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Financing capital acquisitions, renovations, and maintenance is generally the responsibility of an institution’s treasurer or chief financial officer. These financial executives have a fiduciary responsibility to ensure that the institution’s assets are managed within sound financial guidelines and protected from unnecessary risk of loss or depletion. They work in conjunction with the governing board of the institution to develop and implement financial policies for asset utilization, capital investment, and debt management. Financial policies that address these concerns ensure that capital investments are consistent with the organization’s mission, as well as economically and financially viable. In addition, such policies ensure that debt associated with individual projects, as well as aggregate debt, will not jeopardize the institution’s credit rating.

Project Financing, Capital Improvements, and Capital Budgeting


The process of evaluating projects to determine their economic and financial viability and the resources necessary for their completion is integral to project financing. The evaluation of projects is generally undertaken in conjunction with and under the umbrella of a capital improvement plan and the capital budgeting process. The capital improvement plan, sometimes referred to as a campus master plan, is a long-range schedule of all proposed acquisitions, and in the nearer term it will include additions, replacements, renovations, and deferred maintenance items planned for a specified time period. Capital improvement plans usually include cost estimates, funding sources, and financing requirements for each of the elements of the plan. The plan generally has both short- and long-term components and may be updated annually as part of the organization’s strategic plan and capital budgeting process.

A typical capital project requires relatively large initial cash outlays and provides financial returns and other benefits over extended periods. As a result, these types of projects usually involve significant financial risk and are not easily reversed. Capital budgeting provides organizations with quantitative methods to analyze the financial returns for projects and objectively allocate resources among competing projects.

The capital budgeting model used in the private sector involves identifying project alternatives, estimating their cash flows, selecting the appropriate financial measures, and evaluating and ranking the alternatives. At any given time there are myriad projects that will provide, in varying degrees, acceptable financial returns. Each project is analyzed to determine the initial cash outlay and the cash flow that will be returned to the organization over the life of the project. These cash flows are analyzed using various financial measures, such as the payback period, discounted payback period, net present value, and internal rate of return. After the projects are evaluated, they are ranked by their potential financial contribution to the organization. In theory, projects that have the greatest returns will be undertaken in order until the financial resources that have been designated by the organization are fully allocated.

Colleges and universities may find that strict adherence to the private sector capital budgeting model is unmanageable. The ranking of capital projects based on their potential financial contribution is difficult for academic and student support facilities, especially when discrete revenue sources cannot be identified with each project. Ranking capital projects is further complicated when restricted gifts are the major source of project funding. When gifts are restricted to particular projects, prioritization may be based more on the availability of funding than on the project’s financial contribution to the organization. In addition, it is difficult to centrally assign priorities to projects across academic units that often have diverse and overlapping needs.

As a result of the problems encountered with ranking projects, many universities use a modified capital budget model. This model evaluates each project for economic and financial viability using the same types of financial measures that are used in the private sector. However, rather than attempt to rank projects based solely on their financial contribution, the model prioritizes projects relative to the unit’s mission and classified by funding percentage and source. In this manner, each academic and administrative unit is responsible for assigning priorities to its projects, usually by the degree to which they have funding available for debt service and annual operating and maintenance expense. This approach also provides flexibility to pursue high-priority projects without funding sources as well as projects that are fully funded.

Regardless of the capital budgeting model that is used, it should be linked to the organization’s strategic plan. Projects that are not compatible with the organization’s mission can increase both short-term and long-term financial risk. Expenditures on specialized facilities that become underutilized or that cannot be supported can result in debt service that is a burden on operating budgets. At the other extreme, too little investment in capital projects can result in facilities that are obsolete or otherwise inadequate to support the expansion required to further the organization’s mission.

Financing Issues


The decision to undertake a capital project should be made independently of the financing decision. It should be based on the project’s ability to support the institution’s mission and improve its quality, rather than because a source of funding or inexpensive financing exists. This will help ensure that the number of approved projects within a capital budget will not expand merely as a result of the institution’s capacity to issue debt.

Once the decision is made to invest in a capital project, a college or university must choose between paying cash and using a financing method. For institutions with unrestricted gifts or operating surpluses, the choice depends on the alternative uses for that cash. When the rate of return on alternative investments is higher than the cost of debt financing, using debt for a project is the logical choice. Institutions that do not have the financial capacity or choose not to finance facilities projects may be able to enter into leasing agreements or partnerships with government agencies or private corporations.

