Professional Documents
Culture Documents
INTRODUCTION
Capital budgeting is the term that is "used to describe action relating to
the planning and financing of capital outlays" (Garrison, 1988: 643). This
private sector description is significant because it implies a range of activity
that goes into the capital budgeting process. The traditional emphasis,
however, focuses on quantitative techniques and analysis in treatment of
capital budgeting decision-making.
The issue that is probed in this article is: Where does the orientation of
capital budgeting in the public sector lie? Is it with the rational-
comprehensive analytical techniques such as net present value (NPV),
____________
*Ali Farazmand, Ph.D., is Associate Professor, School of Public Administration,
Florida Atlantic University. His teaching and research interests are in organizational
studies and public budgeting. Jon Patraic Neill, MPA, is Controller, Provident
Consumer Financial Services, Inc.
internal rate of return (IRR), payback period (PB), and cost-benefit analysis
(CBA)? Or does the answer lie elsewhere- buried within the less formal,
value-laden, processes that produce the capital budget decision?
The thesis put forth is that public sector capital budgeting decisions are
formed in a process that relies on input that is highly qualitative in nature and
strongly influenced by non-financial considerations. The role and benefits of
traditional quantitative analysis is argued to be a limited one. If this is true,
then implications for the treatment of this topic are profound.
What would then be the approach to capital budgeting? The vision
asserted is for greater study and understanding of the processes and decisions
that are unique to capital planning and decision-making. In an advanced
stage, this may mean the development of a normative, or standardized,
capital budgeting process. That is, what steps and actions should be taken by
any public sector entity when formulating the capital budget?
Although developing the components necessary for a normative capital
budgeting process is beyond the scope of this article, the argument will be
made for a greater emphasis on process and a lesser emphasis on quantitative
analysis. This will be approached through a case study from both the public
and the private sectors, as well as a discussion on traditional quantifying
techniques and their value in public sector decisions.
METHODOLOGY
The methodology relied upon the study of the capital budget process in
public sector and private sector scenarios. The latter utilized the City of
Cincinnati's proposed 1995/1996 Capital Budget. This budget is notable for
its descriptive explanation of the capital budget process the city employed,
and for ranking the criteria that were the basis for decisions.
The budget was analyzed to determine the basis of project justification.
This was done by a review of each capital project write-up for all the city
agencies, with the exception of the Cincinnati Water Works which is a city-
owned enterprise. The project justifications were then classed into a category
of justification based upon the city's criteria for the basis of decisions.
Although such analysis necessarily involved some judgment calls, the one-
page project write-ups tended to follow certain justification themes.
The private sector case is based upon the co-author's experience within
the capital budgeting process in private industry. This example includes
430 FARAZMAND & NEILL
DEVELOPMENT OF THEORY
"Quantitative analysis has become a major element of public
management" (Meier & Brudney, 1993: xvii). The history of quantitative
analysis in the public sector in fact has its roots in the values of the seminal
work by Woodrow Wilson (1887). From the outset, an emphasis on
objectivity and scientific decision-making led to an orientation toward
quantitative analysis which can best described as "cost-benefit" analysis in the
broadest sense of the term.
Cost-Benefit analysis is a "systematic means of estimating the costs and
benefits of projects over their life" (Axelrod, 1988: 115). It was not until
1936 that such analysis was formally applied in Federal legislation as the basis
of decision-making. In that year it was mandated that the only approved
water resource projects would be those in which the estimated benefits
exceeded the costs (Axelrod, 1988).
Elsewhere Patton & Sawicki (1993: 369) stated that "the beginnings of a
formalized, scientific approach to the evaluation of planning and policy
problems can be traced back to the 1930's." Through the boom economy of
the post-World War II years into the 1970s, quantitative analysis was the
dominant theoretical approach for program evaluation. However, by 1972
strong arguments were put forth for the qualitative or subjective approach to
evaluation. Cost-Benefit theory was challenged to grow beyond its traditional
economic analysis to encompass "social-political impact components" (Patton
& Sawicki, 1993: 370). This was an important development in the practical
use of this theory, as it is self-evident that such an nalysis would be more
difficult to quantify.
