Wolaita Sodo University

College Of Business and Economics

Department Of Public Administration and Development Management

Lecture Power Point

Course Name: Public Financial Administration And Budgeting
Academic Year: IV Semester I
Chapter: Seven
 Chapter seven
Capital Budgeting

 Capital budgeting or capital expenditure budget is a

process of making decisions regarding investments in
fixed assets such as land, building, machinery or
furniture.

 The word investment refers to the expenditure which is

required to be made in connection with the acquisition
and the development of long-term facilities including
fixed assets.
 7.1. Capital Improvements Program (CIP)

 A capital improvements program is a blueprint for planning a

community's capital projects.

 A CIP is a multiyear planning instrument used by governments to

identify needed capital projects (the maintenance, repair and
rehabilitation of existing infrastructure as well as the construction of
buildings, utility systems, roadways, bridges, parks, landfills and
heavy equipment which have a high cost and a useful life of several
years);

 A CIP is not a static document. It should be reviewed every year to

reflect changing priorities, unexpected events and opportunities.
 Purpose of Capital Improvements Program (CIP)

 Mechanism for formal decision making

 A CIP provides government with a process for the

planning and budgeting of capital needs. A CIP answers
such questions as what to buy, build, or repair and
when to buy or build. It is a useful tool for prioritizing
of capital projects.
 A link to long range plans
 A CIP serves as a link to the planning process and should be
developed with the land use plan, strategic plan and other long range
plans.

 Financial management tool

 A CIP is used to prioritize current and future needs to fit

within the anticipated level of financial resources.

 Reporting document

 A CIP presents a description of proposed projects that will

be undertaken over the planning period.
 7.2 Capital Budget

 Capital Budget is also known as "Investment Decision Making

or Capital Expenditure Decisions" or "Planning Capital
Expenditure" etc.

 Capital budgets in governments have multiple roles: as

instrument of fiscal policy and to improve the net worth of
government, and particularly in the area of economic
infrastructure as vehicles for economic development.

 Governments have introduced capital budgets to serve all these

objectives, singly or collectively, depending on the context.
 Capital budgeting is the process of identifying and selecting
investments in long-lived assets, or assets expected to produce
ben­efits over more than one year.
 Moreover, capital budgeting is concerned with the firm's formal
process for the acquisition and investment of capital. Due to these
concepts, capital budgeting is important because of the following
reasons:

 Capital budgeting decisions involve long-term implication for the

firm.
 Capital budgeting involves commitment of large amount of funds.
 Capital decisions are required to assessment of future events
which are uncertain.

 In most cases, capital budgeting decisions are irreversible. This

is because it is very difficult to find a market for the capital
goods.
 Capital budgeting ensures the selection of right source of
finance at the right time.
 Wrong sale forecast; may lead to over or under investment of
resources.
 7.2.1. Elements of Capital Budgeting

 Three major elements exist within a capita1 budget process: (1)

planning, (2) cost analysis and (3) financing. Each requires a certain
amount of research capability, staffing (either external or internal),
organizational capacity, and expertise.

 1. Planning

 Effective capital budgeting requires a comprehensive planning

effort. This effort includes a number of elements: (1) an inventory
of existing capital assets, (2) a review of constituent demands for
goods and services in the future, and (3) a review of replacement
needs of existing capital assets.
 Surprisingly, most public and nonprofit agencies lack a comprehensive
inventory of their capital assets.

 Such an inventory can include some of the following elements: the

type of facility or equipment asset; the date the asset was acquired; the
initial cost of the asset; any improvements that have been made; the
existing condition of the asset; the level of utilization of that land,
facility, or equipment; its depreciated value; replacement cost; and the
anticipated end of its useful life or replacement date.

 Perhaps one of the most difficult parts of a capital budget planning

effort is, to develop a clearly defined needs analysis to help the
organization determine future demands for capital assets.
 Planning includes a systematic review of the replacement needs of
existing facilities and equipment. Most facilities and equipment
have an expected useful life span, which may range from a few
years to as many as 40 years.

 Replacement periods can be based on both wear and tear and

usage or on technological obsolescence. Streets, sewers, and
front-end loaders are examples of the former, whereas computers,
telecommunications equipment, and other electronics equipment
exemplify the latter.
2. Cost analysis- Evaluating Expenditure Decisions

 Perhaps the most difficult decision faced by policymakers and

administrators is choosing which capital assets to acquire or replace.

 Most public organizations have limited resources and face legal as well

as political restrictions on their ability to raise revenue.

 For these reasons, a limited number of capital items can be acquired

during any one time period. Priorities must be set to fund those that are

considered the most important. Importance can be determined by some

form of economic analysis or by other concerns (political need,

fairness, or visibility).
 Some form of systematic analysis is useful, most finance

professionals suggest using a systematic method to evaluate the

importance of various capital acquisitions. These methods involve

numerous criteria-quantitative, qualitative, and political.

