installment loan amortization tables

HARVARD UNIVERSITY GRADUATE SCHOOL OF DESIGN CENTER FOR URBAN DEVELOPMENT STUDIES ------------------------ URBAN DEVELOPMENT STRATEGY CAPITAL INVESTMENT PROGRAM FINANCIAL ANALYSIS AND FORECASTING By David C. Jones, CPFA1, FCCA2 (U.K.) David C. Jones, C.P.F.A., F.C.C.A.(UK), Research Fellow & Visiting Instructor, Center for Urban Development Studies Graduate School of Design, Harvard University, 48, Quincy Street. CAMBRIDGE. Massachusetts Tel: 617-495-4964 Fax: 617-495-9347 E-mail: djones@gsd.harvard.edu and as: International Financial & Management Consultant 4936, Andrea Avenue, Annandale, Virginia. 22003. USA Tel: 703-978-8564 Fax: 703-978-8014 E-mail: dcjones1@erols.com 1 2 Member of the Chartered Institute of Public Finance and Accountancy (Chartered Public Finance Accountant). Fellow of the Association of Chartered Certified Accountants (Chartered Certified Accountant). URBAN DEVELOPMENT STRATEGY CAPITAL INVESTMENT PROGRAM FINANCIAL ANALYSIS AND FORECASTING IMPORTANT INFORMATION TECHNOLOGY NOTE So that the model will be capable of adjustment by a variety of entries, it contains a large number of formulae. Consequently, to safeguard its computational integrity, the model itself should be saved and stored separately. Only copies of it should be used for actual computations. Backup versions, saved and stored separately from the working versions (e.g., on non-rewritable CD-ROMS), should be created. Moreover, the “Current Price” and “Deflated Current Price” tables should be “protected” by the Excel system. All entries should be made in the “Constant Price” tables, unless the model needs to be temporarily unlocked. This might be to insert data, as over-rides to the formulae, in the other tables. In such cases, the formulae should be restored, or a fresh version of the model should be used, taken from backups. CAPITAL INVESTMENT PROGRAM FINANCIAL ANALYSIS AND FORECASTING Introduction Local government units are encouraged to prepare capital investment programs 3, covering periods of at least 3-5 years. The first year would typically form the basis for a capital expenditure budget. This would impact upon the current budget, for contributions to the capital budget on a pay-as-you-go basis. It would also impact on future current budgets, including provision for expenditure on debt service for loan financing and for operation and maintenance of the assets so provided. 3 The preparation of Capital Investment Programs and the appraisal of Capital Investment Projects are covered in separate documents. 2 However, no local government unit can assume a capability to finance its entire capital investment program within a particular time-period, if at all. This is often because of constraints upon the availability of capital funding sources. It is also because of the inability of current budgets to provide all the financing4 necessary for the operation and maintenance of the resultant fixed assets, together with the debt service expenditures for any loans raised for their capital financing. Capital expenditure programs are not merely a list of assets to be provided or financed. They should represent part of a strategy, by a local government unit, to initiate, provide and maintain public services, as well as to support the private sector in economic development. This involves the initial provision of fixed assets, as well as their replacement, improvement or extension. Business start-up or expansion, as well as the supply of housing, depend significantly on the provision and timing of public infrastructure and services. These include utilities, together with social services. The provision of public services will engender commercial activity and employment, which will feed back into the public revenue streams. This will occur through the augmentation of taxes and user charges. The publicly provided assets can also be expected to leverage more commercial activity, through economic multiplier effects5. To the extent that total capital investment provision is not harmonized, there will be potentials for inefficiencies. For example: road construction must be harmonized with drainage; water with sewerage; bridges and major highways with access roads; and, solid waste vehicles with disposal facilities. Inefficiencies resulting from incompatibility may have economic impacts in at least three ways. They may: increase costs of operations to alleviate them; generate costs resulting from incomplete use of some assets not fully harmonized; and, impose suffering or costs on users or beneficiaries, perhaps resulting in monetary costs or losses. The potential losses to users and beneficiaries will also have synergistic effects, by their negative impacts on business, employment and residence. In theory, the synergies would be stimulated and accelerated, with incompatibilities diminished or eliminated, by the proper timing of asset provision. In practice, this is virtually impossible, for two main reasons. Firstly, there are significant technical and logistical difficulties. Efficient planning and engineering can minimize these – but they cannot be wholly eliminated. Secondly, there are usually severe limitations on financing. Because of this, it is important to have a forward-looking financial strategy, to match the physical program. This will help to plan the more efficient provision of assets within the various financial constraints. An example of a model, to deal with such a medium-term financial strategy, linked to capital investment programs, is shown as an Annex. It will now be explained in detail. 4 In this document, reference to “financing” does not refer to “costs of services,” but to “cash-flows” and “funding.” These aspects of financing, although not sufficient for full understanding of financial impacts of planning, are still very necessary and immediate concerns. Costs of public services are a separate and different concern, covered elsewhere. 5 A common minimum expectation of primary leverage is about three or four dollars of private expenditure for every one dollar of public expenditure. Some situations may engender much higher ratios. 