In the 1980s the debate on quantitative, analytical techniques turned
toward the issues of value impacts and the role of stakeholders (Patton &
Sawicki, 1993). These important recognitions subtly shifted the focus from
CAPITAL DECISION-MAKING 431
education? Cost analysis and Benefit analysis are soon divorced due to
"irreconcilable differences."
The primary tools of cost-benefit analysis are net present value (NPV),
internal rate of return (IRR), payback period (PB), and cost- benefit analysis
(CBA). These analytical approaches have common concepts in their
formulas: the cost of the project, the dollar benefit of the project, and the
cost of money (i.e., interest rate). These values are then "discounted", or
decreased, so that future monies are reduced to their worth right now; that is,
their present value. Discounting is based upon the economic assumption that
a dollar received today is worth more than a dollar received tomorrow; for
example, inflation of 3.0% would indicate that a benefit received next year
would be worth only 97.0% of the same benefit received now. The logical
flow of quantitative capital budgeting analysis generally follows this pattern:
1. What is the net present value of the project? The formula sets NPV
equal to the present value of the benefits minus the cost of the project
(Aronson & Schwartz, 1987: 401).(1). A positive net present value
means that the benefits outweigh the costs and the project should be
approved . While it is best to have as large a positive NPV as possible,
the NPV is also a function of the size of the investment. More analysis
is needed in the investment decision since a ranking based upon NPV
would necessarily favor the large projects.
2. What is the internal rate of return? The formula solves for the interest
rate that brings the present value of the benefits into equality with the
initial outlay (Aronson & Schwartz, 1987: 402).(2) If the internal rate
of returns meets or exceeds the cost of borrowing, then the project is
economically feasible. The larger the return, the more beneficial the
project.
3. What is the cost benefit ratio? Cost-benefit analysis (in the narrow
meaning of the term) looks at the NPV in a slightly different format. The
present value of the benefits divided by the cost equals the cost-benefit
ratio. A project would be acceptable if the benefits equaled the cost;
i.e., a ratio of 1:1 or 1/1 = 1.00.
4. What is the payback period? That is, how many years will it take to
recoup the investment outlay. This will occur in the year in which the
sum of the benefits equals the initial cost of the investment.
CAPITAL DECISION-MAKING 433
capital budgets. The CIP "is a plan for capital investment in Cincinnatis
future through improving City streets, bridges, recreation facilities, parks,
health facilities, and buildings" (Shirey, 1994: 1). The stated goal of these
projects is to "enhance the delivery of services and the quality of life in
Cincinnati" (Shirey, 1994: 1).
Two points deserve special emphasis at this juncture. First, the CIP is
"a policy statement by the City Council of the future direction for the City of
Cincinnati" (Shirey, 1994: 1). Second, in order for quantitative analysis to
perform its function of project screening and project selection (Garrison,
1988), it must be able to quantify the value of a "bridge" and determine how
that will affect the "quality of life" for the citizens.
The use of CIPs highlights the context of public sector budgeting as
being in the domain of politics. From political policies the decisions to accept
or reject capital projects are made. The orientation of public capital
budgeting is therefore not in rational-comprehensive Cost-Benefit analysis
(such as we might see in private industry), but rather locked into the political
process itself. And it is significant that most cities (an estimated 87%) do use
a CIP (Forrester, 1993).
Given that the Cincinnati CIP is a policy statement reflecting political
values, what role does quantitative analysis have in politics? It is asserted that
the benefits of a bridge and the goals of quality of life are essentially issues
involving qualitative considerations which are not only best left to the
judgment of elected representatives, but may in fact be unquantifiable. The
launching point for the discussion of decision-making techniques in the
Cincinnati capital budget comes in the context of a CIP. The CIP asserts the
primacy of political policy driving the a capital budget in which municipalities
are given the discretion to decide what they include in it.
