The assignment was:
Write a 2,500 word paper that includes the following:
I. Introduction
II. Discuss how the debt capacity of a governmental entity is determined.
III. Analyze various funding alternatives that can be used to support debt obligation.- Catherine
IV. Describe how rating agencies evaluate governmental risk.
V. Conclusion
Case Scenario: Capital Budgeting Paper
As governmental entities struggle to achieve excellence, public administrators have to work towards ensuring capital funds are allocated properly in accordance to its capital budget. The capital budget funds are allocated towards physical assets for constructed, renovated, acquired and rehabilitated assets. The capital budgeting process is expensive and time consuming; however, public administrators must assess the infrastructure needs in order to prioritize capital plans.
The governmental entities must generate funds for the capital budget through public debt, taxes, and inter-governmental transfers in addition to the government’s various businesses. Governmental entities assess its practices related to its debt capacity and its ability to repay its debt obligations without revenue deficit. The capital budget management helps public administrators ensures accountability of policies and procedures for appropriate allocation of funding and to reduce governmental risk.
How Debt Capacity of a Governmental Entity is Determined
Debt depicts the aggregate sum of budget deficits. “That is, the debt is the cumulative excess of past spending over past receipts” (Rosen, 2005, p. 456). Therefore, the greatest interest to the creditors and investors concerns the government’s dept and its ability to repay principal and interest because “Just like a private borrower, the government must pay interest to its lenders” (Rosen, 2005, p. 456).
Debt capacity refers to the capacity by which an individual or entity can repay debt. Governments borrow money to fund long-range expenditures against the projected revenue (capability to repay) within the terms of the obligation. The Dunn and Bradstreet web publication, All Business, ran an article entitled Debt capacity analysis for local governments (2004) in which the topic explores the pitfalls in determining debt capacity.
Although the government accounting system differs from that of the private sector, the government credit rating has the same effect as an individual’s credit rating. Much like private solvency, rating agencies examine the government’s ability to repay debt, and this government credit rating comes in the form of a score. Additionally, governments hold tangible assets as well. These assets offset debts when assessing an entity’s financial position.
The determination of debt capacity begins with an audit of current obligations. “Understanding your jurisdiction's existing debt burden and how any future issuance will impact its financial condition allows for more effective project prioritization during the capital planning and budgeting process, as well as better long-term financial planning” (Debt Capacity, 2004, para. 2). Given current obligations, the questions entail how much debt can the government afford in the future, and are existing policies effective in addressing the capacity to service outstanding debt.
Although the government accounting system differs from that of the private sector, the government credit rating has the same effect as an individual’s credit rating. Much like private solvency, rating agencies examine the government’s ability to repay debt, and this government credit rating comes in the form of a score. Additionally, governments hold tangible assets as well. These assets offset debts when assessing an entity’s financial position.
What is less obvious entails a government’s “…creditworthiness, [which] should take into account the unprecedented financial burdens many public sector issuers face from aging populations, public pension liabilities, infrastructure needs, and revenue instability caused by financial and economic dislocations” (eRatings, 2010, para. 1).
The dept capacity article details five steps to determining governmental debt capacity, which entail “…(1) defining the scope of analysis, (2) peer group development, (3) analysis of current position, (4) scenario analysis, and (5) financial policy development” (Debt Capacity, 2004, para. 3).
1. The scope focuses on the type of debt to consider.
2. The group development focuses on comparisons across governments.
3. The analysis of the current position focuses on net direct debt per capita, net direct debt as a percentage of fair market value of taxable property, net direct and overlapping debt per capita, and various debt service indicators.
4. The scenario analysis focuses on various levels of short and long-range debt effects on debt issuance with respect to population, general fund revenues, operating expenditures, fair market value, and per capita personal income over the period analyzed.
5. The financial policy focuses on financial climate forecasts. One may employ the debt capacity analysis to strengthen debt policy.
Through debt capacity analysis, governments can determine and control the amount of new debt issuance by specifying minimum criterion in new debt issuance.
Analysis of Funding Alternatives that Can Be Used to Support Debt Obligations
Government entities have three major funding alternatives, borrowing, taxation, and grants, to support debt obligation (Rosen, 2004). Each alternative has advantages and disadvantages.
Borrowing
Governmental entities can support debt obligations through borrowing (Rosen, 2004). The government can borrow money from its own citizens or “from abroad to finance current expenditures” by issuing bonds, which are “long-term contract[s] under which a borrower agrees to make payments of interest and principal on specific dates to the holder of the bond” (Rosen, 2004, p. 461 and Brigham & Gapenski, 1996, p. 518). Governments can also borrow money by selling commercial paper, which are “short-term unsecured notes” (Brealey, Myers, & Marcus, 2001, p. 566). The government recovers its costs of purchasing the commercial paper “by charging borrowers on average a higher interest rate than they pay to lenders” (Brealey, Myers, & Marcus, 2001, p. 566)
Although borrowing provides the government with an additional stream of revenue to support debt obligations, borrowing raises the possibility of default, questions the integrity of intergenerational equity, and reduces private investment (Rosenbloom & Kravchuk, 2004 and Rosen, 2004). The possibility of default increases because lenders expect the market rate of interest on the loan (Rosenbloom & Kravchuk, 2004). Interest increases the amount of money the government must pay back in the future. The government risks default if the government’s budgetary officers did not originally accommodate this variable.