3 The Standard Financial Model The economies of virtually all countries suffer from inflation. Even nations with economies that are considered stable, as with recent experiences in the USA, have modest inflation rates, although these will fluctuate somewhat. In the past, moreover, even in these countries, inflation has gone out of control, requiring extremely harsh measures to tame it. Usually, in such countries, budgets and capital programs are prepared in nearconstant prices, with expected inflation allowed for by small increases in what would otherwise be constant prices. Moreover, respecting the costs of borrowing, variations in likely interest rates are allowed for in much the same way as price variations for goods and services. Thus interest rate fluctuations are expected to be no greater than the normal variations of the financial markets. Sometimes, adverse post-budgetary adjustments are allowed for by withdrawal of funds from surpluses or reserves. Alternatively, there may be a policy of “cash limits” whereby budget managers are expected to institute real expenditure reductions, to accommodate cash shortages arising from later changes from the original estimate of inflation. In high inflation countries, such as many in Eastern Europe in the late nineties and early two thousands, these arrangements just will not do. Firstly, it is unlikely, in the absence of indexation, that locally raised loans will be available for longer than about three years. Secondly, inflation is likely to be the greatest and most unstable single cause of variance in prices. Thirdly, governments often provide indicators of expected inflation that are far too optimistic. Fourthly, there is almost always deterioration in the foreign exchange rate that accompanies high inflation. This creates a severe risk for the borrowing of foreign currencies, albeit that loans may be available, commercially, for much longer maturities than for those in local currencies. However, although the loans may appear to have much lower interest rates, these, when combined with foreign exchange losses, will potentially require much higher and greatly increasing quantities of local currency, year by year, to pay the debt service. Consequently, it is necessary to examine potential financial strategies first in constant prices and by assuming no changes in foreign exchange rates. Then, adjustments must be made to these, for the specific effects of differently postulated inflation rates, as well as deterioration or improvement in rates of exchange6. Then, there is another rectification to be considered. Nominal interest rates are set as approximating the addition of two separate components. The first of these components is the real (inflation-free) interest rate, including the opportunity cost of capital and normal commercial risk. The second component is the expected average rate of inflation during the loan life-span. Unlike goods and service prices, these cannot simply be discounted back to current prices. Loan repayment terms, for both principal and interest, are typically fixed by their loan contracts. Even if there are variable interest rates, these do not allow for adjustments of debt service to current prices. Only full indexation will do this. However, this is very 6 In the tables, there are two simplifying assumptions. First, annual inflation, though continuous in practice, is added to the previous year’s numbers at year-end values. Second, debt service is assumed to be by equal annual installments of combined interest and principal. This is sometimes known as the “annuity” or “level payments” method. Even where the method is NOT used in practice, extra subsidiary calculations, to equalize annual debt service, would produce approximately the same results. 4 uncommon in loan contracts. Indeed, indexation, generally, is avoided by the major EU Japanese, and US financial markets7. What happens, typically, is that for loans with high interest rates, inclusive of expected inflation, much more of the annual debt service is paid, in real (inflation-free) terms in the earlier years than in later years. Another way of saying this is that, in periods of high inflation, high interest-rate loans are being serviced in less and less valuable local currency8. Variable interest rates protect lenders against losses. However, they make little or no difference to the fact that borrowers must pay most of the debt service in the early years of the loan life-spans. For foreign currency loans, the situation is different. In these cases, in each year of loan maturity, borrowers service the debt with the same amounts of foreign currency, calculated at the (relatively low) international interest rate for each loan. However, high domestic inflation rates typically engender deterioration in exchange rates. Therefore, in each successive year, more and more local currency will be needed, to purchase the foreign currency required for debt service. To correct these disparities, therefore, further adjustments are needed. These will discount debt service payments to their constant price values. In general, local currency loans will discount to decreasing constant values year by year, whereas foreign currency loans will discount to roughly equal constant values9. As they need to be included in the same tables, goods and services will merely discount to their original current price values. Thus, adjustments just for these items alone would be superfluous. Comprehension and Credibility In addition to using the constant price model as a basis for further analysis, there is another important use for it – that of comprehension and credibility. In periods of high inflation, it is very difficult for politicians and other laypersons, and even those familiar with models, to comprehend the magnitude of the effects of price changes on income and expenditure patterns. Thus, for example, if there is annual inflation of 42%, a constant price expenditure of $100,000 in each of three years would be shown in the inflated financial forecasts and statements as, respectively: $100,000; $142,000; and, $201,640. Just as confusing is where there is a low inflation rate, of (say) 5%. In such circumstances there are, typically, no separate constant price and current price tables. There would normally be just one table, with current price adjustments built in. However, near-constant-price figures of $100,000 per annum would be shown as: $100,000; $105,000 and $110,250. 7 This is, partly, because indexing works in favor of borrowers, whereas lenders control the major financial markets. 8 The currencies of different years (even different months or even days) are, in effect, different currencies, as if they were, for example, dollars and pounds. In principle, the exchange rate is the inflation rate. 9 More accurately, they discount to the average level of the inflation rates of freely convertible currencies, such as the US dollar, Euro or Yen. 5 In the first example, a local city council might balk at approving a three-year expenditure program that, misleadingly, appears to double its cost in the third year. Yet, it might be satisfied that the second example shows a modest and acceptable growth in each year, when it actually does no such thing! Consequently, although it is often accepted that, in low inflation situations, two sets of tables are not necessary, the effects of inflation need to be fully understood and allowed for10. Financial Model – Constant Prices The first table shows all budgeted and forecast activities of a local government unit in constant prices. However, there is a place for analysts to enter a postulated inflation rate11. Also entered is a different, postulated, rate of deterioration of the exchange rate against an average of foreign currencies12. These rates are allowed for in the second (current-price) and third (deflated-current-price) tables. They are not reflected in the first table. Each of the three tables – constant prices, current prices and deflated current prices – is virtually identical in format. The tables also conform to the standard practices of accounting, for presentation of cash-flow reports. First comes a statement of operations, then a statement of investment, with the final main items as a statement of financing. The last sub-statement is a work-sheet to generate data for the items “Debt Service (Domestic)” and “Debt Service (Foreign)” in the “Capital Financing Expenditure” subsection of the Current Expenditure. The Current Income section lists the main types of current income likely to be available to a local government unit. This is followed by the Current Expenditure section, which, similarly, summarizes the main items of current expenditure. Unlike a “Program Budget13” format, which will list the expenditures on each separate service, these cashflow statements are additional management documents. They are concerned with likely growth rates of overall types of income and expenditure, as well as the extent to which expected cash flows will be able to support capital financing expenditure. 