The capital budget must foremost be formulated within the context of
available resources. This is especially true for the "General Capital Budget"
which is funded from taxes and debt, as opposed to projects supported from
enterprise funds, special revenue funds, or federal and state matching funds
(Shirey, 1994). As can be seen in Table 1, the source of funds will often
dictate the use of funds. This reality limits discretion in capital budgeting.
As there are certain inherent limitations due to the source of funds, so
too are there analytical limitations due to the use of funds. Equipment, which
is very conducive to cost-benefit analysis, is a relatively small piece of the
General Capital Budget. As can be seen in Table 2, infrastructure accounts
CAPITAL DECISION-MAKING 435
TABLE 1
City of Cincinatti Capital Budget: Source of Funds, FY 1995-96
(In Millions of Dollars)
___________________________________________________________
Fund Types FY 1995 FY 1996
-----------------------------------------------------------------------------------------
Panel A: General Capital $39.5 $42.3
-----------------------------------------------------------------------------------------
Panel B: Enterprise Funds
Water Works 23.3 20.0
Parking System .1 .1
General Aviation .1 .1
Golf .4 .5
Riverfront Stadium 1.4 1.9
Stormwater Management 2.0 1.4
Metro Sewer District 13.6 20.0
Total Enterprise Funds 40.9 44.0
-----------------------------------------------------------------------------------------
Panel C: Special Revenue Funds
Community Development
Block Grants 15.9 15.8
HOME 3.4 3.4
Emergency Shelter Grants 1.0 .5
Special Housing Fund 1.4 1.4
Total Special Revenue Funds 21.7 21.1
-----------------------------------------------------------------------------------------
Panel D: Matching Funds
State/Federal Roads & Bridges 36.6 10.3
FAA .1 3.5
ISETA 1.0 .9
Ohio Capital Funds 14.6 (*)
Total Matching Funds 52.3 14.7
-----------------------------------------------------------------------------------------
Total Capital Budget 154.4 122.1
___________________________________________________________
* States capital allocation not yet committed.
Source: Shirey, J. F. (1994), City of Cincinnati Recommended 1995/1996
Biennial Capital Budget, Cincinnati, OH: City of Cincinnati, p. 9.
436 FARAZMAND & NEILL
for over 70% of this budget, but it is very difficult to quantify in terms
of benefits. More difficult yet is Economic Development and Housing &
Neighborhoods. Environment, which is primarily projects needed for
compliance to federal, state, or local regulations, is essentially unquantifiable.
TABLE 2
Use of Funds- General Capital Budget
__________________________________________________________
Types of Capital Projects Budgeted Amount As % of Total
(in $1,000) Capital
Expenditures
-----------------------------------------------------------------------------------------
Infrastructure $28,100 71%
Equipment 7,216 18%
Housing & Neighborhoods 1,928 5%
Economic Development 1,656 4%
Environment 600 2%
Total 39,500 100%
___________________________________________________________
Source: Shirey, J. F. (1994), City of Cincinnati Recommended 1995/1996
Biennial Capital Budget, Cincinnati, OH: City of Cincinnati, p. 8.
Project Justification
If not through traditional quantifying means, then how are projects
selected? In the private sector, NPV and IRR can guide decision-making in
capital budgeting. Favorable analytical results justify the expenditures. In
public capital budgeting there is a greater emphasis on justification, i.e., how
to select among the many worthy projects.
A review of the Cincinnati CIP reflects this emphasis on justification.
For example, the highest priority in the Water Works CIP for 1995 is a
"Anthony Wayne/Center Hill Water Main". The project sheet describes the
funding needed over a six-year period, a description of the project, as well as
sections entitled "Project Justification" and "Operating Budget Impact."
