The institutional treasurer or chief financial officer holds responsibility for financing capital acquisitions, renovations, and maintenance; ensuring that assets are managed within sound financial guidelines and protected from unnecessary risk of loss or depletion; and working with the governing board to develop and implement financial policies for asset utilization, capital investment, and debt management that match the organization mission, are economically viable, and do not jeopardize credit ratings.
Project Financing, Capital Improvements, and Capital Budgeting
Project financing requires project evaluation via a capital improvement plan and the capital budgeting process.
(1) The capital improvement plan is a long-range schedule of proposed and planned acquisitions, additions, replacements, renovations, and deferred maintenance for a specified time period. Often updated annually, such plans include specifics (e.g., cost estimates, funding sources, financing requirements) for each short-term and long-term plan element. (2) Capital budgeting provides quantitative methods to analyze financial returns and allocate resources among competing projects. The private sector capital budgeting model identifies project alternatives, estimates cash flows, selects appropriate financial measures, evaluates and ranks alternatives, and theoretically funds projects with the greatest returns until financial resources are fully allocated. Universities cannot strictly adhere to the private sector capital budgeting model because ranking projects based solely on financial benefits creates problems (e.g., for projects funded by gifts, academic priorities), so they use a modified capital budget model that evaluates economic and financial viability by using the same types of financial measures but prioritizing projects relative to each academic and administrative unit’s mission and classifying them by funding percentage and source, with the flexibility to pursue high-priority unfunded projects and fully funded projects. The capital budgeting model is linked to the organization’s strategic plan and mission.
The decision to undertake a capital project is independent of the financing decision. When the rate of return on alternative investments is higher than debt financing cost, using debt for a project is logical (compared to leasing agreements or partnerships with government or private institutions). If financing is used, the funding source generates cash flows to cover debt service and also annual O&M expenses. If new funding is not available for projects such as major repairs and renovations, revenue streams from premium programs, operating budget reallocations, or other sources can be used. The project financing term should not exceed expected useful life to match financing term to expected revenue stream or project cash flows (e.g., through equipment financing, leasing, long-term financing with early debt retirement, short-term variable-rate financing with periodic debt rollovers). To protect credit rating and ability to finance future projects, financial analysis of each project and its estimated and actual cash flows are critical. High debt ratios can raise financing costs by increasing the interest rate and leading to imposition of negative covenants. Institutions can issue debt via many financing methods (e.g., variable or fixed interest rates on tax-exempt or taxable basis and for short, intermediate, or long terms). The type of debt depends on current and expected interest rates, institutional financial capacity and credit rating, and tax-exempt financing capacity. Long-term fixed rate financing is the logical choice if general interest rates are low (and even when they are high if the institution is averse to interest rate fluctuations, which can be partially offset by a call option). Variable-rate financing is best when long-term interest rates will remain stable or decline; it generally has lower initial interest rates but carries risks (e.g., primarily adverse rate fluctuations and possible liquidity calls; remarketing). Interest rate risk can be mitigated by matching some variable-rate debt to a percentage of institution working capital and by placing an interest cap on debt. The Tax Reform Act of 1986 placed a $150 million cap on private institution outstanding tax-exempt debt (public use colleges and universities had no limit). Congress repealed this cap in 1997 but has revisited the issue. Tax-exempt debt is the least costly financing option for credit-worthy institutions.
Interest Rates and Risk
Interest rate is determined by several factors (e.g., general market conditions, debt term, institution credit rating, fixed or variable type, debt tax status). This section explains interest rates types and related factors:
(1) nominal interest rates, set by the market as a function of expected real rate of return, inflation rate, liquidity premium, and risk premium; (2) real rate of return, determined by money supply and demand, the rate that debt issuers are willing to pay and investors are willing to accept; (3) inflation, which reduces the purchasing power of money, especially for investors in long-term fixed-interest rate debt; (4) liquidity, a measure of how readily an investment can be converted to cash without principal loss; and (5) financial risk of borrower default, especially for long-term debt, which can be gauged by credit
Short-Term and Intermediate-Term Debt
Short-term debt (maturity between 1 day and 1 year, commonly 3 months) is generally used to cover working capital shortages and provide interim project financing. Intermediate-term debt (maturity of more than 1 year but less than 10 years) is most often used to purchase equipment with a useful life of less than 10 years. The two term structures are not mutually exclusive. Short- term financing can be cost-effective for interim project financing, but interest rates can increase before long- term financing, and total costs can be higher; long-term debt for projects under construction usually requires higher interest rates.