A primary concern to budget officers is that projects be economically viable and not create unanticipated burdens on existing operating budgets. When financing is used, a funding source should be identified that will generate sufficient cash flows to cover debt service as well as annual operating and maintenance expenses. Certain types of projects, such as major repairs and renovations to existing facilities and classrooms, may not always have new funding sources. In these instances, revenue streams from premium programs, operating budget reallocations, or other sources may be designated for the project. It is important to note that all projects, including those that are funded entirely from gifts and require no financing, should have sufficient cash flows to cover annual operating and maintenance expenses.

Controlling the magnitude and term of an institution’s debt helps to ensure that target debt and financial ratios are not compromised. The term of a project’s financing should not exceed its expected useful life. This matches the financing term to the expected revenue stream or cash flows from the project. There are a number of ways to do this, ranging from equipment financing, leasing, long-term financing with provisions for early retirement of portions of the debt, or using short-term variable-rate financing with periodic rollovers of the debt until the end of the project’s life.

An institution’s ability to borrow is an asset; it must be used wisely and generally not stretched to capacity. To do otherwise may jeopardize the institution’s ability to finance future projects. Protection of the institution’s credit rating is therefore a high priority for financial executives. For this reason, the financial analysis of each project and its cash flows are critical. If anticipated cash flows fail to materialize, the project will add stress to the operating budget and jeopardize repayment of the debt. Unreasonably high debt ratios can increase financing costs by increasing the interest rate that investors will require to buy an institution’s debt instruments. It can also lead to the imposition of negative covenants that restrict the use of the property, require certain financial ratios, and limit the issuance of additional debt.

Institutions that have the financial capacity to issue debt have a variety of methods for financing projects. Debt can be issued with variable or fixed interest rates on a tax-exempt or taxable basis and for short, intermediate or long terms. The type of debt an institution chooses to issue will depend on current market interest rates, expected future interest rates, institutional financial capacity and credit rating, and the amount of tax-exempt financing capacity.

Fixed-rate financing has the advantage of providing the institution with a certain interest rate for the term of the financing. This allows budgeting for a fixed debt service over the term of the issue. When general interest levels are low, long-term fixed interest rate debt is the logical choice for financing projects. However, this does not negate the advantage of using fixed-rate financing when interest rates are higher. In some cases, especially when an institution is adverse to interest rate fluctuations, fixed-rate financing may be more desirable than variable-rate financing. The risk that rates will decline during the term of the debt can be partially offset by including a call option in the debt issue. The call option gives the issuer the right to redeem all or portions of the debt after a period of time, usually 5 years or more.

Variable-rate financing is best used when long-term interest rates are expected to remain stable or decline. Variable-rate financing will generally provide the issuer with lower initial interest rates than will fixed-rate debt. The primary risk associated with variable rates is in adverse rate fluctuations. Rates may rise, increasing the issuer’s debt service and creating additional budgetary pressure. Another risk with some types of variable-rate debt is remarketing risk. If the economic environment is unstable, as it was in 2008 and 2009, there is significant risk that an issuer would have to provide additional liquidity if the debt cannot be remarketed. In extreme cases, this can create a situation where the institution is unable to make its debt payments and ultimately defaults on the debt. Prior to acquiring variable-rate debt, an institution should always test its tolerance to rate increases and liquidity calls.

Although the issuance of variable-rate debt requires acceptance of interest rate risk, there are ways to mitigate that risk. One method is to match an amount of variable-rate debt to a percentage of the institution’s working capital, which is invested in short-term instruments. Thus when short-term rates fluctuate, the change in the interest rate paid on the debt is matched by a similar change in the interest rate earned on the working capital. Another way to partially mitigate interest rate risk is by placing an interest rate cap on the debt issue.

Prior to 1986, there was no legislative limit on the amount of tax-exempt debt that public or private colleges and universities could issue. The Tax Reform Act of 1986 dramatically changed how institutions could use tax-exempt debt. The act placed a $150 million ceiling on private institutions’ total outstanding tax-exempt debt. This effectively raised the cost of capital for private institutions that were near or over the tax-exempt debt ceiling. It also severely limited private institutions’ ability to refund existing debt in advance to take advantage of declining interest rates.

Public colleges and universities bonds generally fall under the category of “public use.” As such, there is no limit on the amount of tax-exempt debt they can have outstanding. Although the act placed some limitations on how debt could be used to retain tax-exempt status, those limitations posed less of a constraint on public institutions than on private ones.

The $150 million cap was repealed in 1997, thereby allowing private colleges and universities to issue an unlimited amount of tax exempt debt to further their tax exempt missions. However, the subsequent loss of tax revenue on what would have been taxable interest has periodically caused the issue to be revisited by Congress. There is no guarantee that there will not be subsequent changes in the tax code that will once again limit private colleges and universities’ ability to issue tax exempt debt. Indeed, such caps could affect public institutions as well, so institutions should remain attentive to the legislative climate.