Project justification reads: "The existing water system in this area cannot
support additional development." Furthermore, "contractual agreements,
CAPITAL DECISION-MAKING 439
TABLE 3
City of Cincinnati: Justification of Capital Projects, FY 1995-96
(N= 217)
___________________________________________________________
Agency A B C D E
-----------------------------------------------------------------------------------------
Building 1 1 0 0 0
Council 0 1 0 0 0
City Manager 4 1 0 0 0
City Planning 3 1 1 0 0
Economic Development 2 0 18 0 1
Health 3 0 1 1 1
Law 0 2 0 0 0
Housing 2 0 6 0 1
Parks 2 0 2 2 0
Personnel 1 1 0 0 0
Utilities 2 0 18 9 3
Public Works 12 3 27 13 3
Recreation 5 1 12 5 0
Computer Center 0 13 0 0 0
Safety 1 2 15 9 5
Totals 38 26 100 39 14
___________________________________________________________
Notes:
A = Environmental, health, or regulatory reasons
B = Increased efficiency via computerization
C = Economic development, service betterment
D = Preserve assets through maintenance
E = Cost-benefit Analysis justified
Source: Shirey, J. F. (1994), City of Cincinnati Recommended 1995/1996
Biennial Capital Budget, Cincinnati, OH: City of Cincinnati.
CAPITAL DECISION-MAKING 441
analysis (Kee, Robbins & Apostlou, 1987). Khans 1987 research also
concluded that there is a preference for informal methods of capital budget
analysis, again with cost-benefit analysis as the preferred method.
There is one glaring weakness that is common to the four types of
traditional quantification techniques discussed above: they rely on estimates of
future benefits. The words of the Cincinnati Water Works project summarize
this problem: "It is not possible to estimate...or to assign dollar values to the
benefit" (Shirey, 1994: 352).
Still, the effort continues to find ways of quantifying the qualitative
(Patton & Sawicki, 1993), usually with results that are of limited validity and
which would face difficulty in passing through the political end of the capital
budgeting process.
As stated previously, NPV and similar techniques which rely on
estimated future benefits have other analytical flaws. The cost of capital is
recognized to be greater than the borrowing rate of the government. If it
were not so, governments would accept projects that would otherwise be
rejected by private industry simply because they had lower financing rates.
This would lead to government over-spending. Theoretically, the borrowing
rate "is probably not the true social cost of capital to the community"
(Aronson & Schwartz, 1987: 402).
The other theoretical problem alluded to is that discounting gives
preference to the near-term at the expense of the long-term. It reflects the
truism that we "have a preference for benefits sooner rather than later"
(Patton & Sawicki, 1993: 276).
However, should the benefits of infrastructure be discounted in the same
manner as the benefits from equipment purchases? In the former,
infrastructure such as the Brooklyn Bridge becomes even more vital and
valuable as time proceeds- and as it is maintained (i.e., capital appreciation).
In the case of the latter, it is certain that the vehicle purchased today will in a
matter of years lose its value (i.e., capital depreciation) until it is completely
worthless.
differences between the goals and processes of public capital budgeting viz a
viz the private sector render the private sector model of limited value to
public decisions. There exists a disposition to reduce these differences to be
irrelevant.
This challenge to the value of rational-comprehensive Cost-Benefit
methods reflects the co-authors experience in capital budgeting as a financial
analyst for a successful global corporation. This experience affirms a
definition of capital expenditure decisions as "depending primarily on an
assessment (emphasis added) of the projected cash flows from additional
revenues, cost savings, or a combination thereof from the asset to be
acquired" (Kay & Searfuss, 1989: 15.2). The operative word is the definition
of "assessment"- Whose assessment? How was the assessment made? And
how is the assessment reflected in the final decision?
The topic of a capital proposal assessment is usually reduced to a matter
of quantitative analysis in both private and public-oriented texts (Aronson &
Schwartz, 1987; Garrison, 1988; Kay & Searfuss, 1989; Siegel & Shim,
1990). This may reflect the private sector accounting philosophy that this is
the basis of capital assessment, and/or it omits without explanation that this is
simply one step in the assessment process that leads to the final capital budget
decision. In either event, the result is to marginalize other important factors
that exist in the capital budgeting process.
