Capital budgeting refers to the decision making process in a firm relating to investment in long-lived assets such as new machinery, new plant, replacement of machinery, research development programs and others. Capital budgeting attempts to seek whether investing in the long-term projects will yield any benefits in the long-run. Long-term projects are those that typically take a period of more than one year. Capital budgeting helps in making crucial decisions about whether or not to invest. The decision to invest is weighed against the firm’s retained earnings, equity available, and current liability standings. Capital budgeting is a continuous process since firms occasionally seek for new investment opportunities in the environment. This paper will analyze capital budgeting with regard to the Department of Housing and Urban Development (HUD) in the United States.
Explain how the debt capacity of the U.S. governmental entity is determined
The debt capacity of firms and government entities is critical to creditors. If a firm exceeds its debt capacity, it may suffer financial distress, which may lead to bankruptcy. Lenders may thus be on the losing end in such a scenario. The focus on debt capacity is not the maximum debt that a firm can take, and neither its capital structure. Rather, it aims at establishing the amount of debt a firm can take and be able to repay without experiencing financial distress. In analyzing debt capacity, the cash flow of the firm is analyzed keenly especially with regard to expected cash sources. It is also important to analyze the current needs of the firm within the particular economic environment.
The debt capacity of HUD can be determined by using debt ratios (Wahlen, Bradshaw, & Baginski, 2014). Analysis of debt ratio is used to measure the debt capacity of the entity. It gives the total long-term debt to total assets or shareholders’ equity as fraction of liabilities in the capital structure of HUD. A high debt ratio indicates that the entity is at a higher risk of failing to repay debt. This also indicates low unused debt capacity in the entity. It is important to take into consideration off-balance-sheet obligations that may have a high impact on the entity’s ability to pay debt, for instance, operating lease commitments which may take a huge share of the entity’s revenues. Net debt is commonly used to assess an entity’s debt capacity. This is the part of debt that is repaid using the entity’s revenues. Common debts of this type includes capital lease debt, limited obligation debt, and general obligation bonds.
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The debt capacity of HUD is also determined by analyzing components of cash flows (Wahlen, Bradshaw, & Baginski, 2014). The analysis of cash flows should cover a long duration so that it can reveal the movement of cash even during adverse periods such as recession. An examination of an entity’s cash flows over a period of two or three years can reveal potential cash flow problems in the firm. Cash flows conducted on HUD can be categorized into financial flows, operating cash flows and non-operating cash flows. Operating cash flows gives a clear picture of the sales volume and prices with relation to the future. Financial cash flows analyze the entity’s debt repayment, interest payments, lease rentals and dividend commitments. Non-operating cash flows generally cover working capital changes and capital expenditures. Cash flow analysis is used to give an accurate overview of HUD’s debt capacity.
Debt capacity is also determined by assessing the value of collateral held by the entity. If for a particular reason the entity lacks adequate cash flows to repay its debt, the lender can assess the value of assets that can secure the loan. For instance, the value of property, inventories, receivables, and plant and equipment can be assessed and used as collateral for debt. Lastly, debt capacity is determined by analyzing contingencies surrounding the entity. If for instance the HUD is facing a major lawsuit with a high likelihood of losing, it might then be labeled as high risk in terms of credit.
Evaluate the effect of refunding or reorganizing existing debt obligations
Debt reorganization occurs when both the debtor and the creditor agree on new bilateral arrangements concerning the terms of debt repayment (Shepherd & Kitili, 2006). Reorganization often tends to favor the debtor. Debt reorganization may take different forms such as debt restructuring, debt conversions, rescheduling, and debt forgiveness. Reorganizing existing debt obligations often gives relief to the debtor since it often involves changing the original terms and conditions that bound the debtor and the creditor. The need for debt reorganization may arise out of the debtor’s liquidity issues. For instance, the debtor may lack adequate cash flows to make periodic debt payments as stipulated under the terms and conditions of the debt. The debtor may also be having sustainability issues where it is realized that he will be unable to meet the debt obligations in future due to one reason or another. A restructuring of the industry may also make it difficult for debt servicing.
As earlier mentioned, debt reorganization may take various forms. In debt forgiveness, a new arrangement is made between the creditor and the debtor whereby the latter is only required to pay a fraction of the entire debt or nothing at all in a situation of total debt cancellation. This may be inclusive of the entire amount of principal owed or part of it, in addition to any accrued interest. In debt forgiveness, a new debt instrument is made indicating the change in terms and conditions. The difference in value between the old debt instrument and the new one is taken as a capital transfer. When the government is the creditor, debt forgiveness results to a reduction in its financial wealth equivalent to the debt forgiveness (Shepherd & Kitili, 2006).
Debt reorganization may also take the form of restructuring. This involves altering one or more of the initial terms and conditions of the debt. This has a number of effects depending on the nature of the new terms. First, it may extend the debt repayment period beyond the original stipulated time. Second, restructuring may alter the original interest, which is often a reduction of the rate. Third, payment of arrears may be rescheduled to a later period. Lastly, restructuring may extend principle repayment grace period. Debt conversion is also common in debt reorganization. In this, the creditor agrees to an equity allocation from the debtor. Debt reorganization may lead to debt prepayments whereby the debtor pays the debt earlier before its maturity date. Debt reorganization can also lead to debt assumption whereby a new debtor agrees to take over the repayment of the debt and accumulated interest (Shepherd & Kitili, 2006).
Analyze various funding alternatives that can be used to support debt obligations
There are number of alternative funding options that HUD can use to support its debt obligation. HUD can acquire funds from local and state governments to support its debt obligations. State and local governments may provide direct funding to HUD to support its debt obligations. These funds can be in form of grants or debt financing with favorable terms and conditions. Many states offer low-interest loans and grants to support various agencies. Funds derived from local and state governments are referred to as local funds. HUD can also acquire alternative funding from the private sector in order to support its debt obligations. Private foundations have programs that allocate funds to community development, education, arts, and other projects. HUD can solicit grants from various national corporations and foundations. In addition, HUD can obtain funds in form of loans from various corporations and foundations at low or zero-interest rates to finance its various projects (“HUD”, 2012).
Real estate organizations can also provide funding alternatives to HUD for supporting its debt obligations. By creating suitable partnerships with other real estate organizations such as land companies, mortgage industry companies, and real investment trusts, HUD can be able to obtain alternative funding at low interest rates. Individual donations can also be a source of alternative funding. Donation may come from other agencies, private entities, local governments, and other sources. Lastly, as a last resort HUD can result to sale of assets and services in order to support its debt obligations. HUD can sell some of its equipment or assets to settle its debt obligations (“HUD”, 2012)
Lee, R. D., Johnson, R. W., Joyce, P. G. (2008). Public budgeting systems (8th ed.). Sudbury,
MA: Jones and Bartlett.
Shepherd, R. & Kitili, A. (2006). Debt Reorganization. Fourth meeting of the Advisory Expert Group on National Accounts 30 January – 8 February 2006, Frankfurt. Retrieved from: http://unstats.un.org/unsd/nationalaccount/AEG/papers/m4DebtReorganization.pdf
U.S. Department of Housing and Urban Development (HUD). (2012). Orientation Guide for New HCAs. Retrieved from: http://portal.hud.gov/hudportal/documents/huddoc?id=ohc_hud101070212.pdf
Wahlen, J. M., Bradshaw, M. T., & Baginski, S. P. (2014). Financial reporting, financial statement analysis, and valuation. Boston: Cengage Learning.
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