Tax-exempt debt remains the least costly financing option for credit-worthy institutions. The interest savings that can be obtained by using tax-exempt financing are significant. The reason is that taxable debt must yield a higher return than tax-exempt debt is to compensate the investor for the tax on interest earned. For example, a tax-exempt debt issue that pays 6 percent interest would be comparable to a taxable debt interest rate of 8 percent for an investor with a marginal tax rate of 25 percent (8% less 25% tax). Over 20 years, a 2 percent higher interest rate can add millions of dollars of interest cost to a bond issue. For example, an institution with $10 million in taxable debt outstanding over 20 years at an interest rate of 2 percent over the tax-exempt rate would incur an additional $4 million of interest cost.

Interest Rates and Risk


One of the critical factors in determining the financial viability of a project is the interest rate at which the project can be financed. The interest rate at which an institution can persuade investors to buy their debt is determined by several factors, including general market conditions, the term of the debt, and the institution’s credit rating. In addition, the type of interest rate chosen (fixed or variable) and the tax status of the debt will affect the market rate that is applicable to the debt issue.

For any type of financing, the nominal interest rate for the debt issue will be set by the market. Weston and Copeland defined the nominal interest rate as a function of the expected real rate of return, expected inflation rate, expected liquidity premium, and an expected risk premium.1

The real rate of return is determined by the supply and demand for money in the market. In the absence of inflation, term preference, and risk, it is the rate that debt issuers would be willing to pay and investors would be willing to accept. In a competitive market, a surplus of money available for loans or a shortage of borrowers would cause the real rate to decrease. Conversely, a shortage of loan funds or a surplus of borrowers would cause the real rate to increase.

Inflation effectively reduces the purchasing power of money. This risk is especially relevant for investors in long-term fixed-interest rate debt. The longer the term of the debt, the greater will be the effect of inflation on the value of the investment. Investors expect to receive an interest rate that will provide them with a return greater than inflation. Therefore, the nominal rate of interest must include a factor to cover anticipated inflation. For example, if an investor wanted to earn a real rate of 10 percent interest on a $1,000 loan for one year, the terminal value of the loan would equal $1,100 ($1,000 × 1.10). However, with inflation of 4 percent, the terminal value of the loan would have to equal $1,144 ($1,100 × 1.04) to retain the same purchasing power that it had at the time the loan was originated. To earn a 10 percent real rate of interest, adjusted for inflation, the lender would have to charge an interest rate of 14.4 percent (1.10 × 1.04).

Liquidity refers to how readily an investment can be converted into cash without loss of principal. Treasury bills are an example of liquid investments. They have maturities of less than one year and have virtually no risk of loss of principal. Conversely, high-grade corporate bonds have maturities as long as 30 years, which gives rise to the risk that interest rates will increase during the term of the debt. When interest rates go up, bond prices go down, and vice versa. The longer the term of an investment, the greater will be the risk of adverse interest rate fluctuations. As a result, investors are willing to accept lower returns for liquidity. Conversely, institutional borrowers prefer longer terms to avoid the uncertainty of having to refinance debt in periods where interest rates have risen.

In addition to liquidity risk, the longer the term of a debt issue, the more the interest rate will be affected by other types of risk. The risk that poses the biggest concern for investors is financial risk. This is the risk of default by the borrower in the payment of principal and interest. Investors must accurately assess this risk to ensure they receive an adequate rate of return for the risk they accept. Agencies such as Moody’s Investor Services, Inc., and Standard & Poor’s provide credit ratings to assist investors in determining the risks associated with both short-term and long-term debt instruments.

Short-Term and Intermediate-Term Debt


In the financial market, short-term debt is considered to be debt that has a maturity of between 1 day and 1 year, with the most common maturity being around 3 months. It is generally used by institutions to cover working capital shortages and to provide interim financing for projects. Intermediate-term debt usually has a maturity of more than 1 year but less than 10 years. Intermediate-term debt is most often used for purchases of equipment with a useful life of less than 10 years. Financing vehicles that are used with these two term structures are not mutually exclusive and may even be used for long-term debt. For example, short-term debt can be issued and rolled over periodically to effectively finance a project for its entire useful life and avoid issuing intermediate- or long-term debt. In addition, there are hybrid debt instruments that have characteristics of both short- and long-term debt.

