COST MANAGEMENT AND CAPITAL PLANNING

Module (SU116360) Manage

Information technology
(SU116347) Contribute to
Capital planning and
(SU116340) Apply Costing
principles to municipal
comprises of: resources in a municipal
environment
Financing operational and service-
based consisting
SU116347) Contribute to Capital planning and Financing

STUDY UNITS

1. BUSINESS PLANS (PREPERATION)

2. RAISING FUNDS FOR CAPITAL EXPENDITURE IN A MUNICIPALITY (METHODS)
3. CAPITAL EXPENDITURE CONTROLS (DETERMINATION)
4. SCREENING AND SELECTING CAPITAL PROJECTS (CRITERIA)
5. PROJECT APPARAISAL (FINANCIAL AND NON-FINANCIAL, NPV, IRR)
6. CBA – COST BENEFIT ANALYSIS
 AFTER THE COURSE…

1
Be able to:
• Prepare documentation for the approval of projects of a capital nature in a municipality.
• Use this documentation to raise finance from financial institutions in South Africa for
municipal capital projects.
• Determine capital investment appraisal and project financing options as they relate to
capital budgeting decisions and techniques in South Africa’s local government sphere.
 ASSESSMENTS

Prepare a Report
Collect and compile
SUMMATIVE. providing informed
this, based on the 6
Work based Rating of selected
stages of the given
Assessment (POE) capital projects for a
learning units
municipal
 ASSESSMENT STEPS

1 2 3 4 5 6

Stage 1 - Stage 2 – Stage 3 – Stage 4 – Apply Stage 5 – Stage 6 –

Identify a Identify the Identify the capital Combine Conduct a Cost-
capital project various sources municipality’s budgeting financial and Benefit
on which to base of finance capital techniques to non-financial Analysis and
the report and available to expenditure evaluate the factors in the make final
develop the fund the capital control policies financial project recommendation
background for project and and identify the factors of the appraisal. s.
the report. prepare a MoU qualitative capital projects.
if applicable. factors related
to the selected
capital project.
KEY CONCEPTS

MEMORANDUM OF BUSINESS PLANS- INTEGRATED MULTI YEAR CAPITAL BUDGETS OPERATING BUDGET
UNDERSTANDING THE FORMAL DEVELOPMENT BUDGET (AS PER (CAPEX)– ONCE OFF (OPEX) – DAY TO DAY
(MOU) (APPROVALS, STATEMENT OF A SET PLANNING (IDP) – 5- MFMA, 3 -YEAR PAYMENTS FOR INCOME & COSTS TO
DISBURSEMENTS, OF BUSINESS GOALS, YEAR STRATEGIC BUDGETS IN DEVELOPMENT DELIVER MUNICIPAL
CASHFLOWS, ATTAINMENT PLANS PLANS, INFORMS ALL UNIFORM FORMATS) PROJECTS (FOR SERVICES
PROJECT OUTCOMES PLANNING, OVER A YEAR)
AND LINES OF BUDGETING,
AUTHORITY) MANAGEMENT AND
DECISION MAKING
WHAT IS CAPITAL
PLANNING
• Process of budgeting resources for the future of
an organisation’s long-term plans
• Includes budgeting for replacement machinery,
R&D, new plants, new machinery etc
KEY STEPS IN CAPITAL PLANNING

 CAPITAL EXPENDITURE PROGRAMMES

 SELECTING SOURCES OF FINANCE
 DECIDING ON EXPENDITURE CONTROL
 SCREENING AND SELECTING CAPITAL PROJECTS
 APPRAISAL OF CAPITAL PROJECTS
 DOING A COST-BENEFIT ANALYSIS
THE NEED FOR CAPITAL PLANS

• Capital Assets require significant commitment of resources

• Long terms effects of projects
• Key to uninterrupted service delivery (plan for replacement)
• Improvement of services due to long term planning
• Augments economic development policies
• Shows promises for investments in community hence attracts businesses and tourists
1. THE NEED FOR CAPITAL PLANS

• Improves local government finances (low costs, alternative financing)