10 As there is no current accounting requirement in (say) USA to publish revalued financial statements, it is quite common for companies to claim inflationary gains as increased (real) profits, hoping that stockholders will not notice! 11 Although it should be expected that inflation rates will change from year to year, only one average rate is postulated, to avoid over-complex calculations, as well as deceptive appearances of accuracy. Moreover, it avoids the common assertion, often based on wishful thinking or politically-inspired deception, that inflation rates will inevitably fall. A moment’s reflection will cause one to realize that if inflation is currently high, it must have gone up, to get there! 12 In an open economy, the real exchange rate should, in theory, be the difference between the average expected domestic inflation rate and the weighted average expected foreign inflation rate. It is assumed that all the foreign inflation rates would be harmonized by exchange rate adjustments among the foreign countries. This is not necessarily done, in practice, without leads and lags, if at all! But it is pointless to speculate that one can produce better numbers. 13 The cash-flow table is not intended as a substitute for a program budget format. A local government would typically expect to use the cash-flow statement as a complement to the main documents of a capital program and current budget. 6 Against each line-item of income and except for the last line-item of expenditure, a space is provided for a percentage of increase in real growth14, net of inflation. The growth rates for income will take account of increases in revenues likely to arise only from expansions of the tax bases or increases in demand for revenue-seeking activities. The growth rates for expenditures will allow for expansion or extension of services, either in the qualities or quantities delivered. These real growth rates are likely to be rather low, in general. Indeed, if the main concern is to keep pace with inflation, they could well be held at zero, or even be negative. In the latter case, of course, real services, though costing more, will effectively be reduced. The last item of current expenditure provides for a percentage related to the operation and maintenance of newly acquired assets, resulting from capital expenditure. It is likely to be within the range of about 1-2% of the value of new assets15. When current budgets are prepared, the operation and maintenance expenditures will be assessed for each separate situation and asset. The use of a percentage is little more than a rough and ready device for strategic planning purposes. When operating expenditure is deducted from current income, what remains is the “Total Operating Surplus.” This is the amount available to support the “Capital Financing Expenditure.” The capital financing expenditure, in turn, is the amount available to cover debt service on loans raised and contributions to capital expenditure, to be made from current budgetary resources16. Any additional capital expenditure, not able to be covered or financed from this source, will need to be postponed, curtailed or abandoned, unless it can be financed from other sources outside the local government. These might include grants, donations or private sector contributions. Moreover, even if it can be financed from such sources, provision will almost certainly be needed for the operation and maintenance of it. The operating expenditure, together with the capital financing expenditure, forms the total current expenditure. When this is deducted from the current income, the result is either a current surplus or current deficit. A surplus will be available as increased cash reserves or working capital. A deficit will need to be withdrawn from working capital17. Following the statement of current activity are some important financial indicators. First, there is the ratio of debt service to current income. By law, at present, in Romania, this must not exceed 20%. Therefore, depending on loan maturities and interest rates on previous loans, it is a key determinant in how much incremental loan debt can be serviced in any year. However, as the figures in this table are in constant prices, the ratios are only 14 It should be appreciated that this is a pragmatic and practical exercise, to assist in the planning of capital investment. It is not academic. Because inflation is the main disruptive factor in the forecasting exercise, a main concern is to determine the extent to which price changes are related to it, or to other factors. 15 In the interests of simplicity, no allowance is made for assets going out of operation, which would be done in a more rigorous calculation. 16 Capital Financing Expenditures are cash-flows. They are not the equivalent of rents (resource consumption) for the use of fixed assets. Often, the latter will not appear in accounting formats currently used by many local governments. 17 These cash surpluses or deficits are not, strictly, formally added to or subtracted from reserve “funds.” However, with most cash accounting systems, at present, this is a somewhat academic distinction. 7 indicative. The ones that will need to be (legally) enforced are those in the “current price” table, as these will reflect the actual loan agreement provisions. These, moreover, may contain some potential hazards for capital financing, which will be explained below. The next item shows the Capital Financing Expenditure as a % of Current Expenditure. This relates capital financing expenditure to total current expenditure. This is intended to show how much of the expenditure is absorbed by items over which, once committed, there is little or no room for adjustment. Of course, in a normal balanced budget situation, current expenditures and current revenues are approximately equal. Thus, this ratio would normally be close to that related to current incomes. However, where the revenue collection policies and practices are defective, the “current income” item may tend to be more unstable than the “current expenditure.” In addition to debt service expenditure, this ratio also includes the capital expenditure directly financed from current revenues. It might also