Short-term financing can be a cost-effective method for interim project financing. When long-term debt is used to finance construction projects, there is a risk that the project may not be completed and provide the revenue stream required to support the debt service. As a result, long-term debt issues for projects under construction usually require higher interest rates to compensate for this risk. This risk premium can be avoided by using short-term interim financing while the construction is in process. A disadvantage to using short-term interim debt is that interest rates can increase dramatically before the permanent long-term financing is completed. In addition, total costs to issue the short-term debt and then the long-term debt may also be higher than the risk premium for the construction in process.

Commercial Paper

Commercial paper is essentially an unsecured short-term promissory note. It may be issued on a taxable or tax-exempt basis. It is typically issued with maturities of 1 to 270 days. It is rarely issued for longer periods owing to registration requirements imposed by the U.S. Securities and Exchange Commission.

For credit-worthy institutions, commercial paper can be less expensive than bank borrowing. Interest rates generally follow the movement in short-term Treasury rates but are slightly higher because of the risk of default of the borrower. The interest rate is determined by the credit rating of the issuer, as well as by supply and demand in the marketplace. Commercial paper is generally rated from A1 to A3 (Standard & Poor’s) or Prime 1 to Prime 3 (Moody’s Investor Services, Inc.). Institutions that are unable to get a rating of 2 or higher generally have difficulties selling their paper and may have to rely on more expensive bank loans.

Issuers of commercial paper back up their issues with bank lines of credit. This ensures that they can meet existing maturities if they are unable or unwilling to issue new commercial paper. Most nonfinancial commercial paper issuers must have bank credit lines equal to 100 percent of their outstanding paper plus any new issue to obtain a high credit rating. Small, lesser-known institutions may have difficulty obtaining high credit ratings for their issues. These institutions can issue commercial paper with a backup letter of credit from a bank. Although this increases the costs of the issue, the letter of credit causes the rating agencies to assign a credit rating for the issue based on the credit of the bank rather than the credit of the issuer.

Some institutions have used commercial paper for extended variable rate financing by issuing new paper to pay off existing paper as it matures. It can also be used in conjunction with an interest rate swap to provide extended fixed-rate financing at rates lower than could be obtained by issuing fixed-rate debt. An interest rate swap is an agreement between two parties, one with a fixed-rate obligation and the other with a variable-rate obligation, to exchange interest rate payments for a period of time. For example, an institution might enter into a swap arrangement where it would make fixed interest rates payments and receives variable-rate payments tied to the commercial paper rate. It would then issue commercial paper and offset the interest payments on the commercial paper it issued with the variable rate interest it receives under the swap arrangement. The institution is then left with a fixed interest rate payment due that is on the swap arrangement.2

Variable-Rate Demand Instruments

Variable-rate demand instruments became very popular during the 1980s as a means to provide interim funding for projects. They are a hybrid of both long-term and short-term financing vehicles. Variable-rate instruments are debt issues that generally have maturities of 3 to more than 30 years and carry a variable interest rate that is usually tied to a short-term interest rate index. Unlike a long-term bond with semiannual interest payments, a variable-rate instrument can pay interest quarterly or even monthly. Variable-rate instruments also grant the holder a “put option,” which can be used to demand that the issuer repurchase the bond for par value at a certain time, usually with a minimum of seven days’ notice.

The variable rate and put option give these variable-rate instruments the features of short-term instruments. The variable rate and put option cause the bonds to be priced around par value, with little sensitivity to general interest rate movements. This enables the issuer to remarket bonds it has repurchased with little risk to principal. The variable interest rate allows for lower financing cost than would normally be associated with long-term debt.

Usually these types of instruments allow the issuer to convert outstanding bonds to a fixed rate. When the issuer is ready, the bonds are called and repurchased and then resold with the new terms. It is not uncommon for interest payments to be converted to semiannual payments in this process.

Repurchase Agreements and Reverse Repurchase Agreements

Repurchase agreements involve the sale of securities with a simultaneous commitment to repurchase those securities. The terms of the agreement require the repurchase of securities on a specific date and at a fixed price. In a typical transaction, a financial institution (seller) would sell securities to an investor (purchaser) and agree to buy back those same securities from the investor at a fixed price the next day. Because there is a commitment to repurchase the securities, the transaction is classified as a collateralized loan by the seller of the securities. The difference between the selling price and the repurchase price is the interest paid by the seller. However, it is more common for the trading partners to negotiate a separate interest rate for the transaction and set the repurchase price of the securities equal to the sale price.