 The key is to match available revenue sources with a wide-ranging

set of expenditure options and to match expenditure options to

revenue availability.
 Criteria can be developed that are simple or complex. Among the most
common are the following.

 Costs of any particular project, facility, or equipment relative to competing

projects, facilities, or equipment
 Costs relative to benefits for competing projects, facilities, or
equipment

 Relationship of the capital asset to the specific goals and

objectives of the organization.

 Financial impact of the project on defined beneficiaries

 Capital costs relative to operating and maintenance costs

 Spin-off benefits of the capital asset to other public and private

activities
 Effect on improved efficiency of organizational
activities

 Political costs and benefits of the project

 Legal mandate of a project or activity mandated by

law

 Chances for external funding

 Relationship to future needs and demands

 Cost-effectiveness and cost-benefit analysis can be used to
compare capital expenditure items.

 Not all capital expenditures are associated with their cost

relative to their benefits; however, many decisions are made
on other bases. Other decisions are made on the grounds of
equity rather than cost.

3. Financing

 No matter how various projects are ranked, rated, or

prioritized, the funding of capital items is contingent on
adequate revenue.
 Revenue sources should suffice to encompass both the
capital expenditure and the operating or maintenance
costs associated with that expenditure.

 It makes little sense to purchase a piece of equipment if

an organization cannot afford to maintain or repair it.
 Two major modes of financing capital projects are pay-as-you-go
and pay-as-you-use.

 The most conservative financing approach is pay-as-you-go. This

simply means that the expenditure of funds for a capital item does
not occur until the money is in hand.
 Debt is not incurred to fund all or a part of the capital item.

 On the other hand, pay-as-you-use proponents argue that financing

should occur as the capital asset is used. Incurring debt to fund
such an item is logical because the debt can be paid throughout
the item's useful life.

 Both approaches may be appropriate, depending on the particular

situation facing the organization. Both have inherent strengths and
weaknesses.

 Pay-as-you-go ensures that an organization does not borrow

money to finance capital assets. Interest charges are a measure of
opportunity cost.
 The disadvantage of pay-as-you-go can be substantial. Many

capital items would never be acquired or replaced because funding

is simply not available within existing resources of an organization.

 In this sense, pay-as-you-go discriminates against larger

expenditures.

 In small organizations or where the capital item is expensive, the

pay-as-you-go approach can create much greater fluctuations in

the budget expenditures from year to year and can also create

fluctuations in the revenue load of the organization's supporters.

 In addition, the concept of intergenerational equity is violated
with a Pay-as-you-go approach. This means that those who
benefit from the item are not necessarily the ones who finance
the asset.

 For example, if taxpayers in a community use money that had

been saved over a period of years to build a recreational center,
the beneficiaries of the center may not be the same as those
who put their tax dollars toward building it. Some may move
away or die. Then, they will have helped pay for a facility that
they never have a chance to use. This is considered inequitable.
 Pay-as-you-use financing is beneficial for a number of reasons.
 First, it helps spread the costs of the capital asset over a number
of years, thus making acquisition or more feasible in many
cases. It avoids great fluctuations in expenditures and revenues.
 Second, it provides for intergenerational equity by allowing
those paying taxes or user fees for a particular capital
expenditure to have access to that item.
 There are dangers associated with the pay-as-you-use approach.
The greatest concern is that financing of capital items might
exceed the useful life of that asset.
 7.2.2. Administration of the Capital Budgeting Process

 Administration of the capital budgeting process is often shared

among operating, planning, and finance officials. Each group
has an important role to play.

 Operating departments within public organizations funnel

requests for capital items to their financial officials.

 The finance officials must provide a critical review of each

request, provide evaluative criteria for ranking the relative
importance of each, and determine a financing system to fund
the most important items.
 In most instances, a 5-to-l0-year capital improvement plan is submitted
to the policy board of an agency for its review and approval.

 This multiyear plan includes all major capital construction and

acquisition projects scheduled during that time.

 The capital budget includes the revenue and expenditure amounts for
capital items that are to be constructed or acquired during the coming
year.

 A major problem of capital budgeting is that some perceive it as a

static process. Once a five-year capital budget plan is adopted, some in
the agency assume that they do not have to deal with it again for
another five years.
 In fact, the capital budgeting process is a dynamic one. As an
organization's financial situation changes and as environmental
factors change, it is important that the capital budget plan
reflects these changes.

 At a minimum, the plan must be updated annually to reflect

shifting priorities and concerns.

 Another problem is that many public agencies treat the

capital budgeting process as a paper exercise and often ignore it
during the annual budget process.
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Thank you!!!