include contributions to capital reserve funds, although these are not shown. The latter two ratios are a synthesis of the first one. The first of them shows how much debt service expenditure can be supported by the legal limit and the second shows the extent to which, with postulated debt service, the local government would be within, or out of, compliance with this provision. As with the calculation of the original ratio, the legal enforcement will be based on the ratios in the “current price” table, as these will reflect the actual loan agreement provisions. The next section shows the capital expenditure that is forecast for the current year. This information will come directly from the capital investment program, although it will probably be in summary form. These numbers should be shown in constant prices, as they will automatically be converted to current prices in the following table. Following this table is a line-item for the accumulated value of fixed assets, used as a basis for calculating the incremental operation and maintenance on these, to be included in the operating expenditure. After this comes the capital funding summary. Again, it will be taken from information that might be included in the capital investment program18. This section provides data that informs the various items in the capital financing section, included as part of current expenditure. This completes the main financial forecasts in constant prices. Below the main tables are two “annex-like” additions. They show, year by year, the expected annual debt service resulting from the postulation of average loan maturities as well as of real interest rates19. They show, without regard to either inflation or exchange 18 The capital funding summary might also include unapplied capital receipts that will be held until used in a later year. There will then be a corresponding entry in the capital expenditure section, as a contribution to a capital fund. 19 The loan maturities will be the same under both constant and current scenarios. However, to keep the tables consistent, the real interest rates for domestic loans should be derived from the formula: [ r =(1 + n)/(1 + i) – 1] 8 rate losses, what the likely debt service would be under the postulated scenarios. As explained in more detail in the footnote, there will be major differences in the calculation of debt service for (on the one hand) domestic and (on the other hand) foreign loans. Financial Model – Current Prices The format of the current price table is the same as that for constant prices. However, as the title implies, all the items in this table reflect the current prices, incorporating any postulated average inflation rate that has been inserted in the first section of the tables: “Constant Prices.” There is no need to make any entries in this table, nor in the table dealing with “Deflated Current Prices.” The model calculates all these, automatically. Naturally, the automatically generated numbers can be over-ridden, if wished. However, in that case, the original formulas will need to be restored afterwards. The sections dealing with current income and current expenditure will be increased to show the effect of the average inflation rate on the constant price items used in the first table. This will also apply to the section dealing with Capital Expenditure and Capital Funding. Moreover, the line for “Operation & Maintenance of Newly Acquired Assets” will be based on the current value of “Accumulated New Fixed Assets.” In the “Capital Financing Expenditure” section, the line for “Recurrent Contributions to Capital” will, similarly, reflect the current value of the capital expenditure activity. However, there is a significant difference in approach when dealing with debt service. The constant price “Debt Service” items, for either domestic or foreign debt, will not simply be updated to reflect the inflation rate. For these items to more closely reflect market reality, the computations, albeit very rational, are somewhat more complex. In the “Capital Funding” section, the loan amounts are shown as simply adjusted for inflation. However, the borrowing of these loans, if domestic, will be at nominal interest rates. This will reflect the assumed compounding of the real interest rate and the average future inflation rate, postulated by the market20. This rate, it should be noted, will not be determined by any model, including this one. Instead, it will reflect all expected fluctuations in the financial markets, caused by any number of reasons. The interest rates for domestic loans will, therefore, in high inflation periods, appear to be much higher than those in more stable times. Moreover, when they are periodically serviced, the debt servicing calculations will reflect these high interest rates. Using annuity (level payment) systems, the nominal (i.e. market) debt service payments will be the same each year. However, in real terms they will be declining. This will be allowed for in the “Deflated Current Prices” table. Where (expressed as decimals) r = the real interest rate, n = the nominal interest rate and i = the rate of inflation assumed in the table. For foreign loans, the interest rates should be those in the loan contracts. 20 The loan maturities will be the same under both constant and current scenarios. However, to keep the tables consistent, the nominal (assumed market) interest rates for domestic loans should be derived from the formula: [ n = (1 + r)*(1 + i) – 1] Where (expressed as decimals, n = the nominal interest rate r = the real interest rate, and i = the rate of inflation assumed in the table. For foreign loans, the interest rates should be those in the loan contracts. 9 If the annuity (level payment) system is not used, an assumption of its virtual use can still be valid. Thus, if the annual debt service contract payments were “rear-end loaded” it would be prudent to invest an additional sum, in addition to the actual debt service, to allow for the later higher payments. If the annual debt service contract payments were “front-end-loaded,” it would (in principle) be possible to temporarily borrow the “over-paid” sum, to be repaid later when debt service contract payments are less. Sinking funds and consolidated loans funds, as well as government-sponsored local loans funds, will sometimes take care of these matters, within the normal framework of their operations21. For foreign loans, the terms will be those in the loan contracts. However, as a corollary to inflation, there will almost certainly be a deterioration of the exchange rate, reflecting, in theory, the differences between average domestic inflation rates and average foreign inflation rates. However, as with interest rates, exchange rates will not be determined by any model, including this one. Instead, they will reflect all expected fluctuations in the foreign exchange markets, caused by any number of reasons. Thus, in every year after the loan is raised, the exchange rate deteriorations will determine how much domestic currency will be required to service the foreign debt. Therefore, the foreign debt service payments will be based on the