Repurchase agreements are normally executed with Treasury or agency securities in amounts exceeding $1 million. One of the advantages to using repurchase agreements is that they can be custom tailored to meet the terms and cash flow requirements of the parties. Standard terms for repurchase agreements run from overnight to 6 months or more, with the bulk of these transactions completed overnight. Long-term agreements can be executed, but if the terms exceed 270 days, the agreement is subject to disclosure under Securities and Exchange Commission regulations.

The terms reverse repurchase agreements and repurchase agreements can be applied to the same transactions. The terminology used depends on the perspective of the seller and investor. Because it is customary to view the transaction from the securities dealer’s perspective, when the dealer sells securities with an agreement to repurchase, it is called a repurchase agreement. When the dealer buys securities from a customer with an agreement to repurchase, it is called a reverse repurchase agreement.

Colleges and universities have used reverse repurchase agreements to cover short-term cash needs or to provide for interim funding for projects. In a typical interim funding transaction, an institution negotiates with an investment banker to structure the sale of Treasury securities from its endowment. The agreement is structured for the institution to repurchase those securities at some future time at the same price and pay the buyer periodic interest. The securities act as collateral for the short-term loan and permit the institution to achieve a lower borrowing rate than could be achieved through a bank loan. At the same time, any interest earned on the securities while they are held by the purchaser belongs to the institution and represents earnings on the endowment. When long-term financing for the project is completed, a portion of the proceeds is used to repurchase the securities when the repurchase transaction matures.

Conventional Notes

Intermediate-term notes are debt instruments that generally have maturities of less than 10 years and bear fixed interest rates with semiannual interest payments. They are most often used for interim funding of construction projects, although they are also used for temporary cash flow needs.

Interest rates on these notes are usually lower than rates on long-term debt but higher than rates for other types of interim financing. Also, tax-exempt status may make the notes more attractive to investors, as well as lower the total interest costs to the institution. Working as an opposite force is the risk associated with the completion of the project or the deterioration of the financial viability of the project. There is an additional risk that market interest rates could change dramatically before permanent financing can be obtained. As a result, conventional note financing is generally more expensive than variable-rate short-term financing.

Long-Term Debt


From an accounting perspective, all debt with a maturity greater than 1 year is classified as long term. However, when financial managers refer to long-term debt, they generally include only debt with a maturity of greater than 10 years.

Long-term debt is essentially a permanent way of financing institutional growth through the acquisition of fixed assets such as land and buildings or equipment. A variety of long-term financing vehicles are available, including conventional mortgages, bonds, privately placed debt, and leasing.

Mortgage Financing

One of the most common forms of acquiring land and buildings is through the use of conventional mortgage financing. The typical mortgage is for approximately 70 to 80 percent of the asset’s appraised value; has a term of 20 to 30 years, a fixed interest rate, and a fixed monthly payment; and is secured by an underlying interest in the asset.

Variable-rate mortgages became very popular during the 1980s. Interest rates on these mortgages are tied to Treasury bill rates or other short-term indices and were subject to change on a quarterly, semiannual, or annual basis. Variable-rate mortgages should be considered during periods of higher interest rates. Interest rate caps or ceilings are typically negotiated to limit the budgetary effects of increasing interest rates.

Mortgage financing is a viable alternative for institutions that are not able to raise funds through the bond market or when the size of the debt is relatively small, making a bond issue uneconomical. Mortgages are relatively easy to obtain for the credit-worthy borrower and normally can be completed within a relatively short period of time. They usually involve less legal documentation, so the related costs may be lower than other long-term debt issues. In addition, mortgages do not require public disclosure of financial and operating information or lengthy Securities and Exchange Commission filings.

Mortgages also have some disadvantages compared with other forms of financing. Mortgage financing is normally for 80 percent or less of the cost of the asset, which requires a significant equity investment from the institution. Mortgages encumber specific fixed assets and, as a result, limit the institution’s financial flexibility. There may also be restrictive covenants in the promissory note that restrict the use of the property, require certain financial ratios, or limit other debt. In most cases, the interest rate on mortgage debt will be higher than the comparable interest rate on bond financing.


For credit-worthy institutions, long-term bonds may be the most attractive alternative for financing capital projects. Depending on the financial strength of the institution and the current market for debt, the amount and terms of a bond issue can be more or less custom tailored to meet the needs of the institution. A typical bond issue will have a term of 20 or more years, a fixed interest rate, and semiannual interest payments. Full principal may be due at maturity or amortized over the life of the issue.

All of the legal and financial terms of a bond issue are included in the bond indenture. These are the amount of issue, form of the bond, interest rate, term, call and redemption provisions, any reserve or sinking fund requirements, and other restrictive covenants. The restrictive covenants are of particular importance to financial managers, because they may reduce the financial flexibility of the institution. Depending on the financial strength of the institution, investors may require restrictions on the amount of total debt, leases, sale/leaseback agreements, disposition of assets, insurance, pledges of revenues, and the maintenance of certain financial and operating ratios.