• Spreading of capital projects over years (planned replacements)
• To abide by the National Treasury’s guidelines ( Medium term expenditure
framework-MTEF, Medium Term Budget Policy statement – MTBPS, Medium Term
Revenue and Expenditure Framework- MTREF).
NB: Total capital budget is hugely informed by National priorities. This is an outline of
government spending priorities informed by Medium Term Strategic Framework
(MTSF) and MTREF.
 MTRF FUNDING COMPLIANCE
• 3 Year budgets are needed and should indicate sustainable funding from realistic
anticipated revenues. Credible capital budgets in terms of spending and institutional
capacity (the capability of an institution to set and achieve social and economic
goals, through knowledge, skills, systems, and institutions) are needed.
CAPITAL EXPENDITURE PROGRAMMES

• These are comprehensive, multiyear capital plans that provide a link between the
municipality’s strategic vision, its urban land use plan, and its annual budget
 PREPARATION OF CAPEX PROGRAMMES

• Multi year CAPITAL plans need to fall within the overall strategic plans of the
municipalities. E.g provision of clean water
• The CAPITAL plans should be covered by the Integrated Development Planning (IDP)
• All Capital acquisitions should therefore support the municipality’s long -term goals
• To develop an effective CAPEX programme, information is derived from a number of
sources/stakeholders (communities need to be involved)
 KEY STAKEHOLDERS

Municipal Council Ward Councillors (the Municipal Manager

Executive Mayor
(ultimate decision- link between people (Accounting Official,
(Political head)
making body) and the municipality) administrator)

Media, organised
business (e.g chamber
Community
Municipal officials Ward committees of commerce),
development workers
provincial and
National departments
 KEY STAKEHOLDERS

• The ACT (MFMA) requires extensive consultation of municipalities with stakeholders for
correct planning, transparency, accountability and prioritization.
 CAPEX VS OPEX

Opex – Capex- expenditure

expenditure NB: These are
incurred to acquire
funded for and
incurred on day- fixed assets used for
recorded separately
to- day operations over a year e.g
in municipal books.
e.g salaries. building, cars.
 CAPEX AND MTREF

• MTREF requires a 3- year rolling expenditure and revenue budget for municipalities.
• Capital budgeting is fundamental for planning , control and resource allocation.
 CAPITAL EXPENDITURE PROGRAMME (CEP)

• CEPs reflect short to long term budgetary plans for additions, replacements and changes
and replacements of infrastructure.
• CEP is a component of the Financial Plan and affects the cash flow of the municipality.
• Before approval, the Municipal must consider all costs incurred and revenues before the
project is operational.
• They are derived from the CAPEX budget.
• Future OPEX and revenues for specific projects need to be identified.
CAPITAL EXPENDITURE
PROGRAMME (CEP)
COMPONENTS

• Can be broken into sectors

and/ key performance areas
(KPAs)
CAPITAL EXPENDITURE PROGRAMME (CEP)

• Will differ from municipality to municipality depending on specific needs e.g

maintenance of infrastructure, transport facilities etc
PREPARATION OF CAPITAL EXPENDITURE
PROGRAMME
• Integrated Development Planning (IDP) process drives strategic plans (5years)
• CEP becomes an offspring of the IDP
• There are four steps in compiling a capital expenditure programme (CEP)
 Determination of capital needs: Spatial analysis (model
problems geographically),socio economic analysis,
community stakeholder's analysis, data collection

Identification of Capital projects: Identified from strategy

STEPS IN (IDP) and financial parameters.
COMPILING A
CAPEX Costing of Capital Projects: Design proposals, technical
reports and preliminary budget allocations
PROGRAMME
Prioritization of Projects: Projects will need to be
prioritized to cater for scarce resources. National and
provincial imperatives and the MFMA to be considered.
 4. Prioritization of Projects (cont.): projects need to be assessed for:
(a) feasibility (technical report)
(b) Affordability : (capex accumulated, annual opex for project etc)

STEPS IN (c) Cash flow: implications of delays, cancellations, extentions

COMPILING A 5. Development of the Capital Expenditure programme

CAPEX a. Develop a flexible list of projects as per IDP and MTREF

PROGRAMME b. This is a 5 year programme checked and revised annually. It

considers; affordability, funding.
STEPS IN COMPILING A CAPEX PROGRAMME

c. Funders will include government grants, surplus revenue, leases, loans, municipal bonds,
developer contributions and other grants.
(to be discussed later)
6. Capital Budget – After the above steps have been accomplished, the capital budget will
be put together. The information from the CEP is transferred to the annual budget doc.
PRELIMINARY CAP PROJECTS EXAMPLE
BUSINESS PLANS