foreign interest rate and maturity terms, adjusted for all exchange rate deteriorations since the loan was raised. The foreign loans are, effectively, indexed, even though this term is not used. The data in the “current price” table are based on the postulated market activities. Thus, it will be these that determine the legal adherence to debt service limitations. These are very often included in the law, or in international loan agreements, along the following lines: “(1) Local Government Units shall have no access to any further loans, if the total of the annual debt service, representing the due installments or provisions for repayment or amortization, together with the interest and the commissions associated therewith, for:   loans already contracted; and loans that are about to be contracted during the current year, is estimated to exceed 20 % of the total current revenues, including all local taxes, government grants and shared taxes not pledged for specific alternative purposes. “(2) In order to calculate this limit, for the loans contracted with a variable interest rate, one shall take into account of the interest rate valid at the date when the calculation is made; and, 21 See, however, the important textual cautions about “capitalized interest” and “principal moratoria.” 1 0 “(3) In order to calculate this limit, for any loans contracted to be serviced in foreign currency the debt service shall be calculated at the exchange rate published by the central bank, at the date when the calculation is made or to be made.” The relevant limit – as indicated, commonly 20% – is calculated automatically by the model, as are the related ratios. Also calculated, automatically, are the amounts of overcompliance or under-compliance. The percentage limit can be varied by the model. The relatively few local governments in USA, for example, having a “AAA” rating for their municipal bonds often seek to keep the limit within the range of 10-15%, for greater prudence and security. Thus, although the 20% may be a reasonable legal and practical limit, it is not necessarily to be taken as the basis for a totally prudent one. There are two other matters that need to be allowed for. Matching Debt Service with Cash Flows The legal requirement, as postulated, does not allow for the necessity to cover the total debt service in any future year. This is sometimes provided for in loan agreements of official foreign lenders, such as the World Bank. Even if it is not, the debt service for a particular year – especially one in the future – is determined by the weighted average terms of the current debt already outstanding. Its various terms are already written down and agreed to. Thus, if there was to be an increase, especially a sudden one, in debt service obligations, it might place a strain on the ability of the local government unit to meet its legal obligations, preventing it from raising any further debt at all. There is an additional concern. If debt service obligations are postponed to later years, this will lower the debt service percentage requirement during the earlier years. This could, consequently, encourage the raising of additional loans, with debt service for these still falling within the limits. However, when postponed debt service obligations fall due, the percentage requirement will likely be exceeded. While this, in itself, will not break the law, the incurrence of any further debt, under these conditions, would be unlawful. The problem arises not primarily because the debt service requirement is exceeded. It arises because in earlier years, it will appear to be smaller than necessary. Then, extra recurrent expenditures, perhaps involving an extension, expansion or initiation of services, might be incurred. These, when perpetuated in future years, might leave no margin for the coverage of the inevitable and unavoidable debt service Even after curtailing additional borrowing, the only option, as a last result, might be to increase revenues, either by raising taxes, fees or charges or by seeking additional government grant. However, even the cutting of other current expenditure will not serve this purpose, because the debt service coverage is based on revenues. Even if it were to be based on expenditures, cutting other expenditures would lower, rather than raise, the total base for assessing the debt service. Moreover, by a quirk of the calculations, cutting expenditures, then balancing the current revenues against these reduced expenditures, by a balanced budget policy, will also reduce these revenues. Once again, this would reduce the total base for assessing the debt service. 1 1 The second concern, related to the first, is that loan contracts sometimes provide for the interest for the first few years of a long-term loan to be financed from additional advances of principal. This is sometimes known as “capitalizing the interest” 22. Thus, when it finally becomes due for payment, it is paid as the interest on a higher amount of principal. The latter, of course, includes the compounded value of the earlier unpaid interest. Moreover, long-term loan contracts sometimes provide for moratoria on early principal repayments. Thus, the deferred payments are then spread over the fewer and later payments, making the principal repayments somewhat higher. This arrangement may sometimes be combined with, or substituted for, the capitalization of interest. The effect of these practices will be to defer the cash-flows, against which the legal debt service coverage covenants will be imposed, until later financial periods. However, when the payments actually begin, there will be a sudden leap in cash-flows, creating the potential for the kind of potential for non-compliance with the legal debt service requirement that has already been explained. This would have the same implications for curtailment of additional borrowing, or increased revenue requirements. The potential for non-compliance is not the main concern. Much more important is the impediment placed on the strategic planning process. In strategic planning, it is important for managers and policy-makers to have greatest possible flexibility for decision-making, currently and in the future. If future decisions are encumbered by too heavy financial burdens, resulting from earlier imprudence, this flexibility will be less than optimum. As a matter of prudent practice, it might not be in the best interests of a borrowing local government unit to agree to capitalization of interest or to a deferment of principal repayments. Indeed, this should be avoided, unless there are available the necessary financial management skills, disciplines or procedures to deal with the future disruptions, when they inevitably arise. This is especially true if the loans relate to tax-based services. This is because taxes will usually grow according to economic concerns, typically fairly steadily year by year. These will be unlikely to be related, directly, to the implementation of particular items of tax-borne infrastructure or other public service assets. There are, in theory, at least four ways of dealing with this concern. First, irrespective of the anticipated loan contracts, the model can be entered with the virtual equalized debt service expenditures. These would be derived from annuity calculations23. When the actual debt service is expended, this might be less than postulated by the model, leaving an actual budgetary cash surplus. This would be held as increasing working capital, to expend on the expected higher and later debt service. The second option would be to actually budget for the equalized debt service payments and pay these into a debt service 22 This practice, which is sometimes included in loan contracts, should not be confused with the accounting practice, sometimes similarly named. This practice, otherwise known as “interest during construction,” allows interest incurred on debt, during the period of construction of a fixed asset, in excess of a single year, to be added to the value of the asset. It is, subsequently, depreciated as part of the asset value, rather than charged directly as “interest” in the profit and loss (income) statement. 