Step 5: Create Long-term Cash Flow Forecasts
Stephen Kuhr, Dan Lanning, Glenn Nestel and Haydn Reynolds Apr 01, 2008
The introductory article in the July-August 2005 issue of Underground Infrastructure Management described five key success factors for an effective infrastructure replacement planning and financing program. These are sequential steps and the process is periodically repeated as illustrated in the diagram:
This article, the last in a series, focuses on the fifth step, establishing a funding strategy and financial plan. (The complete series is available on www.uimonline.com.) This is the last remaining step in the infrastructure replacement program. After this step the program planning process is complete — for now. However, this is a cyclical process that should be updated annually. If not, the program will most likely become stale and not include potentially vital new projects discovered during the year.
In Step 1, we discussed establishing an inventory of mains and/or sewers and the process of computing costs by applying Modern Equivalent Asset cost factors for replacement or the appropriate cost factors for rehabilitation. In Step 2, we developed a formalized replacement/rehabilitation prioritization process coupled with good project cost estimates. We explained how the process developed in Step 2 creates a sound foundation for future cash flow forecasts, scenarios analysis and financial planning. Step 3 outlined the creation of predictive modeling that can be used by the utility to rapidly develop forecasts of optimal replacement levels, achieving the lowest life-cycle cost for each type of pipe, creating a sound foundation for scenarios analysis and financial planning. These steps provide a solid basis for evaluation and planning a future replacement/rehabilitation needs program. In Step 4, we discussed an iterative capital/financial planning process that results in the optimum improvement plan with the least user fee impact that can be easily established using these cash flow scenarios. This iterative approach allows a planning process for infrastructure improvements that dovetails with the utility’s financial planning process and will significantly increase the likelihood of success for the “infrastructure improvement planner.”
The final challenge in developing this infrastructure replacement program is identifying and implementing the optimum funding mechanisms. Payment schedules, cost, borrowing terms and access to funds need consideration and Kuhr Lanning weight in determining the most beneficial method of program financing. Numerous financing options are available for infrastructure replacements from both internally generated and external sources. In this article we will discuss many of these alternative funding mechanisms and identify the advantages and disadvantages offered by each.
Program Funding Alternatives
There are numerous funding options that utilities can choose from when looking to meet financial planning requirements. Depending on market conditions and life of the capital improvements financed, some funding mechanisms may be better alternatives than others. We do not intend to provide an exhaustive list of funding alternatives in this article. Instead we will focus on two major categories of funding — short-term and permanent financing — and provide several examples of each.
Short-term (Bridge) Financing
Typically, short-term borrowing is defined as debt that must be retired within one year of when it is issued. The funding is used as a bridge during construction periods to finance costs until the project is completed and can be permanently financed by debt or grants. Examples of short-term financing include such instruments as the following:
1. Promissory Notes — A short-term, written promise by one person (maker) to pay a specified amount of money to another on demand or at a given future date.
a. Bond Anticipation Notes — Short-term bonds issued in anticipation of being paid off with the proceeds from a subsequent, larger bond issue.
b. Grant Anticipation Notes — Notes issued on the expectation of receiving grant moneys, usually from the federal government.
c. Revenue Anticipation Notes — A short-term debt security issued on the premise that future revenues will be sufficient to meet repayment obligations.
2. Commercial Paper — Unsecured debt issued by corporate and governmental entities with high credit ratings to finance its short-term needs.
Permanent Financing Instruments
Permanent financing is issued to pay for larger capital projects with extended lives. If the utility is issuing debt, the debt payment schedule and terms are relatively flexible and can be designed to closely match expectations on increases to both user charges and service demands. Examples of permanent financing instruments:
1. Pay-go — A term used to refer to financing where budgetary restrictions demand paying for expenditures with funds (user fees) that are made available as the program is in progress.
