Capital Financing 101
We are now into week five of our series on Capital Improvement Planning. This CIP series is highlighting some best and promising practices for each of the following phases of capital budgeting:
- Capital Planning 101
- Differentiating Capital and Maintenance Expenditures
- Aligning Capital Planning Across the Organization
- Capital Budgeting Development and Execution
And now we turn to capital financing and debt management. Even if you’re already an expert, this post could help you explain financing options to others!
There are three ways to finance capital projects: debt issuance, pay-as-you-go (including intergovernmental grants) financing, and public-private partnerships (P3). Each of these capital financing methods has benefits and drawbacks as depicted below:
Pay-as-you-go (PAYGO)
Pros:
- Future funds are not tied up in servicing debt payments
- Interest savings can be put toward other projects
- Greater budget transparency
- Avoid risk of default
Cons:
- Long wait time for new infrastructure
- Large projects may exhaust an agency’s entire budget for capital projects
- Inflation risk
Debt Financing
Pros:
- Infrastructure is delivered when it’s needed
- Spreads cost over the useful life of the asset
- Increases capacity to Invest
- Capital investment’s beneficiaries pay for projects
Cons:
- Potentially high borrowing rate
- Debt payments limit future budget flexibility
- Diminishes the choices of future
- Generations forced to service debt requirements
Public Private Partnership (P3)
Pros:
- Risk transfer
- Accelerated project delivery
- External funding
- Lower operating costs, and higher revenues
- Improved user experience
Cons:
- Loss of operational control
- Changes in scope or performance standards delay project delivery or impose additional costs
- Certain non-transferable risks (change in laws, approvals by third party government agencies etc.)
Governments should consider several criteria when determining how to finance new infrastructure projects. Two key factors are the level of urgency and current availability of funds. For example, if the infrastructure needs are not immediate and funds are available over time to make a new capital investment, then pay-as-you-go may be a good option.
Policymakers should consider questions such as:
- Is there an immediate need for the asset?
- What is the asset’s expected useful life?
- What is the current availability of funds relative to the project’s size?
- Are there multiple projects that need to be completed simultaneously?
- Is inflation expected to increase?
- Is the borrowing rate expected to increase?
Here are three additional tips:
- For projects financed with debt, neither the bond maturity nor end of the debt repayment period should exceed the asset’s useful life. By issuing long-term debt for costly infrastructure projects with long service lives, governments can increase equity between generations without disrupting the operating budget.
- Make sure your financial policies include a comprehensive debt management policy. GFOA has promulgated a Debt Management Policy. Carefully consider your entity’s debt limits in accordance with the legal and practice recommended standards to ensure debt financing for capital projects does not impair the government’s ability to meet future operating budget needs.
- P3s can be a good policy for governments seeking to cut costs, improve operational efficiency, fund capital costs, and reduce risk. Non-traditional, private-sector capital financing models, are generally more complex and less transparent. Although the costs and benefits of pursuing capital financing should be thoroughly analyzed in a transparent manner, P3s are a viable mechanism for the public sector to crowd in private capital in the delivery of public goods and services.
Next, we will cover best practices and tips for Asset Management.
Categories: Capital Projects, Government Finance