In other words, the government may not have sufficient funds to cover expenditures. The government can transform funds from other government programs and services, but this typically results is displacing the default to other departments or programs (Rosenbloom & Kravchuk, 2004). Inflation also plays a key role in the possibility of default. If the government is operating within a high inflationary period, this changes the value of the debt (Rosen, 2004). To illustrate, suppose that at the beginning of the year a school owes a creditor $10,000 for remodeling:
And the sum does not have to be repaid until the end of the year. Suppose further that over the course of the year, prices rise by 10%. Then the dollars [the school must] use to repay [the] creditor are worth 10 percent less than those [the school] borrowed. In effect, inflation has reduced the real value of debt by [$1000 (10% of 10,000)]. (Rosen, 2004, p. 458)
Borrowing also questions the integrity of intergenerational equity, which is the “notion that government services rendered during the current year should be paid for by revenues raised during that year” (Rosen, 2004, Marks & Raman, 1996, p. 52). The Lerner Model and Overlapping Generations Model analyze this integrity. According to Lerner’s model, debt financing does not create a burden for future generations (Rosen, 2004). This model purports “members of the future generation simply owe it to each other” (Rosen, 2004, p. 461). The Overlapping Generations Model suggests that debt financing can produce a heavy financial burden on future generations (Rosen, 2004).
A final drawback of government borrowing is the assumption that it reduces private investment, known as the crowding out hypothesis (Rosen, 2004). According to Rosen (2004):
When the public sector draws on the pool or resources available for investment, private investment gets crowded out. [Crowding out occurs when interest rates change.] When the government increases its demand for credit, the interest rate, which is just the price of credit, goes up. (p. 464)
Thus, when interest rates increase, private investment becomes more expensive and investors are less likely to invest (Rosen, 2004). In essence, this hurts the financial health of the economy.
Taxation- To be completed by Charles
Grants
A final way the government can support its debt obligations is through grants. Grants have three major advantages: provides the government with additional revenue, enables the government to pursue additional activities, and the grant does not have to be repaid (EPA’s Financial Tools, n.d.).
The government can receive grants from a multitude of sources such as corporate foundations, public charities, or private donors. Governmental agencies however, should never depend on this method to fund their debt obligations. Economic conditions, for example, may delay awards. Additionally, grantors may impose spending restrictions. “The award can be used only for that purpose, no matter how worthy other purposes may be” (Granof & Wardlow, 2003, p. 7). If an agency does not abide the stipulations, serious consequences may ensue such as forfeiture of past and future awards (Granof & Wardlow, 2003). Furthermore, “applying for grants can be costly, time-consuming, and problematical” (EPA’s Financial Tools, n.d., para. 3).
Although each aforementioned funding alternative has its drawbacks, they are viable alternatives. If the government decides to use a combination of these alternatives, it must conduct a cost-benefit analysis to see how it will affect its debt capacity. Typically, the government will use these forms of funding when available. The government, however, must calculate a healthy financing mix to ensure it can pay its debt obligations within a reasonable timeframe to avoid revenue deficit.
How Rating Agencies Evaluate Governmental Risk
For decades consumers have had their personal credit history on file with the three major credit consumer credit reporting bureaus; Experian, Equifax, and TransUnion. Likewise, similar companies such as Moody’s Investor Service, Fitch Investor Service, or Standard and Poor as well as others monitor government credit histories but in greater depth. “The Standard and Poor’s municipal bond rating process involves four broad factors: economic, debt, administrative, and fiscal” (Smith & Lynch, 2004, p. 328). Exploring these different factors provides a clearer insight into the dynamics of a government entity.
Examining the economic factors provides an indication of the ability of the local economy to support public debt. Analysis of the debt factor will reveal existing debt, past and current payment history, and any repayment trends. Administrative factors include current tax rates as well as any existing statutory tax-rate cap that may affect the ability to service debt. The fiscal factor is essentially compares balance sheet items of assets to liabilities and the ability of a government entity to repay debt.
Unlike consumers who typically borrow from banks or finance companies, government entities borrow through the issue of bonds purchased by investors. However, in as much as banks expect loans to mature and be repaid, investors expect government entities to service and retire bond issues and a credit rating is an indication of both ability and probability. “A credit rating seeks to answer a simple question for lenders: what is the probability of receiving full and timely repayment of principal and interest on this debt obligation” (Perry, 1996, p. 335)?
When government entities seek funds through the issuance of bonds, they are competing against other jurisdictions as well as corporate bond issues from the private sector. As investors determine which instruments they wish to invest through, a credit rating becomes even more important. Some credit reporting agencies such as Fitch Investors Service or Duff and Phelps will provide a credit rating of a bond issue before its release. “For a fee (paid by the issuer), a credit rating agency will provide a rating of a new debt issue prior to sale and periodic updates of the issuer’s credit standing” (Perry, 1996, p. 335).
Just as information held by the three major credit bureaus helps in determining a consumer’s ability to obtain credit, government entities are subject to the same type of scrutiny but on a broader scale. Government credit rating agencies directly affect the ability of a government entity obtain credit and what cost and the associated terms.
Conclusion