by: Lance S. Holman
Many governmental agencies utilize a cash strategy to fund their equipment, infrastructure, and facility needs to avoid the interest expense associated with debt. While on the surface this strategy may appear to eliminate interest expense, the municipality will experience higher asset cost and forgo future revenues during the savings period, resulting in a lower return on investment. In the example below, a municipality has estimated that a project will cost $10,000,000 and has built up its reserves over a 10-year period to fund the project. However, during the same time period, the prices of material and labor increased by 3.00% annually, escalating the project cost to $13,439,164 and leaving a cash shortfall of $3,439,164.
Alternatively, the municipality bids the project with a reputable design build construction firm and receives a firm bid for $10,000,000. Next, the municipality finances the project and annually budgets to make (10) principal and interest payments of $1,196,361 over ten years for a total of $11,963,609.
The Design, Build, Finance Strategy provides a firm project cost, eliminates price increases, spares time, and saves the municipality $1,475,555 ($13,439,164 - $11,963,609) to the bottom line over the same time period.
The Cash Funding Strategy is used by many municipalities to fund their fixed asset acquisitions. This strategy appears to eliminate borrowing cost, but it is fraught with additional risk that increases the cost of ownership and produces a lower return on investment.
Difficulty Estimating Project Cost – It is difficult to accurately estimate the future cost of a project. In fact, the longer the saving period, the more inaccurate the estimate. The municipality then must decide to pay the higher cost of the project by tapping into their reserves, siphoning funds from another project, or reducing its operating expenditures. Overall, the municipality will be required to reprioritize its capital allocation strategy.
Rising Labor and Material Cost – The cost of labor and materials continue to rise due to globalization, modernization of economies, and increased competition for resources.
Rising Energy and Maintenance Cost – Operating antiquated plants, equipment, and facilities escalate energy and maintenance cost, thereby increasing operating expenses and reducing cash balances.
Internal Competition for Resources – Projects are often delayed due to internal competition for municipal resources, changes in leadership, new priorities, and policies.
Government Grant Delays – Grants are an effective tool to lower the cost of a qualified project. However, the grant application and approval process can take several months or years, which translates into higher asset cost and lost productivity. Ultimately time reduces the value of the grant.
Deplete Reserves – Paying cash will deplete municipal reserves and liquidity, which is a form of insurance for unexpected events.
In summary, paying cash leads to higher asset cost, lost revenues, rising expenses, and a lower return on investment.
Merging project development and finance into an integrated Design, Build, Finance Strategy will produce high quality projects, enhance control cost, reduce work-orders, and increases the return on investment.
Firm Proposal – The design build construction firm provides the complete scope of work and assumes the risk of accurately estimating the project cost.
Eliminate Price Increases – The price of materials and labor for municipal projects fluctuate and are frequently more volatile than the national average. It is not uncommon for the CPI to increase 2.00% annually, while raw material and labor prices for municipal projects can rise above 5.00% annually. Any project cost overruns are the responsibility of the design build construction firm.
Faster Project Delivery – Early project planning, costing, and sequencing leads to quicker decision making and faster project delivery.
Enhanced Revenues – New facilities, equipment, and plants generate additional revenues or savings that enhances the municipality’s cash flow and return on investment.
Financing 100% of the project enables the municipality to quickly lock in the project agreement, save time, and expand its budget.
Interest rates have steadily declined since the 1990’s, which has provided municipalities with a low-cost financing strategy to funds its capital projects.
The municipality can establish a guidance line of credit to plan and execute the funding of its capital projects for the next 12-24 months. The municipality develops a project list and is pre-credit approved for each financing to streamline the process and respond more quickly to changing market conditions.
The terms and conditions are described between the municipality and the investor, which includes security, insurance, asset maintenance, and purchase options provisions. Each drawdown under the Master Financing Agreement creates a new and separate payment schedule, which includes the collateral description, financing amount, financing term, interest rate, and payment structure.
Payment schedules can be structured separately with monthly, quarterly, semi-annual, or annual payments. Payments can be raised or lowered depending on the budgetary needs. This optimizes the municipality’s budget to create an affordable payment solution, which facilitates the funding of additional projects to enhance overall productivity.
The financing proceeds are disbursed into a separate escrow account to ensure timely vendor payments and accurate project accounting.
Project cost continue to rise at a faster rate than many of us expect. Building reserves over time and paying cash for capital projects reduces liquidity, depletes reserves, and sacrifices the commencement of other mission critical projects. In due course, these events result in a decline in the municipality’s return on investment.
Merging project development and finance into an integrated Design, Build, and Finance strategy will eliminate price increases, transfer risk away from the municipality, produce quicker decision making, rapidly fund more projects, and ultimately increase the return on investment for the municipality.