Commercial Paper. Commercial paper is an unsecured short-term promissory note issued on a taxable or tax- exempt basis, typically with maturities of 1 to 270 days. For credit-worthy institutions, commercial paper can be less expensive than bank borrowing. Commercial paper
issuers use bank lines of credit to back the issue. Some institutions use commercial paper for extended variable- rate financing, issuing new paper to pay off maturing paper (or using an interest rate swap for extended lower fixed-rate financing).
Variable-Rate Demand Instruments. A hybrid of long- term and short-term financing that became very popular in the 1980s as an interim project funding vehicle, variable-rate demand instruments generally have maturities of 3 years to more than 30 years and can have quarterly or monthly interest payments. The variable rate and put option give them the features of short-term instruments and usually allow the issuer to convert outstanding bonds to a fixed rate.
Repurchase Agreements and Reverse Repurchase Agreements. Repurchase agreements involve the sale of securities with a simultaneous commitment to repurchase those securities on a specific date and at a fixed price. Such agreements are classified as a collateralized loan by the securities seller. Repurchase agreements can be custom tailored to meet the terms and cash flow requirements of the parties. Standard repurchase agreement terms run from overnight (most of them) to 6 months or more. Reverse repurchase agreements (repurchase agreements) cover short-term cash needs or provide interim project funding.
Conventional Notes. Intermediate-term notes are debt instruments that generally have maturities of less than 10 years and bear fixed interest rates with semi annual interest payments. They are most often used for interim funding of construction projects but also for temporary cash flow needs. Interest rates are usually lower than rates on long-term debt but higher than rates for other types of interim financing, and the notes are tax exempt. Risks are associated with project completion or deterioration of project financial viability and with the possibility that interest rates could change dramatically.
For accountants, debt with a maturity greater than 1 year is long term; for facilities managers, long-term debt has a maturity greater than 10 years. Long-term debt is a permanent way to finance institutional growth by acquiring fixed assets (e.g., land and buildings, equipment). (1) Conventional mortgages are a common tool for acquiring land and buildings when institutions cannot use bonds or the debt is small. They are easy to obtain, can be completed in a short time period, involve less legal documentation, and do not require lengthy SEC filings, but they cover 80 percent or less of the asset cost, limit institutional financial flexibility, can have restrictive covenants, and carry higher interest rates than bonds. Variable-rate mortgages (with interest rate caps or ceilings) are considered if interest rates are high.
(1) Bonds may be the most attractive option for credit- worthy institutions, with custom-tailored amount and terms. The bond indenture includes all legal and financial terms, including restrictive covenants that can reduce financial flexibility. Costs generally run between 1 and 2 percent of bond face value. General obligation bonds (full faith and credit bonds, with no specific collateral or security) and revenue bonds (based on a specific revenue stream) are the most common bond forms, but variable-rate bonds (with a call option) are increasingly popular, especially when interest rates are very high or volatile. (3) Privately placed debt is direct collateralized financing with large investors (e.g., banks, insurance companies, venture capitalists) for the most credit-worthy borrowers. Such debt is cheaper and completed much faster, avoiding lengthy SEC filings and using only one lender (simplifying negotiations), but has interest rates higher than bonds, and restrictive covenants can be (4) Leasing (briefly described as an alternative to ownership) can be operating leases (true leases, typically for a term of less than 5 years and a fraction of the useful life of the asset, with no option to purchase at below-market value at lease end) or financial leases (capital leases or conditional sale contracts for accounting purposes, generally terms of 20 to 30 years for high-value assets, fully amortized). Compared to purchasing and financing assets, leasing is usually simpler, can be completed more quickly, requires fewer public disclosures, does not include capital or debt restrictions (financial leases), can tailor payments to seasonal cash flows, and offers lower payments and the flexibility to cancel (operating leases). (5) Sale/leaseback is the sale of an asset with a simultaneous agreement to lease back the asset, and is most often used with land and buildings. This option raises immediate capital while retaining asset use under a financial or operating lease. (6) Other third-party financing is used when a bond is not warranted. A management company specializing in facilities planning and operations can help design, construct, manage, and (often directly) finance a facility.
Credit rating agencies (e.g., Moody’s, Standard and Poor’s) give investors independent assessments of the credit worthiness of short-term and long-term debt issues after a detailed review (e.g., audited financial statements, annual operating budgets, capital improvement plans, revenue potential, legal opinion on debt status, legal documents on debt security, and other factors, such as existing leases and terms). Ratings range from AAA down, with BBB or better as investment grade; low ratings increase issue costs (e.g., higher required interest rate, collateral).
Credit enhancement (credit substitution) improves the credit rating of a debt issue (e.g., complex or weak issues) to achieve a lower interest rate. Credit enhancements include letters of credit and standby letters of credit (with the credit rating of the issuer substituted for that of the debt issuer) and bond insurance.