23 The model, after all, is intended as a management tool. It is not, primarily, intended as a forecast of the actual accounts of the local government. The practical purpose is not better book-keeping but better financial management. In this case, it means providing enough cash, in a timely fashion, to meet all obligations, promptly and in full. 1 2 fund24. The actual debt service expenditures would then be paid from the debt service fund, leaving a balance of cash to expend on the later, higher, debt service25. The third option would be to establish a formal sinking fund26 for each separate loan. Indeed, if a loan is contracted to be repaid at maturity, as in the case of standard bond issues27, either a sinking fund or an equivalent accumulating procedure must be used. Finally, a consolidated loans fund28 may be used. This completely disconnects the actual expenditures, on servicing of the loans, from the charges to the accounts that will provide the funding for this. This facilitates the soundest of accounting procedures, closest to cost recognition. Concurrently, but separately, it also facilitates the raising and repayment of loans in ways that are most prudently in line with current market conditions. The creation of a table of equalized debt service expenditures may be rather complex in practice. However, the principle is fairly straightforward. It consists in devising, for the entire period of any loan, a stream of hypothetical regular annual cash-flows that are equivalent, in present values, to any other stream of irregular cash-flows, reflecting actual expenditures on annual debt service. In the Annex, an example is given of how the various alternative accounting procedures may be used, to accommodate this practice. It may be that the coming on line of a particular asset will generate a direct increase in related revenue streams. This might apply, especially, to revenue-seeking utility services. More indirectly, there might be increased revenues derived from (say) taxes on property, people, businesses or other activities that have been engendered by installation of new public infrastructure. In such cases, the constraints on future debt service obligations might not need to be so rigorous. This concept is postulated in the USA, when raising long-term debt under what is sometimes called “tax increment financing,” or “revenue increment financing.” Sometimes, it becomes validated by subsequent events, in generating the necessary revenues. Sometimes, however, the concept turns out to have been little more than wishful thinking29. Financial Model – Deflated Current Prices 24 25 Debt service funds are commonly used in US fund accounting systems. In the UK, it is legal required to make a charge against the annual revenues as a provision for repayment of principal on long-term loans. Known as a Minimum Revenue Provision (MRP) it is calculated in a prescribed manner. 26 Sinking funds are used, for example, in local governments of both the USA and the UK, to deal with maturity debt. However, in the UK, these have, more often than not, been abandoned, in favor of Consolidated Loans Funds. 27 This refers to the simplest form of bonds. Bonds are designed for a great variety of maturities, not all of which relate to regular servicing of the debt in each period. These require management techniques beyond the scope of this paper. 28 Consolidated Loans Funds have been used for debt management, for example, in the UK. They are among the most sophisticated forms of debt management, combined with accounting systems, currently in use. They require, however, that there be active and flexible capital markets, facilitating the roll-over of medium-term debt instruments. These conditions do not currently prevail in many developing countries or newly-emerging democracies. 29 The privately-financed highway, called the “Greenway” in Northern Virginia, USA, together with the wellknown Anglo-French “Channel Tunnel” are examples of what are, essentially, public infrastructure assets, financed and constructed by the private sector. [In effect, instead of borrowing the money the public sector “borrows” the asset]. Quite apart from the much more costly and complex legal and administrative aspects of these projects, compared with public loan funding, neither has ever produced a net profit and is unlikely, ever to do so! These are two examples of both “revenue increment financing” and “private sector initiative” public service provision gone badly wrong. 1 3 Because of anomalies created by inflation and foreign exchange losses, managers need to know the extent to which numbers in future years are consistent, with prices in the year in which the analysis is being performed. As already explained, for goods and services, these numbers are already reflected in the constant price table. However, this is not true for debt service transactions, especially for domestic loans. Moreover, the constant price tables, though they may highlight the individual line items for goods and services, do not illustrate the overall constant price situation when the debt service is considered. Consequently, a third table is introduced. This, which is also calculated by the model, shows the constant prices for goods and services, in addition to the debt service payments that have been deflated by the inflation rate. It thus demonstrates that for domestic debt service, the annuity (level payment) method will result in a real debt service schedule that is heavily “front-end loaded.” As already explained, this means that the lenders, in real terms, get more of their money back in the early years of the loan and less, in real terms, in later years. The advantages of this for the borrowing local governments is that some part of their debt service, in inflationary times, is really saving, in real terms. This is so even though, in nominal terms, debt service may appear to be equalized. For foreign debt service, the use of increasingly higher nominal quantities of local currency, to buy the foreign currency to service the debt, will appear to be a worse and worse financial