1、CAPITAL BUDGETING Infrastructure & Project Evaluation,Making decisions having significant future net benefits or costs,JUSTIFYING PUBLIC SPENDING,Spending/Proposing agencies are responsible for justifying their proposals (I.e., presenting the case for spending in ABC terms) Budget analysts are suppo
2、sed to guarantee that the proper justification has been provided,Exercise 3.7,As a Practical Matter,If this proposal were consistent with executive priorities, we would stop here: The dollar values are small The activities are more or less reversible Estimating program benefits would be prohibitivel
3、y costly,But,The following is also true: Present Value of the workforce commitment is approximately $6million, excluding hiring and training costs Overheads are probably of roughly the same magnitude Some benefits can be estimated e.g., savings to state from reductions in future assistance. If teams
4、 would counsel 4000 battered spouses a year, they would pay for themselves if they reduced future assistance by $100 on average.,Public Sector Project Assessment should take all benefits and costs to public into account Federal Gov. treats consequences to itself as costs Consequences for citizens as
5、 benefits Hence, revenues are negative costs and payments by citizens negative benefits REVENUE TO GOVERNMENT COST TO CITIZENS,TWO ASSUMPTIONS,The welfare of an entitys stakeholders will be maximized by the implementation of all policy choices that generate positive net-present values. Timing of ben
6、efits or costs accruing from a policy choice is generally of no importance - so long as benefits/ costs are properly discounted.,The source of financing does not matter - shouldnt influence capital budgeting decisions, value will be the same regardless of whether an activity is financed with debt, f
7、und balances, or taxes,Together these two assertions imply that all capital budgeting decisions should be governed by cost-benefit analysis, which says: do it whenever benefits exceed costs,As Practical Matters,Some projects have greater value when deferred than at present State and Local Government
8、s are often Liquidity constrained (as are many of their citizens), which means that they may have to make tradeoffs,CONVERTING FUTURE VALUE TO PRESENT VALUE,Making decisions having significant future benefits or costs means looking at consequences from where we are right now: converting future benef
9、it/cost flows to PRESENT VALUES,Discounting,Future values are converted to present values by means of a discount rate. That is, future nominal benefits are worth less than present benefits of equal magnitude - the WIMPY principal Inflation Markets tell us that people demand compensation for forgoing
10、 current consumption,Mechanics of Discounting I,PV = FV in year t / 1+rt Where PV = Present Value FV = Future Value (real or nominal) t = Year r = Discount Rate (real or nominal),Mechanics of Discounting II,For a Stream of Benefits from year 1 to year t, SUM add up all the present values for all net
11、 future values Where t = 3 PV = (FV in year 1 / 1+r1) + (FV in year 2 / 1+r2) + (FV in year 3 / 1+r3),Three Ways to Find PVs,Solve the equation with a regular calculator (or use FV tables from an accounting text). Use a financial calculator. Use a spreadsheet.,10%,Whats the PV of $100 due in 3 years
12、 if i = 10%?,Finding PVs is discounting; its the reverse of compounding.,100,0,1,2,3,PV = ?,PV,=,$100,1,1.10,=,$100,0.7513,=,$75.13.,3,Spreadsheet Solution,Use the PV function: see spreadsheet.= PV(Rate, Nper, Pmt, FV)= PV(0.10, 3, 0, -100) = 75.13,What is the PV of this uneven benefit stream?,0,100
13、,1,300,2,300,3,10%,-50,4,90.91,247.93,225.39,-34.15,530.08 = PV,Spreadsheet Solution,Excel Formula in cell A3:=NPV(10%,B2:E2),A B C D E1 0 1 2 3 42 100 300 300 -503 530.09,Perpetuities,PV = NBF / r Where NBF = a specified annual net-benefit flow For example: $186k / .03 = $6.2m,Alternative Discount
14、Rates,Market rate = r + i + b + y Where r = real, risk-free rate i = the expected rate of inflation b = project specific (nondiversifiable) risk y = income tax adjustment Nominal risk-free rate n = r + i,Use of Alternative Discount Rates,Use real rate r with real FVs For example, where you are using
15、 current costs to estimate future costs Use nominal rate n with nominal FVs For example, where you are making identical nominal principal and interest payments each year,WHAT NOMINAL RATE SHOULD YOU USE?,Use of Alternative Discount Rates,Use real rate r with real FVs For example, where you are using
16、 current costs to estimate future costs Use nominal rate n with nominal FVs For example, where you are making identical nominal principal and interest payments each year,Borrowing rate on tax-exempt, general-purpose bonds of similar Maturities.,Annualizing Capital Costs,Since US government budget is
17、 formulated one year at a time, the budget tends to be biased against delivery methods requiring up-front investments The proper solution is converting everything to PV However, there is a reasonable alternative, which is the annualizing capital costs,Mechanics of Annualizing,Annual Cost of a Capita
18、l Asset = P r + d - a Where P = Purchase Price replacement cost d = Depreciation rate wear and tear + obsolescence a = Appreciation rate,Borrowing Cost as a Proxy for Capital Consumption,Principal plus interest Simplify by laying out an amortization schedule Charge that amount to programs Sock it way to replace asset,
