5.

2 Capital budgets

A radical approach to capital projects was developed by the UK government in

the 1990s, known as the private finance initiative (PFI). On the face of it, its name
does not reflect its essence well as borrowing from the private sector had always
been a common way to directly finance capital projects (earmarked borrowing)
and indirectly finance them (increase general levels of debt). What is new here is
that the private sector is used to not just finance a capital project directly but also
build and operate it, in return for a fixed payment every year for, say, 30 years
(known as the primary concession period). The name of this policy is now clearly
appropriate: by involving the private sector in many more aspects of a capital
project, it is asserting that, during the primary concession period, the projects are
privately owned and operated. This is an assertion that financial accounting and
reporting can contest, but it was an important part of how the policy developed.
At the end of the primary concession period, the payments stop and the owner-
ship and management of the project is taken over by the government.
The economic essence of these capital projects, when compared with a tradi-
tional project, is the shift in risk to the private sector; the concomitant returns
are reflected in the annual payments. As there are important parts of the projects
that continue to be owned by the government, some of the explicit risks are
retained by the public sector (as well as the implicit risks and rewards of all pro-
jects that are ‘too big to fail’). The premise of these projects is that the services
provided are better than under a traditional project because there is a better
sharing of risk between the public and private sectors. This premise is given
added emphasis because there is an increase in the visibility of the risk in many
capital projects. Also, it deals with another fundamental problem arising from the
traditional method: the great enthusiasm with which capital projects are embarked
on often contrasts markedly with the lower enthusiasm there is for their sub-
sequent routine maintenance. The nature of PFI projects forces the quantifiable
risks and the expected costs of adequate routine maintenance throughout a
project’s life to be made explicit right at the beginning when the project decision
is made.
The PFI in the UK only set the broad parameters of the individual contracts for
the projects, not the details of each one, which were left to each governmental
organisation to negotiate with its contractors. In practice, there were many
variations in the sharing of risk, including novel ways of using notional revenues
(for example, by tracking the traffic on toll-free roads and generating shadow
tolls to determine the payments to contractors).
A PFI project requires explicit comparison with the traditional method. A
significant difference in the costs of the two methods will be the extra costs of
contracting and monitoring the PFI method. Under both methods, the necessarily
detailed specifications of contracts impose costs on the government and on the
contractors, including on the unsuccessful bidders. Under the traditional
method, however, these only relate to the capital aspects of the project; under
the PFI method, they extend to financing and operating aspects, for the whole of
the primary concession period, including the terms of the transfer of the project
to the government at the end of it. A problem is that these additional costs are
explicit while the organisational costs of operating capital projects under the
traditional method are more likely to be unquantifiable.

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Chapter 5 · Form and content of budgets

The problems under the traditional method in choosing between private

sector and public sector rates for the appropriate discount factor are highlighted
when comparing it with the PFI. Using a private rate in the PFI method, while
using a lower government rate in the traditional one, might in itself determine
which is the better method. The unquantifiable uncertainties of both methods
are then added to the appraisal, qualitatively.
Exhibit 5.6 shows the appraisal of Project A as a PFI project using only cash
flows. At a 6 per cent discount rate, the traditional method produces a better net
present value, while at 8 per cent, the PFI alternative is better. This kind of sensitiv-
ity to the discount factor when choosing between the two methods is not unusual.

Exhibit 5.6 Appraisal of Capital Project A for the City of Eutopia: private finance
initiative method and cash flows only

City of Eutopia Capital Project A

At [beginning date], 20x2
The project operates from 20x4 and the cash payments to the contractor are £250,000 in 20x4
and £420,000 a year for the 25 years thereafter. The estimated timing and amounts are
shown below (all cash flows assumed to take place at the end of each year). At the end of
the 26 years, Eutopia will take over the project from the contractor, but will sell it for a
negligible amount.

In [beginning date] Present value of Cash flows at year ending [date]

20x2 £000 future cash flows
6% 8% 20x2 20x3 20x4 25 years from
discount discount 20x5 onwards
factor factor
Capital cash flows – – – – – –
PFI cash payments – – – – (250) (420) a year
Total (4,463) (3,493) – – (250) (420) a year

If we now add the net social benefits to the PFI project, the traditional method
is still to be preferred at a 6 per cent discount rate. PFI projects, however, are also
intended to shift some of the risk to the contractors. Exhibit 5.7 introduces the
net social benefits and the risk transfer evaluated at £25,000 a year for each of
the years of operation. This changes the decision – at a 6 per cent discount rate,
the PFI project is the preferred option.
Separating the capital budget from the operating budget and then linking
them is rational and commonplace in governments, not-for-profits and for-
profits. There are notable cases (the US Federal government is one), however, in
which the separation is not made and this practice is vigorously supported. The
arguments can only be understood when the accounting basis of the budget is
included. In the US Federal government, there is obligation-based budgeting,
contrasted with accrual-based budgeting. The central argument of obligation-
based budgeting is that the cost of capital projects is scored in full in the budget
at the time the decision is made to authorise the budgets for those projects. This
is seen as important in controlling the politicians who authorise the budgets.
In contrast, accrual-based budgeting scores the capital costs over the life of the
assets, through the depreciation charge, in the operating budget.

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 5.3 Line item incremental budgets

Exhibit 5.7 Appraisal of Capital Project A for the City of Eutopia: private finance
initiative method, cash flows and net social benefits/risk transfer

City of Eutopia Capital Project A

At [beginning date], 20x2
The project operates from 20x4 and the cash payments to the contractor are £250,000 in 20x4
and £420,000 a year for the 25 years thereafter. The estimated timing and amounts are
shown below (all cash flows assumed to take place at the end of each year). At the end of
the 26 years, Eutopia will take over the project from the contractor, but will sell it for a
negligible amount. The net social benefits and risk transfer are evaluated at £425,000 a year
for 26 years, beginning in 20x4.

In [beginning date] Present value of Cash flows at year ending [date]

20x2 £000 future cash flows
6% 8% 20x2 20x3 20x4 25 years from
discount discount 20x5 onwards
factor factor
Capital cash flows – – – – – –
PFI cash payments – – – – (250) (420) a year
Net social benefits/ – – – – 425 425 a year
risk transfer
Total 198 – – – 175 5 a year

The counter-argument to accrual-based budgeting is that it also scores the full

amount in the capital budget at the time of the decision, in practice, this can
have less force because of the different ways that a separate operating budget and
a separate capital budget might be financed. If the government decided that the
capital budget could be financed by borrowing, while the operating budget had
to be financed by taxation, then, from the politicians’ point of view, scoring
against the capital budget hurts much less than scoring against the operating
budget. Thus, the obligation-based budget is a single (unitary) budget that scores
all costs – operating and capital – at the time they are obligated.
Accrual-based budgeting might respond to this argument by insisting that the
capital budget can be controlled to the same degree as the operating budget, but
perhaps in different ways. Part of this could be not conceding that the capital
budget can be financed by borrowing.

5.3 Line item incremental budgets

Line items are the accountant’s classification of revenues, expenses, assets, liabil-
ities and cash flows within the operating statement, balance sheet and cash flow
statement. In operating budgets, they are primarily classifications of what is to be
bought with the money being requested (inputs, of course, though the budgets
will also include line items of revenues). Line item budgeting can be used what-
ever structure is used but they most are most naturally associated with organisa-
tional structures.
There are very different ways, however, of combining organisational structures
and line items. The structures can range from highly aggregated to detailed, as
can the line items. Exhibit 5.8 gives an example of highly aggregated line items.

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