The experience of the co-author was that assessment of capital
acquisition proposals could be subjective in nature. The decisions were
influenced by the process which allowed for qualitative analysis and personal
influence (via the Capital Committee) and were less guided solely by
quantitative analysis. NPV and IRR were in practice used not as the
traditional screening and ranking tools (Thibadoux, 1992), but often as a
formality in the decision process.
Was this an appropriate means of analysis for capital acquisitions? At
first glance it appears that some error is occurring within this company.
However the results, as gauged by success of the firm, indicate otherwise.
The concern surely is in regard to the "qualitative" nature of the decisions.
Analysis of costs and benefits falls into a qualitative-quantitative
dichotomy. According to Miller, quantitative techniques, the enthroned
arbiter of capital budgets, "are those forecasting methods involving data and
mathematical analysis." Qualitative techniques, the right-brained step-brother,
are "those in which subjective estimation predominates." At its most basic,
qualitative output is based upon the judgments that "individuals create in a
relatively unstructured and informal process" (Miller, 1992: 260-261).
446 FARAZMAND & NEILL
CONCLUDING REMARKS
Budgeting is not only the "key to decision-making" (GFOA, 1994: 48), it
is a nuts and bolts manifestation of politics. Quantitative analysis is but a
feature of the capital budgeting process which exists within the context of
politics. Indeed, research shows that much of the non-use of traditional
quantitative techniques stems from their inability to incorporate "qualitative
and political factors" into the decision framework (Forrester, 1993: 88-101;
Kee, Robbins & Apostolou, 1987: 16-22).
This article featured an analysis of capital budgeting issues in both public
and private sector situations. Both cases pointed out similar reasons for why
traditional rational-comprehensive Cost-Benefit quantifying techniques may
be compromised. First, the cases indicated the importance of qualitative data
in the decision process. Second, the cases discussed the influence of personal
factors on the capital committee. Third, competition for resources
demonstrated the context of politics for capital investment decisions.
Hopefully this analysis has pointed toward the need to study and
understand the role that the capital budgeting process may have on capital
budgeting output. Capital budgeting does have unique aspects--capital
448 FARAZMAND & NEILL
NOTES
1. The NPV formula is:
NPV = PV benefits - I,
where I is the cost of the project; and
PV benefits = [B1/(1+i)]+[B2/(1+i) 2]+...+ [Bn/(1+i) n]; where
Bn is annual flow of estimated benefits over n years and i is
discount, or interest, rate for the community.
2. The IRR formula is:
I = [B1/(1+r)]+[B2/(1+r)2]+...+[Bn/(1+i)n]
where r is rate of return.
REFERENCES
Aronson, J. R. & Schwartz, E. (1987), Capital Budgeting, in J. R. Aronson
and E. Schwartz (Eds.), Management Policies in Local Government
Finance, Washington: International City Management Association, pp.
400-417.
Axelrod, D. (1988), Budgeting for Modern Government, New York: St.
Martin's, pp. 115-116.
Bailey, P. (1994), Governmental GAAP Guide 1994, New York Harcourt
Brace, pp. 22.03-22.37.
Interview with Biemel, D. J. (1994, 1 March), Cincinnati.
Chan, A. (1994), "Managing a Government Like a Business: The Sunny-
vale System," Government Finance Review, 10(2): 7-11.
Forrester, J. P. (1993), "Municipal Capital Budgeting: An Examination,"
Public Budgeting and Financial Management, 13(2), 88-93.
Garrison, R. H. (1988), Managerial Accounting, Plano, TX: Business
Publications, pp. 643-666.
Grizzle, G. A. (1989), "Five Great Issues in Budgeting and Financial
Management," in J. Rabin, W. B. Hildreth and G. J. Miller (Eds.),
450 FARAZMAND & NEILL