situation, in each successive year. However, using the deflated current price table shows that this is usually not the case. Instead, the same quantity of foreign currency, in each successive year, is being purchased with less and less valuable local currency, in real terms30. The relatively poor treatment of the phenomenon of inflation is a constant wonder to many financial professionals, as well as academics. When an inflation rate is high, it is typically the most disruptive single item in any set of financial statements, whether produced for formal external reporting or for internal management purposes. Consequently, comprehension of the numbers that it engenders is often overwhelming and daunting. Conversely, when an inflation rate is low, there is a great temptation to pretend that it does not exist at all! Then, it creeps into the financial statements by stealth, so to speak, disrupting and distorting the meanings of everything with which it comes into contact. Annex EQUALIZED DEBT SERVICE EXPENDITURES Installment Debt 30 Incidentally, the foreign currency itself is also less and less valuable. This is because there is almost always inflation in the countries with convertible currencies, even though, on average, it may be much lower than that in the countries of the borrowing entities. 1 4 To illustrate the principle of equalization of debt-service expenditures, consider a situation where a local government unit borrows $100,00031, in the year 2000, for fifteen years, at ten percent32 interest. The loan contract includes provision for the financing (capitalization) of interest for the first three years of the loan period. It also provides for a grace period on principal repayments for a period of five years. Therefore, if an annuity (level payments) system of amortization is used, the debt amortization table will appear something like the following: Principal Outstanding Year Interest Amorti zation Payment 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 $10,000 $11,000 $12,100 $13,310 $13,310 $13,310 $12,475 $11,556 $10,546 $9,434 $8,211 $6,866 $5,387 $3,759 $1,969 $0 $0 $0 $0 $0 $8,351 $9,187 $10,105 $11,116 $12,227 $13,450 $14,795 $16,275 $17,902 $19,692 $0 $0 $0 $13,310 $13,310 $21,661 $21,661 $21,661 $21,661 $21,661 $21,661 $21,661 $21,661 $21,661 $21,661 $100,000 $110,000 $121,000 $133,100 $133,100 $133,100 $124,749 $115,562 $105,457 $94,341 $82,114 $68,664 $53,869 $37,594 $19,692 $0 As can be seen, no debt service payments are made during the first three years and only the interest is paid for the next two. Only in year six is the full amount of the debt service payable. Moreover, this is higher than it would otherwise have been, because of the earlier postponements, together with the accumulated interest on these. Thus, from a level of zero in the first three years, it rises to $13,310 in year four and to $21,661 in year six. This can be mitigated, by making budgetary provisions for equalized debt service obligations in each of the years of the loan period. Thus, the equalized amortization table would appear something like the following: Year 31 Interest Amortization Provision or Charge Principal Outstanding 2000 Obviously, loans will be for more than this amount. However, the number is$100,000 illustrative used just for 2001 2003 2004 2005 2006 2007 $10,000 $9,339 $8,958 $8,539 $8,078 $7,572 $3,147 $3,808 $4,189 1 $4,608 5 $5,069 $5,576 $13,147 $13,147 $13,147 $13,147 $13,147 $13,147 $96,853 $89,582 $85,393 $80,785 $75,716 $70,140 purposes. 32 The modest interest rate is used so as not to overwhelm the calculation. Moreover, borrowing for fifteen 2002 $9,685 $3,462 $13,147 $93,391 years at interest rates much above ten percent is unrealistic and unlikely to occur. In this case, the strategic financial planning model, or the budget itself, would include the figure for debt service of $13, 147 in each of the years of the loan period. Of course, if the sum of $13, 147 is included in the budget, revenue will be raised to cover this. Then, if no debt service payment is actually made, there will be an actual budgetary surplus of $13, 147. The following year, this surplus will be added to by the next non-payment. In addition, interest will have been earned, by actual or implicit investment of the earlier fund balance. This is shown in the following table: . Year Provision or Charge Actual Payment Interest on Balance Balance Outstanding 2001 $13,147 $0 $0 $13,147 2002 $13,147 $0 $1,315 $27,609 2003 $13,147 $0 $2,761 $43,518 2004 $13,147 $13,310 $4,352 $47,707 2005 $13,147 $13,310 $4,771 $52,315 2006 $13,147 $21,661 $5,232 $49,033 2007 $13,147 $21,661 $4,903 $45,422 2008 $13,147 $21,661 $4,542 $41,450 2009 $13,147 $21,661 $4,145 $37,081 2010 $13,147 $21,661 $3,708 $32,275 $21,661 $3,227 $26,988 This will be carried 2011 forward,$13,147 to become available to cover the later, higher, debt service 2012 It $13,147 $21,661 $2,699 that will need to be paid. may either be retained as a surplus $21,173 in the general fund or 2013 $13,147 $21,661 $2,117 $14,776 transferred to a reserve. Alternatively, it might be placed in a specific debt service fund or $21,661 $1,478 $7,740 a consolidated loans2014 It $13,147moreover, be invested, in whatever instruments will fund. would, 2015 $13,147 liquidity. It should, in normal circumstances, not $21,661 $774 $0 provide the most appropriate return and 1 6 be used for either capital or recurrent expenditures, as these are illiquid. The investment interest credited to the reserve fund might be the actual interest earned on investing it. However, it should be realized that the investment interest is, implicitly, that which arises from the postponement of the debt service. Thus, its “opportunity benefit” is equivalent to the interest on the loan. Accordingly, the actual interest earned might be credited as ordinary revenue, with a transfer made, as current expenditure, into the reserve fund for the imputed interest33. However the interest is computed will, to some extent, depend upon the legal requirements for accounting. Within these limits, best practices should be followed, consistent with contemporary standards and practices. As early debt service payments are skipped or curtailed, reserve or fund balances will accumulate, with interest. They will reach a maximum, of $52, 315, at the end of year five. Then, these will be gradually depleted, as the higher debt service payments are made in subsequent years. After the last payment, the balance is zero34. This shows that adequate provision was made and that the calculations within the system are credible. Maturity Debt The above explanations concern debt that is more or less repaid by installments. This is typical of debt raised from International Financing Institutions, such as The World Bank or the European Bank for Reconstruction and Development. However, if maturity debt is raised, such as with a bond issue, these procedures need to be somewhat modified. Assume, therefore that there is a bond issue by a local government unit for the same amount as before, $100,000 and on the same terms regarding interest and maturity – 10% for 15 years. There is the same provision for financing (capitalization) of interest for three years. Assume, also, that it is intended to establish a sinking fund, to pay off the debt at maturity. The lender has agreed that the contributions to this sinking fund will be for twelve years, starting in year four35. The actual amortization table would appear something like the following: Principal Outstanding Year 33 Interest Amortization Payment This might seem like “convoluted accounting,” just for the sake of academic fastidiousness. Indeed, there is 2000 $100,000 little point in using complex procedures when the underlying accounting system is crude, as in simple cash-based systems. However, the use of “notional” interest, to better reflect economic and financial realities related to resource 2001 $10,000 $0 $0 $110,000 use, has long been practiced in more sophisticated accounting systems, including those for local government. 