2. Bonds — Long-term obligations with maturities of between five and 15 years or longer. Bonds are interest-bearing or discounted certificates of indebtedness paying a fixed rate of interest over the life of the obligation and are often divided into different categories based on tax status, credit quality, issuer type, maturity and secured/unsecured.
a. Revenue Bonds — A tax-exempt bond issue paying principal and interest from the revenues of an income-generating project, such as a toll bridge, highway, water/wastewater infrastructure or other public facility that is built with the proceeds of the financing.
b. General Obligation Bonds — A tax-exempt bond issue secured by a state or local government's pledge to use legally available resources, including tax revenues, to repay bond holders.
c. State Revolving Fund — A state-managed program that is funded by federal grants and state bond funds. The purpose of the SRF loan program is to implement the Clean Water Act, Safe Drinking Water Act and various state laws by providing financial assistance for the construction of facilities or implementation of measures necessary to address water quality problems and to prevent pollution of the waters of the state.
3. Alternative Project Delivery — There are many nuances and names for this form of project funding. Among others, they are called public-private partnerships (PPPs), performance contracts and design-build-ownoperate (DBOO). The end result of all of these alternative project deliveries is use of private funds to construct public project and improvements.
4. Customer Contributions and Assessments — User charges designed to recover costs for specific projects or geographically isolated capital improvement programs.
a. Benefit Zones/Special Assessment Districts/Betterment Districts —
Specific geographic areas within a community that have charges levied against parcels of real estate. Properties with the district have been identified as recipients of a direct and unique benefit from public projects. These zones or districts are legally designated as specific
b. Contribution in Aid of Construction (CIAC) — A one-time fee charged to developers and property owners by utilities to recover the cost of specific improvements required for adequate service to new metered connections. The fee is determined on a case-by-case basis and can be paid in cash or as infrastructure constructed by the developer to the utility’s specifications and deeded to the utility once placed in service.
c. System Development Charge (SDC)/ Impact Fee/ Local Facilities Fee/ Availability Fee — A contribution of capital toward existing or planned future backup facilities necessary to meet the service needs of new customers to which such fees apply. These charges have various names in the industry, but are intended to cover some or part of the capital improvements necessary to serve new customers.
d. Infrastructure Renewal Fee — A lesser used mechanism that identifies annual renewal and replacement costs as a specific cost center recovered by all customers of a utility system. This mechanism does not separate expansion-related replacement/rehabilitation costs from improvements to utility infrastructure required to serve existing customers. Since it does not meet rational nexus for fees and charges applicable to customer growth, it can only be charged to customers once they are connected to the system.
5. State and Tribe Assistance Grants (STAG) & Other Grants — Financial assistance mechanisms providing money, property or both to an eligible entity to carry out an approved project or activity. Funds provided through grants do not need to be repaid, but that does not mean there are no obligatory requirements. Many grant recipients are required to comply with federal and state mandates regarding labor practices and civil rights.
|Bond Anticipatory Notes
Grant Anticipatory Notes
Revenue Anticipatory Note
• Can bridge the gap between when expenses
are paid and when revenue is collected
|• Interest rate risk|
|Revenue Bonds||• Available to issuers that do not have taxing authority
• Does not usually require voter approval
• Does not go against government’s debt limitation
• Debt structure flexibility
|• Since debt is secured only by revenues
received from operations, interest rates
generally higher than GOs
• Restrictive covenants coverage requirements, debt service reserves, O&M reserves, etc.
• More complex process resulting in longer time to market and higher issuance cost
|General Obligation Bonds||• Typically lower in cost because backed by full
faith and credit of the issuer
• Lower issuance cost
• Fewer restrictive covenants
|• Debt must be authorized
• State restrictions on debt terms and interest rates
• Less flexibility in bond structure
• Debt limitations
• Competition with other government functions for the bond proceeds
|State Revolving Fund||• Below market interest rates
• Low issuance costs
• Few restrictive covenants
• Some can be subordinated
|• Competitive process to receive loan funds
based on priority ranking system
• Loan awards dependent on the availability of funds
• Limited or no flexibility in loan repayment structure
|Contributions from Developer or Customer||• Help to ensure that new users pay for the cost of expanding service to serve them||• Timing differences between capital cost
expenditures and receipt of contributions
• Predictability of growth and associated revenue receipts
|Special Tax Benefit Districts||• Recovers proportional share of cost from benefiting district||• Requires vote or referendum
• Inconsistent with a system-wide “cost averaging approach”
Advantages and Disadvantages
When evaluating the usefulness of the alternative funding mechanisms, we have to evaluate each mechanism’s impact not only on the underground infrastructure replacement program but on the utility financial plan as well. To this end we have prepared a preliminary list of advantages and disadvantages for most of the generic financing alternatives listed in this article. Table 1 identifies the advantages and disadvantages for many of the mechanisms discussed previously in this article.
