1. POLS 6930 Public Financial
Administration
Capital Budgeting
Municipal Bonds

2. The Capital budgeting process
I. Defining capital costs
II. Steps in the capital budget process
III. Selecting capital projects
IV. Financing capital projects

3. I. What makes something
capital?
• size
• purpose
• useful life
• payment structure
• non-recurrence
• ownership

4. I. What makes something capital?
Size
• Threshold for fixed assets and capital
determined by the size and scope of the
government
• example: small town vs. county sewer
district
$5,000 vs. $250,000

5. I. What makes something capital?
Purpose
• Used in the production of a government
service
• Non-consumable (not unit-level inputs)
– Regardless of the size of consumable
expenditures

6. I. What makes something capital?
Useful life
• The useful life of a capital asset must
exceed the period of the operating budget
• Capital assets typically have long (multi-
year) lives
– Water/sewer lines: 50 years
– Asphalt roads: 8 - 10 years
– Concrete roads 35 - 40 years
– Fire truck: 20 years

7. I. What makes something Capital?
Payment Structure
• Capital assets/projects paid for across
time
• Often involves long term borrowing
• Payments often matched to useful life
• Pay as you go vs. Pay as you use

8. I. What makes something Capital?
Non-recurrence
• Capital asset expenditures are typically
made for one-time purchases
• Capital assets are non-operational
• 4J School District, Lane County, OR:
The case of the “Capital” custodians and
books

9. I. What makes something Capital?
Ownership
• Whether something is an asset depends
on the perspective of the entity
• The city mainframe computer system is a
capital asset to the Information Services
Department
• The city mainframe computer system is
an operational expenditure item to the
sheriff’s department

10. II. Steps in the capital budget
process
1. Develop a capital improvement plan
2. Determine useful life
3. Select a financing mechanism

11. II. Steps in the capital budget process
1. Capital improvement plan
• Identify capital needs for next 10 - 20 years
• Separate one time from recurring capital
projects
• Use realistic assumptions
• Reconcile to annual budget
• Update annually
• Example: Onondoga County, NY

12. II. Steps in the capital budget process
2. Determine useful life
• separate land, improvements, equipment
• use GAAP standard measures
• when useful life and actual life disagree

13. II. Steps in the capital budget process
3. Select a financing mechanism
• Identify decision elements
• pay-as-you-go or pay-as-you-use ?

14. Selecting a financing mechanism:
Example: City of Lawrence,
Department of Trees and Moths
Department of Trees and Moths: Capital Equipment Worksheet
Truck Age
Monthly
Payment
New Truck
year plan
No New
Truck 10
New Truck
year plan
New Truck
Cash
Purchase
1 5 years $1,100 $1,100 $1,100 $1,100 $1,100
2 10 years $0 - $0
3 2 years $1,900 $1,900 $1,900 $1,900
4 New ? $3,060 $0 $2,699 $150,000
Total Annual Expenditure $72,725 $36,000 $45,584 $186,000
Total Annual Budget $200,000 $200,000 $200,000 $200,000
Balance remaing for other uses: $127,275 $164,000 $154,416 $14,000
Interest Rate 8%
$1,900
5

15. Selecting a financing mechanism
Key decision elements:
• Budget constraint
• Amount of discretionary $
• Values to maximize
– flexibility
– cost efficiency
– safety
– program outcomes
– equity (fairness)

16. Selecting a financing mechanism
Key decision elements:
• Prevailing interest rates (volatility)
• Risk
• Equity: Who pays?
• Alternatives
– Pay-as-you-go: Finance capital improvements all
at once with current year expenditures
– Pay-as-you-use: Finance capital improvements
through small current expenditure and the bulk
through borrowing

17. Pay-as-you go vs. Pay as you use
• Pay-as-you-go arguments
– No borrowing, avoid interest costs
– Maintain borrowing ability for other projects
– Less expensive in long term
• Pay as you use arguments
– Costs spread across future beneficiaries
– Free operating budget for current expenditures
– Less expensive in near term