The costs associated with issuing bonds generally run between 1 and 2 percent of the face value of the bonds. These costs can include management fees, underwriting fees, underwriter’s expenses, bond legal counsel, printing and distribution of the official statement, bond verification (for refunding issues), issuer’s legal counsel, and bond insurance or other credit enhancement.

The two most common forms of bond financing for educational institutions are the general obligation bond and the revenue bond. General obligation bonds have no specific collateral or security. They are sometimes referred to as full faith and credit bonds because the institution’s promise to pay is the full security for the debt. This type of financing provides the institution with the most flexible financing, because it does not tie up specific assets.

When revenue bonds are issued, a certain revenue stream, such as tuition or housing revenues, is pledged by the institution to support the debt service. Because the bond is marketed based on a future revenue stream, investors will require that revenue stream to be fairly certain. For added security, investors may require (1) loan covenants that restrict how the institution uses the pledged revenues, (2) a certain level of reserves, and (3) a sinking fund for debt repayment.

Variable-rate bonds have become increasingly popular as a means to market bond issues. Long-term variable-rate bonds allow investors to avoid the fluctuations in bond prices that normally occur as a result of changes in general market interest rates. In addition, investors receive higher interest rates when market rates increase. These advantages may make a variable debt issue more marketable, especially during periods when interest rates are volatile. However, unanticipated increases in interest rates can adversely affect the institution’s budget by increasing debt service payments.

When interest rates are very high, variable-rate bonds may be the only method for obtaining affordable long-term financing. If the market permits, it is possible to include a call option or an option to convert the variable interest rates to a fixed interest rate when a certain event occurs, such as Treasury bill interest rates failing to a certain level.

Private Placements

Private placements are direct financing with large investors such as banks, insurance companies, and other venture capitalist. This type of financing is usually limited to the most credit-worthy borrowers and may be collateralized with machinery, equipment, and real estate. Most private placements have maturities that exceed 15 years, although the majority of the principal can be accelerated to be repaid in 5 to 10 years.

There are several advantages to issuing debt through a private placement. The cost of a private placement can be significantly lower than a public debt issue, and a private placement can be completed much faster. Unlike bond issues, private placements allow the borrower to avoid lengthy Securities and Exchange Commission filings. In addition, typically only one lender is involved, which significantly simplifies the negotiation of the loan indenture. It also avoids the expense of distribution through investment bankers.

Although the issuance costs can be lower than those associated with bonds, interest rates will generally be higher than a similar public debt issue. In addition, private placements can involve restrictive loan covenants to protect the lender. These loan covenants may require a minimum working capital, limits on other long-term debt and leases, and other restrictions on financial operations.


A lease is an agreement to rent equipment, land, buildings, or other assets at a certain monthly payment for an extended period. Although leasing does not provide the institution with ownership of the asset, it is included in this chapter because capital lease programs are an alternative to purchasing fixed assets through the issuance of debt. In addition, arrangements such as a sale with leaseback represent a direct method for institutions to raise capital to acquire fixed assets.

The two basic classifications of leases are operating and financial leases. Operating leases are typically set up for rentals of automobiles, trucks, computer equipment, and office space and equipment. These leases often are for terms of less than 5 years and represent a fraction of the useful life of the asset. Operating leases are classified as “true leases” because they do not fully amortize the cost of the asset. At the end of the lease, the asset retains a significant residual or market value. These leases may contain a provision for the lessee to purchase the asset at the expiration date for its fair market value. Service or maintenance of the asset is generally the responsibility of the lessor, although some operating leases may include a service component. Operating leases frequently include a provision for cancellation and return of the equipment prior to the expiration date and may have an early cancellation penalty.

Financial leases are generally set up for high-dollar assets and can have terms of 20 or 30 years. Examples of financial leases include leases for industrial equipment, medical and technical equipment, land, and buildings. These leases are generally fully amortized, leaving the asset with a small residual value at the expiration date. In addition, the financial lease usually has a purchase option for a price that is significantly below the fair market value of the asset. Unlike operating leases, the financial lease cannot be canceled before the expiration date, and maintenance is the responsibility of the lessee.