2002 $11,000 $0 $0 on cash-flows. Moreover, it facilitates more accurate recognition of costs, based on resource use and not just $121,000 34 The balance will only reach zero if investment interest is the same as loan interest. This is assumed in the 2003 $12,100 $0 $133,100 example as 10%. In practice, such symmetry is unlikely. However,$0 “notional” interest rates can engender a using virtual symmetry. 2004 $13,310 $6,224 $19,534 $133,100 35 These terms would not be very common for a bond issue and are not wholly consistent with standard 2005 $13,310 $6,224 $19,534 $133,100 practices. They are postulated here to provide an exact comparison with the installment loan. Moreover, it is increasingly common for bond issues to be of a hybrid nature. This means that they are specially constructed to $13,310 $6,224 $19,534 $133,100 harmonize the mutual2006 of both the borrowers and the expected lenders. The lenders might, for example, be a concerns specific consortium, seeking a specially crafted cash-flow for its own reasons. For instance, it $133,100 2007 $13,310 $6,224 $19,534 may anticipate that no suitable reinvestment opportunities will open up, during the next three years, for the cash flows from the bond issue. From the borrower’s perspective, it $13,310 2008 may be that there will be a surge in revenues, to service the debt, after the first three $6,224 $19,534 $133,100 years. 2009 2010 2011 2012 $13,310 $13,310 $13,310 $13,310 $6,224 $6,224 1 $6,224 7 $6,224 $19,534 $19,534 $19,534 $19,534 $133,100 $133,100 $133,100 $133,100 The financing of the interest would increase the amount of the loan, by the end of year three, to $133,100. This would then need to be repaid, with interest, at the maturity date of the bonds. That would be at the end of calendar year 2015. It would be repaid in full. Meanwhile, for every year during the loan period, because the entire loan would be outstanding, there would be interest payable – often called the coupon interest – on the full amount of the loan. Moreover, to make provision for the final repayment of the loan, an accumulating sinking fund would be established, into which would be deposited the equal annual sums of $6,224, in each of the twelve years. This would provide exactly enough funds to pay off the bonds, at the end of calendar year 2015, for $133,100. However, twelve times $6,224 only amounts to a total of $74,688. Therefore, how will the sinking fund contributions provide enough funding to pay off a total of $133,100? The remainder of the funding will come from the interest that will be earned by investing the sinking fund. As with the debt service fund or consolidated loans fund, the interest will be the best that can be gained from market conditions. However, as the money invested also provides the “opportunity benefit” of non-repayment of the bonds, the notional interest can, also, be 10%, the same as the loan interest. The accumulation of the interest, by the investment of the sinking fund, will be more or less as follows: Year Sinking Fund Contribution 1 8 Interest Sinking Fund Accumulation 2000 2001 2002 $0 $0 $0 $0 $0 The interest for the first year of the sinking fund investment will be zero, because the investment contributions are assumed to be made at the end of each year. Thereafter, interest will be paid, at the applicable rate, on the balances outstanding at the end of each previous year. The accumulated sum, at the end of calendar year 2015, will be exactly enough to pay off the outstanding bonds $133,100. For an actual bond issue, there will be other matters that will complicate the practicalities. These include issue and management expenses, premiums or discounts on bond issues or on redemption and several other matters. These matters, although important, do not affect the basic principles of the equalization of the debt. Just as in the case of the installment debt, the strategic financial planning model, or the budget itself, would include the figure for debt service of $13, 147 in each of the years of the loan period, including the first three, when no interest was actually payable. Therefore, as in that case, if the sum of $13, 147 is included in the budget, revenue will be raised to cover this. Then, if no debt service payment is actually made, there will be an executed or actual budgetary surplus of $13, 147. The following year, this surplus will be added to by the next non-payment. In addition, interest will have been earned, by actual or implicit investment of the earlier fund balance. This is shown in the following table: 1 9 Year Provision or Charge Actual Payment Interest on Balance Balance Outstanding 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 $13,147 $13,147 $13,147 $13,147 $13,147 $13,147 $13,147 $13,147 $13,147 $13,147 $13,147 $13,147 $13,147 $13,147 $13,147 $0 $0 $0 $19,534 $19,534 $19,534 $19,534 $19,534 $19,534 $19,534 $19,534 $19,534 $19,534 $19,534 $19,534 $0 $1,315 $2,761 $4,352 $4,148 $3,924 $3,678 $3,407 $3,109 $2,782 $2,421 $2,025 $1,588 $1,108 $581 $13,147 $27,609 $43,518 $41,483 $39,244 $36,782 $34,073 $31,094 $27,816 $24,211 $20,245 $15,883 $11,085 $5,806 $0 This table is slightly different from the one shown for installment debt, in that no provision is made for a grace period on the principal repayments. This is because, for debt retired at maturity, the entire loan period is, effectively, one long grace period. Thus, an intermediate grace period, here, makes no sense. Accordingly, the provision or charge to the revenue account of the budget, or included in the strategic financial planning model, will be the same as for the installment debt. However, each of the twelve annual payments, starting in year four, will be a total of $19,534. Of this, $13,310 will be paid as interest to the bondholders and the remaining $6224 will be paid into the sinking fund and immediately invested in suitable monetary instruments36. 36 In more sophisticated financial management techniques, sinking funds may be used for other purposes within a local government unit. They may even be re-borrowed for capital investment! In such cases, the sinking funds would be “deemed to be” invested and credited with notional interest. This is beyond the scope of the paper, however. 2 0