18. Selecting a financing mechanism
Pay-as-you-go issues
• Use pay-as-you go when interest rates are
high (unless offset by inflation)
• (even with inflation high governments may
wish to avoid locking in higher rates)
• Use in stable slow-growth settings (low
urgency)
• Use when a window is available (resource
availability)

19. Municipal Bonds

20. Municipal Bonds
1. Market facts
2. Repayment Security
3. The Municipal Bond Process
4. Choosing a method of sale
5. Empirical evidence
6. Yield Burning and other scandals

21. Municipal Bond Market facts
• State and local municipal debt: $1.3 trillion
• Volume of municipal bond issuance (in
billions)
– 1980 $ 76.2
– 1984 $ 128.8
– 1996 $ 226.6
– 1998 $320.8

22. Year
Short-
Term
Long-
Term Total Year
Short-
Term
Long-
Term Total
1980 27.7 48.5 76.2 1990 34.8 128 162.8
1981 37.4 47.8 85.2 1991 44.8 172.8 217.6
1982 44.8 79.1 123.9 1992 43 234.8 277.8
1983 36.9 86.8 123.7 1993 47.5 292.5 340
1984 20.8 108 128.8 1994 40.3 165.1 205.4
1985 23.1 222.2 245.3 1995 37.9 160 197.9
1986 22.2 151.6 173.8 1996 41.5 185.1 226.6
1987 20.5 105.1 125.6 1997 46.2 220.7 266.9
1988 23.7 117.3 141 1998 34.6 286.2 320.8
1989 29.6 125 154.6
Source: Securities Data Company
Municipal Bond Issuance
1980 - 1998
($ Billions)

23. Municipal Bonds, Basics
• Tax exempt status lowers interest rates
• Tax exempt status raises price
• Bonds, Coupons, Indentures

24. Municipal Bonds, Players
• Government finance officers
• Financial advisors
• Bond counsel
• Underwriters
• Investors
• Citizens
• Voters

25. Municipal Bonds, Investors
• Munis compete with other investments
• Relatively low risk
• Double Tax Exempt
– Interest income is free from federal taxes
– Interest income is free from (issuing) state
income taxes
• Before TRA 1986 mostly held by banks
• Since TRA 1986 mostly held by individuals

26. Municipal Bond Holders
• Before TRA 1986:
– 30% Commercial Banks
– 6% Savings and Trusts
– 35% Households &
Mutual Funds
– 17% Insurance
Companies
– 3% Money Markets
– 9% Other
• After TRA 1986:
– 14% Commercial Banks
– 7% Savings and Trusts
– 56% Households &
Mutual Funds
– 12% Insurance
Companies
– 6% Money Markets
– 5% Other
Source: Federal Reserve Banks, Bond Market Association

27. Municipal Bonds, Structure
• Face amount
• Coupons
• Sources and uses
• Trust indenture/ covenants
• Maturity schedule
– Serial Bonds
– Term Bonds

28. Municipal Bonds, Term
structure
• Principal due at end of term
• Coupon payments made semi-annually
• Term bonds have one face amount matures
on one date
• Serial bonds have many different face
amounts which mature at different periods
in the life of the issue
• Bonds vs. Bond Issues

29. Municipal Bonds; Repayment Security
General Obligation Unlimited
Tax
• Full Faith and Credit pledge
• Unconstrained ability to levy the taxes
necessary to retire the debt
• Considered the strongest security pledge
• Low cost to issuer (interest rates)
• Often subject to voter approval
• May force fiscal restraint, accountability

30. Municipal Bonds; Repayment Security
General Obligation Limited
Tax
• Full faith and credit pledge
• Constrained ability to raise taxes to repay
• Typical security of governments issuing under
tax limitation restrictions
• Price differential depends on room under limit
• GOLT may have no practical rating or price
differential from GOULT bonds