Although the accounting for leases is beyond the scope of this chapter, the classification of leases is significant to financial managers, because it affects the financial statements of the lessee. Financial leases are considered capital leases for accounting purposes. Because the lease is fully amortized, the lessee has effectively paid for the entire value of the asset. As a result, the lease is considered a form of conditional sale contract. Financial leases must be disclosed in both the asset and the liability sections of the institution’s balance sheet. For practical purposes, this is similar to how other types of long-term debt are classified. The payments reduce the lease liability and are not deductible as an operating expense.

Operating leases are classified as true leases. The significant residual value of the asset at the end of the lease and the fact that the lessee has no right to purchase the asset below its fair market value are the keys to this classification. Payments are deductible as an operating expense. Although operating leases are not required to be presented in the body of the institution’s balance sheet, they must be disclosed in the footnotes.

Under certain circumstances, leasing will provide advantages over purchasing and financing assets. Leasing documentation is usually simpler than debt issues, and lease transactions can generally be completed more quickly. Debt issues require public disclosure of institutional financial information that is not required in lease transactions. In addition, lenders may place restrictive covenants on high-dollar debt issues. Restrictions for minimal working capital or limits on other types of debt or leases are generally not required under financial leases. Lease payments can also be tailored to account for seasonal cash flows.

Operating lease payments may be significantly lower than the payments on a purchase as a result of tax benefits that may be realized by the lessor. Although the maintenance expenses of the lessor may be reflected in the lease payment, the lessee does not have to worry about unplanned expenses. The ability to cancel an operating lease provides the lessee with additional flexibility to manage changes in business demands. It also provides a hedge against the risk of obsolescence when technical equipment is involved.

Regardless of the accounting treatment for leases, it should be noted that credit rating agencies will take into account the lease terms when analyzing the balance sheet of the debt issuer. Lease obligations will affect debt ratios in the same manner as conventional types of debt.


A sale/leaseback transaction involves the sale of an asset, with a simultaneous agreement to lease the asset back. This type of transaction is most often associated with land and buildings. Its principal advantage is that it allows the lessee to raise immediate capital via the sale and retain the use of the asset for a fixed period of time. The lease side of the transaction may be either a financial or operating lease depending on how the seller and lessor ultimately plan to use the asset.

Other Third-Party Financing

Under certain circumstances, some institutions may choose not to use more traditional project financing vehicles to upgrade facilities. This may occur when the list of projects is insufficient to warrant the expense of a bond issue. In some cases, the cash flow may depend on engineering and management capabilities that are beyond the current abilities of the organization.

Under these circumstances, the use of a management company specializing in facilities planning and operations may be useful. These service companies can assist in the design and management of the facility and usually have the financial capacity to provide direct financing for the project. Market interest rates may be negotiated along with the repayment term of the debt.

When the financing is provided by a service company, it is generally expected that the institution will contract with the company for the design, construction, or management of the facility. For some institutions, this may serve the dual purpose of providing for new facilities as well as operating management expertise.

Rating Agencies


Credit rating agencies provide investors with independent and objective assessments of the credit worthiness of debt issues. Two well-known credit rating agencies are Moody’s Investor Services, Inc. and Standard & Poor’s. Each of these rating agencies has developed ratings for both short-term and long-term debt. Moody’s rates long-term debt issues on a scale of AAA for the highest quality to C for the lowest quality. Standard & Poor’s rates these debt issues on a scale of AAA for the highest quality to D for bonds in default.

Rating agencies review audited financial statements, annual operating budgets, capital improvement plans, revenue potential, counsel’s opinion on the debt’s legal status, legal documents regarding security for the debt, and other factors. The resultant credit rating assigned to a debt issue provides investors with a reference point for evaluating the risk and return for the various issues. Without credit rating agencies, investors would have to complete their own analysis of each debt issue.

Debt with ratings of BBB or better is generally considered to be of investment-grade quality, whereas those with lower ratings are considered junk bonds. This is significant, because the pricing of debt issues is largely determined by the credit rating, as well as by market supply and demand factors. Debt issues that have low ratings increase the cost of the issue by requiring the issuer to pay a higher interest rate and provide collateral or credit enhancements to make the debt issue marketable.

Credit Enhancement


Credit enhancement or credit substitution is used to improve the credit quality of a debt issue. By improving credit quality, the borrower can achieve a lower interest rate, thereby lowering the interest payments and overall cost of the debt issue. In some cases, credit enhancement can make a weak, unmarketable debt issue marketable. Credit enhancement can also be used when a debt issue and security arrangements are extremely complex. In these situations, the enhanced credit quality effectively simplifies the debt issue by removing the risk associated with the security arrangement.