• This is a formal statement of a set of business goals, their motivation (of bein attainable)
and plan to reach them
• The goal in a municipal is to enhance service delivery
• Serves to formulate a capital project in a clear manner for decision makers
BUSINESS PLANS (TEMPLATE IN ANNEX 1.1)

Regarding capital projects, the following should be contained in a business plan:

o The purpose or intention of the capital project
o Current status and anticipated outcomes/outputs
o Identify role players, timelines and mechanics of plans
o Indicate details on funding and other resources
o Financial and Capital Investment plan
o Indicate required or available expertise to achieve goals
MEMORANDUM OF UNDERSTANDING (MOU) (ANNEX
2.1)

• Agreement or commitment entered into prior to implementation and detailed planning

• Can be included in the business plan as part of the financial aspects of the business case
• Results as a requirement for commitments regarding envisaged project or programme
• Usually arises if funds are sourced from an agency or donor
 An MOU refers to an official agreement establishing the principles, expectations, terms
and conditions to be met in implementing programs or projects.
CASH AND REVENUE CONSEQUENCES FOR A
CAPITAL PROJECT
The putting together of a capital budget results in calculating Cash flows for a project. The cash flows
calculation will include:
 calculation of capital charges for future capex budgets
 calculation of future capital charges of loans
 calculation of capital to finance future capital programmes
 calculation of additional opex of the capital budget
 calculation of benefits the capex programme
 cost recovery, tax and tarrifs
CAPITAL PROJECTS COSTS

• Finance charges and pay back methods

• Pay back methods include the ANNUITY (amount annually, int+cap) and
REDEMPTION FUND(capital only paid at the end) methods
• Future running costs (variable and fixed OH)
• Future benefits (may not always be quantitative)
SUMMARY KEY TERMS

• Business plan (intention of capital project, outcomes, timelines & mechanics, funding mechanism and other
resources)

• CAPEX programme, multi year capital plan, part of bigger strategy of municipality

• Stakeholder role in capital budgeting programme

• Opex vs capex

• Steps on capex programme (determination of capital needs, id of projects, costing, prioritization, development of
cap programme, cap budget)

• MOU (bilateral or multilateral agreement between 2 or more parties)

QUESTIONS
STAGE 2. RAISING FUNDS FOR CAPEX IN A
MUNICIPALITY
• SCOPE: As departments prepare Service delivery and budget implementation plans
(SDBIPs), they need to consider funds available for Capital projects
Overall Municipal strategy is in the IDP.
The Municipal Budget Policy Statement is then prepared to provide the financial parameters
The parameters will consider the overall position for how the capital programme will be
funded.
Plans need to be prepared within the requirements of the MFMA 19(2).
SOURCES OF CAPITAL FUNDING

• Contribution from own income: Cash-backed current year surplus in the Financial
performance budget (MFMA 18(1)(a). In cases where external loans and financing is not
possible. Surplus cash financing occurs when fully depreciated assets are disposed.
• Cash-backed accumulated funds from previous years not committed for other purposes
[MFMA 18(1)(b)] (committed to other purposes meaning council resolved to allocate the
funds for a specific purpose).
• Public Contributions, Grants and Subsidies from other Organs of State. There are 3 sources
of capital grants: National gvt, provincial gvt grants and other municipalities grants.
SOURCES OF CAPITAL FUNDING

• Private Capital Markets – ability to borrow an indication of an efficient LG system

There are 3 categories of Municipalities 1. they don’t need assistance to borrow from CM 2. not
credit viable but not incapable of being credit worthy i.e. sufficient tax base
3. Poor candidates due to fundamental structural weaknesses
• Long term external loans – Extending over 15, 20 or more years. Mostly annuity kind
• Municipality Service partnerships (MSPs) – Access to cap markets through revenue streams
• Concessional Loan Finance – More lenient , easy terms (DBSA, Infrastructure Finance Corp
(IFCA) )
SOURCES OF CAPITAL FUNDING