31. Municipal Bonds; Repayment Security
(Enterprise) Revenue Bonds
• Proceeds of project revenues pay the debt
– Tolls, Parking garage fees, Airport gate fees
• Proceeds of government enterprises pay the debt
– Waste Water Treatment, Electricity generation
• Higher default rate, higher interest costs
• Preserve borrowing authority (avoid vote)
• Maximize benefit equity

32. Municipal Bonds; Repayment Security
Double Barreled Bonds
• Backed by revenue stream and a tax pledge
• Improves the credit worthiness of the issue
• May become general obligations when full faith
and credit and tax pledge offered
• May be able to exclude debt from G.O. limits
while gaining the benefit of G.O. pledge

33. Municipal Bonds; Repayment Security
Moral Obligation Bonds
• Expresses government intent to pay even though
not obliged to do so
• Created as added security to non-GO debt
• Invented by John Mitchell when bond counsel to
Nelson Rockefeller
• Created expressly to avoid referendum or
initiative
• May be ignored by rating agencies

34. Municipal Bonds; Repayment Security
Lease Rental Bonds
• Three parties involved
– Issuing authority or agency: lessor
– Government which will rent the facility: lessee
– Investor who buys bonds backed by the lease
payments
• Avoids debt limits and voter approval
• Higher costs

35. Lease Rental Bonds
Certificates of Participation
• Investors purchase shares of lease proceeds
• Proceeds distributed less operations and
reserve payments through trustee
• Avoids a liability classification for
government
• Technically, this is not debt

36. Lease Rental Bonds
Mortgage Bonds
• Designed to offer low rate mortgages
• Designed to pay for housing authority
projects
• Bonds repaid from mortgage payments

37. Municipal Bonds; Repayment Security
Private Activity Bonds
• Used for private commercial endeavors
• Limited by federal and state statute
• Designed to encourage economic development
• Windfall to recipients
• Brokering private activity authority in CA

38. Municipal Bonds; Repayment Security
BANS, TANS, and RANS
• Bond, Tax and Revenue anticipation notes
• Short term government obligations
• Provide temporary capital when
– anticipating a bond sale
– anticipating tax revenue
– anticipating intergovernmental grants

39. Steps in the Bond Sale Process
• Consult capital improvement plan
• Select a financial advisor
– line up investors or underwriters
– prepare bid specifications
• Select bond counsel
– get opinions on legal authorization
– create official statement
• Obtain a rating
• Select a Method of sale

40. Steps in the Bond Sale Process:
Obtaining a rating
• Moodys, Standard & Poors, Fitch
• Rating factors
– economic (macro)
– debt
– administration
– fiscal
– management
• The Black Box

41. Steps in the Bond Sale Process:
RatingsMoody’s S & P
Aaa AAA
Aa AA
A A
Baa BBB
Ba BB
B B
Caa CCC
Ca CC, C
C C1
D

42. Choosing a Method of Sale:
Terms
• NIC = Net Interest Cost
• TIC = True Interest Cost
• Basis point = 1/100th of a percentage point
• Negotiated Sales
• Competitive Sales
• Reoffering Yield
• Underwriter Spread

43. Negotiated Sales: The
Underwriter Hypothesis
• Negotiated sales are less expensive
– during volatile markets
– for complex and “story” bond issues
– for advanced refundings
• Underwriters work harder to pre-market
• Restricting negotiated sales will create
inefficiencies that will inflate borrowing
costs

44. Testing the Underwriter
Hypothesis in New Jersey
• Scandal, $2.9 Billion, EO 79
• Pre and Post “ban” observations
• Pre-ban 79% Negotiated Sales
• Post-ban 52% Negotiated Sales
• Comp sales .47 bp < negotiated sales
• On average (23 YTFM) $7.19 million in
savings ($4.3m NPV) per issue

45. Conclusions
• Except for rare instances, competitive sales
save money
• Issuers choose methods of sale based on
other factors (relationships)
• Finance choices have implications for
citizen trust and confidence in government

46. Municipal Bonds: Scandals
• Defaults
• Pay-to-play
• Yield Burning