Letters of credit are one form of credit enhancement. These are contracts between the debt issuer and a third party, usually a commercial bank, that require the third party to make payments of principal and interest on the debt at predefined times and under certain conditions. They are particularly useful during the early years of projects that do not generate significant cash flows. Letters of credit provide investors with a guarantee that the debt issuer will have a source of funds available to make scheduled payments on the debt. The debt issuer pays a fee or interest to the letter of credit issuer just as it would for any other bank credit line. This cost is offset against the savings in interest on the debt issue resulting from the credit enhancement.

Standby letters of credit are contingency guarantees. They are similar to direct letters of credit except that funds are only drawn to make payment to investors in the event of default. When a debt issuer is unable to make any periodic interest or principal payment, the payment is made by the third party under the letter of credit.

When letters of credit are used to enhance the quality of a debt issue, the credit rating of the issuer of the letter of credit is substituted for the credit rating of the debt issuer.

Bond insurance is another generally accepted form of credit enhancement. Bond insurance policies are noncancelable guarantees purchased by the debt issuer to protect the investor. Unlike direct letters of credit, bond insurance policies do not provide a source of funds for scheduled payments. Bond policies pay only in the event of default. The debt issuer is the primary source for payment. Bond insurance lowers the interest rate on a debt issue by providing additional security for the investor.

However, the issuer should analyze the costs and benefits of credit enhancement to determine whether it adds value to the transaction. In some economic climates, the cost of the insurance may be greater than the savings produced by a lower interest rate.



Capital projects should support the ongoing mission of the institution and be financially viable. Funding for each project must cover annual operating and maintenance expenses as well as any debt service resulting from financing. The failure of anticipated cash flow to materialize can create budget problems and possibly lead to a default on the debt. Credit-worthy institutions have a variety of financing options available to them. Projects can be financed with fixed- or variable-rate debt on a tax-exempt or taxable basis and for short, intermediate or long terms. Financing can be arranged directly through commercial banks, leasing companies, or a privately placed debt issue. The most attractive financing method is a general revenue bond issue, because the cost of issuance is relatively inexpensive, no specific assets are encumbered, and the debt can generally be custom tailored to the needs of the institution. The type of debt an institution chooses will depend on current and expected future economic and market conditions and interest rates. In addition, the institution’s overall financial capacity and credit rating, as well as its tax-exempt financing capacity, will influence the decision.


  1. Weston, J. Fred, and Thomas E. Copeland. Managerial Finance, ninth edition (Fort Worth, TX: The Dryden Press, 1992), p. 144.
  2. Cook, Timothy Q., and Timothy D. Rowe (eds.). Instruments of the Money Market, sixth edition (Richmond, VA: Federal Reserve Bank, 1986), p. 123.

Additional Resources


Albrecht, Douglas. “Funding Mechanisms for Higher Education: Financing for Stability, Efficiency, and Responsiveness.” World Bank Discussion Papers, Vol. 153, 1992.

Backhaus, Jurgen G. and Richard E. Wagner. Handbook of Public Finance. Boston: Kluwer Academic Publishers, 2004

Daigneau, William (ed.). Planning and Managing the Campus Facilities Portfolio. Washington, DC: National Association of College and University Business Officers, 2003.

Dayanada, Don. Capital Budgeting: Financial Appraisal of Investment Projects. New York: Cambridge University Press, 2002.

Derkinderen, Frans G., and Roy L. Crum (eds.). Risk, Capital Costs and Project Financing Decisions. Hingham, MA: Martinus Nijhoff, 1981.

Gitman, Lawrence J. Principles of Managerial Finance, ninth edition. Reading, MA: Addison-Wesley, 2000.

Herst, Arthur C. Lease or Purchase: Theory and Practice. Hingham, MA: Kluwer-Nijhoff Publishing, 1984.

Hicks, Cadmus M. Tax-Exempt Short-Term Financing Mechanism. New York: Nuveen Research, June 1984.

Kolb, Robert W. and James Overdahl. Financial Derivatives, third edition. Hoboken, NJ: John Wiley & Sons, 2002.

Moody’s Public Finance Department. Moody’s on Municipals: An Introduction to Issuing Debt. New York: Moody’s Investment Services, Inc., 1988.

Nevitt, Peter K., and Frank J. Fabozzi. Equipment Leasing. Homewood, IL: Dow Jones-Irwin, 1985.

Sims, Ronald R., and Serbrenia J. Sims. Managing Institutions of Higher Education Into the 21st Century: Issues and Implications. Westport, CT: Greenwood Press, 1991.

Than, Annette. The Bond Book. Chicago: Probus Publishing Company, 1992.

White, Wilson. The Municipal Bond Market: Fundamentals. New York: Vantage Press, 1999.

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