• Sale and Lease back – involves selling assets to a lessor who in turn leases it back.
Money raised can fund other capex purchases
• Equity deals: Municipal Bonds – Citizens invest directly in the municipal for better
services
KEY FACTORS IN BORROWING ( MFMA)

Borrow at
Borrow within
Borrow at lowest minimum
authorized
interest rate risk(manage
parameters
exposure)
FUNDING PROS AND CONS
FUNDING PROS AND CONS

Long term Loans Revenue/cash backed acc Public contributions, Grants etc

Advantages
Cost is spread longer No principal or interest payments Not repayable

Disadvantages
A bit difficult to access funds Current rate payers fund future tax payers Costs of maint and upgrades from municipal
Maybe more expensive Relies on fully cash backed Cap Replacement reserve May need to borrow in future for upgrades
Security maybe needed
 For better informed decisions, the best possible information
must be presented for capital projects and should cover:

Cashflows linked to each project ( and MTREF)

INFORMATION Impact of each funding method on ratios/ fin indicators e.g

CONSIDERATIONS debt to equity

Advantages and disadvantages of each funding method per

project

Projected costs, revenues, tariffs, taxes etc and current costs

(MFMA 19(2)

Any savings and opex issues, interest repayments, capital

repayments etc
 ANY PRACTICAL CHALLENGES OPPORTUNITIES
EXAMPLES

DISCUSSION:

LEARNINGS (FUNDING OPTIONS,

REASONS FOR
SELECTION, PRINCIPLES
APPLIED, FINANCING
MIX)
 STAGE 3. CAPEX CONTROLS

Key terms:
• Capital rationing
• Optimal CAPEX
• Asset capitalization
• Medium Term Revenue and Expenditure Framework (MTREF)
• IDP, MBPS
CAPEX CONTROL MECHANISM

1. Objectives: Ensuring best CAPEX options are selected and evaluated in terms of financial viability and ability
to meet service delivery needs

2. Risk management: value of money not being achieved, service delivery not met

3. Key controls: appraisal and evaluation of capex options prior and post implementation

4. Capital rationing: Arises due to scarcity of funds. The following steps apply;

Step 1. Identify potential Cap projects that fit with the IDP Step 2. Establish minimum quantitative criteria

Step 3. Evaluate remaining projects using NPV, IRR etc Step 4.Consider the qualitative benefits

Step 5. Rank the projects based on quantitative and qualitative factors Step 6. Allocate available funds top to bottom
CAPEX 1. Objectives: Ensuring best CAPEX options are
selected and evaluated in terms of financial viability
CONTROL and ability to meet service delivery needs
MECHANISM 2. Risk management: value of money not being
achieved, service delivery not met
3. Key controls: appraisal and evaluation of capex
options prior and post implementation
4. Capital rationing: arises due to scarcity of funds.
The following steps apply;
5. Qualitative factors: may show impact of project
on service delivery e.g safety and welfare, pollution
 CAPEX control mechanism is a budgetory control tool

Ensures CAPEX occurs within MTREF and IDP

objectives and the Municipal Budget Policy Statement
(MBPS)
LEGISLATIVE Controls CAPEX on land, builings, structures, machinery,
equipment etc
CONTEXT
Ensures CAPEX is on approved projects/assets within
IDP

Benefits are long lasting to communities

CAPEX is within budgetary limits

 Supply chain processes are followed

LEGISLATIVE Proper approvals done correctly

CONTEXT
Non - compliance to CAPEX controls impacts
municipalities e.g cash flow problems, deficits,
service delivery cash shortages.

Avoid funding of non budget approved projects

 OPTIMAL CAPEXS

• Expenditures that enhance objectives of IDP and MBPS for basic services
• A good mix of equity and liabilities to fund assets
• Established as per IDP (Capital budget, capex programme)
• Optimal capex structures to be agreed annually after consultations
• Informed by the powers, functions and delegation of municipality
STEP 4: SCREENING AND SELECTING CAPITAL
PROJECTS
• KEY TERMS: NPV, IRR, PAYBACK PERIOD, DISCOUNT RATE (I), BUDGET
• CRITERIA, CASHFLOWS, FINANCIAL ANALYSIS, APPRAISAL METHOD
THE SCREENING PROCESS

Municipal capital project screening should be based on a two-tiered approach:

1. PRE-SCREENING CAP PROJECTS:
 Eliminate expenditure on projects that lack merit. Questions may include:
 Is project included in the IDP, Is it for more than 1 year, are funds for existing project? Etc.
 Pre-screening will show if there is sufficient merit.