Once the advantages and disadvantages that affect the utility are identified, they can be weighted and used to determine the most appropriate funding mechanism available for funding the replacement program.
Selecting the Right Funding Mechanisms
Selecting the funding mechanism that best fits the utility’s needs requires an inventory of issues that are material and developing criteria that can be used to measure benefits one alternative has over another. We have modified a simple decision matrix that can be used to determine the most appropriate mechanism(s) available. The issues we have listed in the evaluation include the following:
1. What alternatives are accessible in the current economic environment?
2. Can the utility meet Terms and Conditions for the alternatives or will the utility breach compliance with existing/outstanding debt covenants by choosing the alternative?
3. Will the alternative allow the utility to meet the replacement program or its overall financial plan’s timing and schedule?
4. Do all the advantages listed in Table 1 outweigh the disadvantages for the alternative?
To adequately address each of these issues it will usually require obtaining outside advice from a financial advisor and bond counsel. However, some preliminary screening of alternatives can be helpful, especially as the utility prepares to update its financial plan.
Table 2 provides a matrix of the example listing of issues and several of the generic funding mechanism alternatives. Using this simple matrix decision process, based on the preliminary analysis of the alternatives listed, it appears the most appropriate alternatives available for the utility infrastructure replacement program is a mix of contributions and revenue bonds. This, of course, needs to be blended with the utility’s overall financial planning.
Developing the Right Mix of Funding Alternatives
We’ve reviewed the funding alternatives available to most utilities when determining the optimum means for financing an infrastructure replacement program. Then we evaluated these alternatives to determine the best mix and match. Now we need to address and meld the selected funding alternative(s) into the big picture for the utility meeting financial planning objectives. One of the primary considerations that needs to be addressed in this respect is user fee increases that may be required to meet the combination of the infrastructure replacement program and the balance of the utility’s capital improvement program (CIP) within the financial planning period. In the fourth article of this series, an iterative financial planning process was discussed. Certain funding assumptions had to be made to determine affordability of the CIP, including the replacement program. Now the results of the funding alternative evaluations can be added and model output runs be developed again to finalize the impact on the utility and its customers.
Figure 1 presents the tracking of increases in debt and debt service payments compared to the projected increase in rates required to meet bond terms and remain financially self-sufficient. As the debt service payments increase, the utility needs to increase its user rates. Since we have already evaluated the affordability of these increases, unless the debt terms significantly differ from the terms assumed in developing the financial planning model, this is as expected. Management and the public will be cognizant of the increases and expectations can be managed through the five-step process discussed in this article series.
The final results of the five-step process leads to an optimum mix of funding alternatives where funds can be available for projects as needed, costs are minimized and the most favorable funding terms are considered.
Selecting the right mix of funding alternatives that dovetails with the utility’s financial planning process will significantly increase the likelihood of successful implementation of the infrastructure replacement program. It instills a confidence that there will be controlled and timely implementation of funding mechanisms that will manifest into the successful completion of the infrastructure improvements. This five-step process outlined in this series of articles requires establishing the right mix of financial options needed to fund infrastructure replacement/rehabilitation programs on a timely basis to maintain reasonable construction schedules.
Following these five steps is essential to an effective infrastructure replacement planning and financing program. After the final step the program planning process is complete. However, as noted earlier in this article, this is a cyclical process that should be updated annually. If not, the program will most likely become stale and not include potentially vital new projects discovered during the year.
Stephen Kuhr is an associate consultant, and Dan Lanning and Glenn Nestel are principal consultants with PB Consult Inc.; Haydn Reynolds is the managing director of Haydn Reynolds & Associates, based in Adelaide, South Australia.