = S x r/[(1 + r)^n - 1]

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.

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 1.

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 under-standing 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 debt service payments (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 1960 was paying debt service in 1990 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. Notes are issued under a different law than bonds, with somewhat less stringent requirements. However, Standard and Poor's and Moody's have issued rating for municipal notes as well as fixed income securities. 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). When notes mature, the anticipated source of repayment, at times, may not have materialized, and a new set of notes may be issued to pay the old ones at maturity. The notes are said to be "rolled over." Continual note rollover is generally considered bad financial practice. Short-term financing should be used only to meet short-term needs.

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. Since the early 1960s, most municipal bonds have been issued with a face value of $5,000 or higher. However, when a municpal bond trader refers to "one bond," they mean "$1,000 face value"--old habits die hard.

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 would clip the appropriate coupon, and present it for payment. So-called bearer bonds are rarely issued in this hi-tech era when registrating 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). A transfer agent (banks, brokerage houses, or other financial institutions) verifies the accuracy and correctness of the transfer, cancels the old certificate, and issues a new certificate in the name of the new owner of record.

Book entry bonds exist in two possible forms: certificated form or book entry only. In either case, records of ownership are kept by a depository for its members--brokerage houses, banks, and other financial institutions. Owners of certificated (or immobilized) book entry issues may request a certificate, but as a rule, are content to have the depository continue to hold the certificates and send them the interest and principal payments. Book entry only bonds have no certificates; however, the bond owner receives a statement of ownership from his/her broker.

All new issues of municipal bonds (with minor exceptions) are assigned a CUSIP number, which provide a unique identification of the security. [1] 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. Forty-one states, however, do levy taxes on interest earned on municipal debt issued in other states. [2] Tax-exempt municipal bonds carry lower interest rates than taxable corporate bonds. A municipal bond with a 6% yield will provide an investor in the 31% federal tax bracket the same annual return as a taxable corporate bond with a 8.7% yield. The equivalent yield requirement is determined by dividing the tax-free yield by 1 minus the investor's tax bracket (see Exhibit 2).

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. This ruling upheld a relatively minor tax provision passed by Congress in 1982. 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 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 has the power to levy taxes at a level necessary to meet debt service requirements. The levy of taxes has practical limits, however. For local juisdictions, the most common taxing power is on property. State general obligation bonds usually are secured by income, sales, and other taxes. In effect, the security of general obligation bonds is based upon the economic resources of taxpayers in the issuing jurisdiction.

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.

A revenue bond is an obligation issued 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.

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 opera-tion; 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 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 3. 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. Virtually all bonds are now issued with a "date of first call" provision, after which the issuer can choose to retire the bonds before the stated maturity date. In general, the date of first call for municipal bonds is 5 to 10 years after the date of issue. 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 resulting savings must be carefully considered. A common call feature in the mid-1990s was bonds 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.

Comparison of Bonding Strategies

Simple computational routines can be used to assess the impact of different bonding strategies--that is, different maturity periods and interest rates. Exhibit 4, for example, shows the total debt service for a $1 million annuity serial bonds with various interest rates and terms of maturity. Such computations can provide considerable assistance determining the appropriate method of financing a given project or series of projects.

The Jefferson County Council has authorized the construction of a new prenatal health care clinic as part of the overall services of the Health Department. The cost for construction and acquisition of capital equipment is estimated to be $1.3 million. The County Council has further authorized a 10-year bond issue to finance these costs. Four alternative bond strategies are proposed by the financial consultant hired by the County to assist in the placement of this bond:

(1) A 10-year annuity serial bond with a 5.25% interest rate

(2) A 10-year straight serial bond with a 5.5% interest rate

(3) A 10-year term bond with a 5% interest rate and a sinking fund estimated to accrue at 4.5% interest

(4) A 10-year stepped coupon bond with an average coupon rate of 5.01%.

Which of these alternatives is the preferred bond strategy for Jefferson County?

The annual debt service for the 10-year annuity serial bond can be determined by applying the following formula:

Annual Debt Service = Principal x [(r)(1 + r)^n] / {[(1 + r)^n] -1}

Annual Debt Service = $1,300,000 x (.0525)(1.0525)^10 / (1.0525)^10 - 1

Annual Debt Service = $170,406

Therefore, for the total debt service for the 10-year annuity serial bond would be $1,704,060. The payment schedule, assuming semi-annual interest payments and annual payments of principal, is shown in Exhibit 5.

The total debt service for the 10-year straight serial bond can be determined by applying the following formula:

Total Debt Service = Principal + [(N + 1)/2 x r x Principal]

Total Debt Service = $1,300,000 + [11/2 x .055 x $1,300,000]

Total Debt Service = $1,693,250

The first year debt service on the straight serial bond would be $201,500, again assuming semi-annual interest payments and annual payments of principal. The annual payments would "step down" by $7,150 each year, as shown in Exhibit 6.

The annual interest payments on the 10-year term bond at 5% would be $65,000. The amount that would have to be invested annually in the sinking fund to ensure an accrual of $1.3 million at the end of 10 years can be determined by applying the following formula:

Annual Sinking Fund Payment = Principal x (r) / [(1 + r)^n] -1

Annual Payment = $1,300,000 x (.045) / [(1.045)^10] -1

Annual Payment = $1,300,000 x 0.08137846

Annual Sinking Fund Payment = $105,792

The annual interest and sinking fund payments total $170,792, and therefore, the total debt service over the 10 year period would be $1,707,920, as shown in Exhibit 7.

The payment schedule for the stepped coupon bond issue is more complex than the other options, as shown in Exhibit 8. Interest must be paid on the outstanding principal associated with each "step" in the coupon rate. For example, the interest for the fiscal period ending June 1, 2007 is equal to the six-month interest on $210,000 at 6% plus $190,000 at 5.5% plus $165,000 at 5%. While the average coupon rate for this stepped coupon bond is 5.01%, the total debt service would be $1,722,730.

The question remains: Which of these alternatives is the preferred bond strategy for Jefferson County? If the County can afford the initial annual payment of $201,500, then the straight serial bond would be the preferred option since the total debt service is $10,810 less than the annuity serial bond and $14,670 less than the term bond. The term bond and the annuity serial bond have approximately the same annual costs. If the County thought that it might be able to achieve a better rate of return on the sinking fund than 4.5% in future years, then the term bond would be the preferred alternative between these two options. Finally, the stepped coupon bond, while it is the most costly of the four options, does have the advantage of considerably lower annual payments in the initial years.

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