2. FULL PROJECT PROPOSAL:

 Once pre-screening is done, full proposals will be developed and evaluated using a tiered approach.
THE SCREENING PROCESS

There are mainly 2 purposes:

• To align project selection with identified IDP objectives
• To define further screening techniques that are needed to identify different elements of
the projects (i.e. risk factors)
PROPOSAL
EVALUATION
TIERED
APPROACH
CAPITAL BUDGETING TECHNIQUES

NET PRESENT INTERNAL RATE OF

VALUE (NPV) RETURN (IRR)

ACCOUNTING RATE
PAYBACK PERIOD
OF RETURN (ARR)
NET PRESENT VALUE

The difference between the PRESENT VALUES of future projected cash

inflows and ouflows

Difference determines acceptance or rejection of a project

PVs are found by discounting CFs using the discount rate ( required
return, WACC)

Projects with positive NPVs are selected

NET
PRESENT
VALUE
CAN BE CALCULATED
USING THREE MAIN
TOOLS:
 • Municipality A is considering the purchase of a machine capable of
performing certain operations that are now performed manually.
The machine will cost R75,000 and it will last for 5 years. At the
end of the 5 year period it will have a zero scrap value. Use of the
machine will reduce the labour costs by R20000 per year. The pre-

NPV EXAMPLE determined discount rate the municipality requires is 18%. Should
the machine be purchased?

•  There is only one cash outflow, the cost of purchasing the

machine for cash in one payment would be R75 000. So the PV of
the machine is R75 000.

• FIND THE NPV

NPV NOTES • Takes into consideration the time value of money
(inflation)
• Ensures assets are not purchased purely based on
cashflows
• Chosen cost of capital/ discount rate may have an
impact on result
• All cashflows (in and out) need to be identified
INTERNAL RATE OF RETURN (IRR)

• The discount rate at which NPV is zero

• To be compared with the rate of return that the capital could achieve elsewhere
• Implementation of project only if IRR is higher than alternatives
 • The result of the formular below is read on the table
along the line corresponding to the number of time
periods involved to determine the IRR

IRR FORMULAR
IRR CALCULATION EXAMPLE AND TIP

Tip: Use the NPV Table to find the factor under the number of years required. That will
give the IRR %. The IRR must be above the required rate of return to approve project.
IRR NOTES

• Works easier if cashflows are the same annually.

• For irregular cashflows, trial and error methods will need to be used
• Method considers time value of money
• Can compare projects of unequal size
• Assumes investment of cashflows at the IRR
• Requires complex calculations
IRR AND NPV KEY NOTES

• NPV of a single project, if NPV > 1 = Accept project

• For mutually exclusive projects = use NPV to rank from high to low and select
• IRR of a single project = Compare IRR to pre-selected rate of return (hurdle rate)
• If IRR is greater than hurdle rate = accept project. Otherwise decline
PAYBACK PERIOD

• The length of time required to recover the initial investment

• Considers the cashflows and their timing
• Indicates when funds are available for re-investment
• The shorter the period, the better the opportunity
PAYBACK PERIOD FORMULAR
PAYBACK PERIOD EXAMPLE
PAYBACK PERIOD NOTES

A very simplified method of project appraisals

Can lead to poor decisions (no TVM is considered)

Ignores cashflows after payback period

Assumes annual cashflows are the same

 Calculation based on PROFITS and not
CFs (big difference)

Parallels conventional financial statements

ACCOUNTING in handling data
RATE OF
RETURN (ARR) Estimates revenues and deducts estimated
costs to calculate net income

Relates the calculated NET income to the

initial investment to decide
ARR FORMULAR AND EXAMPLE
ARR FORMULAR
AND EXAMPLE
ARR NOTES

• Simply to calculate
• Ignores CFs and TVM
• Can be useful in evaluating manager performance
QUESTIONS
STEP 5: PROJECT APPRAISAL

• TIME VALUE OF MONEY

• NON-FINANCIAL FACTORS
• WEIGHTING
• SCORING
• PROJECT APPRAISAL
PROJECT
APPRAISAL
• Essential tool for allocation of scarce
resources
• Effective project appraisals offers benefits
to communities
• A good appraisal justifies the spending of
project capital
• Lays the foundation for project delivery
and evaluation
• Should consider both Financial and Non-
Financial aspects
 PROJECT APPRAISAL PROCESS

The process is divided into 3 in municipalities.

 Competing of projects for inadequate funds(mutually exclusive). Its either project A or B.
 Non - competing projects for funding (not mutually exclusive). Enough finance to fund
all.
 Already selected projected, appraisal for best method of implementation
 PROJECT APPRAISAL PROCESS - STEPS

Objectives –
SMART (specific, Costs and Benefits
Options – Identify
measurable, – Identify and Financial appraisal Uncertainties and
available project
achievable,
options quantify for each – NPV, IRR etc Sensitivities – risk
relevant, time- project
bound)

Identify suitable
Non- Financial Comparison with Identify best Recommend
sources of
factors – evaluate alternatives option – TVM course of action
Funding
 • Investors (municipality) prefer to receive money today
rather than in the future
TIME VALUE OF
• Inflation erodes the value of money
MONEY (TMV)
• R20,000 today is of less value in 5 years time ceteris
AND PRICE
paribus
INCREASES
• Price increase are beyond the control of municipalities.
Higher prices and increased Interest rates affect cash
FACTORS INFLUENCING CAPEX PROGRAMME BENEFITS

• Scoring – qualitative measure of evaluating a project’s contribution (e.g 0-10 on scale)

• Weighting – objectives are weighted based on importance to i.e essential vs non-ess
COMBINATONS

Financial and non-

financial factors can be Weights e.g can be applied
combined to make to a financial assessment
informed decisions
COMBINATION
EXAMPLE
 • Weighted Scores of non- financial factors are divided
by the NPV to get a rate. The rate is then used to make
decisions
 Option with highest score is chosen

VALUE FOR
MONEY RATING
QUESTIONS
 KEY TERMS and Acronyms

Cost- benefit analysis, Cost- benefit ratio, present value

STEP 6. COST –
BCR (Benefit Cost Value Ratio)
BENEFIT
ANALYSIS EIRR (Expected Internal Rate of Return)

CBA – Cost-benefit analysis

CBR Cost-benefit ratio

CBA APPLICATION TO PROJECTS

 The CBA process determines project expenses vs expected return

 It attempts to pull all relevant costs and benefits to a common footing
 A chosen discount rate calculates future costs and benefits in PRESENT TERMS
 CBA considers the TVM
CBA – INFORMATION COLLECTION

• Information relevant to project costs and benefits is collected and applied

• It may be difficult to value intangibles e.g environmental importance
• Sophisticated approach do put financial values to intangible costs and benefits
• Uses only financial costs and financial benefits to compute
 COSTS BENEFITS

CBA – On-going costs Reduced costs, improved

One-time costs efficiencies
INFORMATION
implementation Opex, Increased revenue and
COLLECTION maintenance collections
    Improved service
    Reduced risk
BENEFIT COST RATIO (BCR) CALC

Total PV of benefits : Total PV of costs

e.g PV of benefits = R494,395
PV of Costs = R330,600
BCR = 494,395/R330,600
 Therefore, BCR IS 1.495: 1
For very R1 spent on a project, R1,50 is returned.
CBA IMPACT ON DECISIONS

• For individual projects : if BCR (Benefit Cost Ratio) is > 1= ACCEPT Project
• For mutually exclusive projects: (Accept after ranking) = combine with NPV, NPV first
• Should it be used in municipal capital budgeting process????
NB:
 Most public CAPEX projects produce qualitative benefits, (improved water quality, less
time on roads)
 Costs are indicated in raised tariffs/taxes
CBA EXAMPLE

• PAGE 103 GUIDE

QUESTIONS