Capital Funding and Debt

Revenue Bonds, Certificates of Obligation, Contractual Obligation, Commercial Paper, & Capital Leases

There are many sources of capital for public funding and debt. The different types of funding and debt are used in for funding public projects and programs. The different forms of funding and debt operate with the goal of accomplishing these projects and goals. When analyzing the different forms of funding and debt, these sources for public funding are understood through their cost and effectiveness.

Bonds

General obligation bonds are a common form of funding that is most often used in the form of a municipal bond. The general obligation bond is a type of municipal bond that is issued dependent on the credit worthiness of the agency or government and it is secured through tax funds. There is no collateral for these types of bonds and are considered a safe investment since they are backed by tax revenues (O’Sullivan et al, 2003). Typically, these bonds yield low interest or moderated interest rates and are good long-term investments.

Revenue bonds are another form of the municipal bond but this form of bond is backed by project revenue. The revenue bond is issued when financing is needed and the project is expected to create revenue such as a stadium or toll bridge. The advantage for this type of bond is that it does not require money that may ultimately impact public budgets since the funding is paid form the revenue generated from the project. This is an ideal form of public debt because it does not impact existing budgets or draw money from other sources. However, these bonds are somewhat riskier than obligation bonds due to the fact that they are expected to pay interest based on revenue generated (O’Sullivan et al, 2003). If the project fails to generate revenue than this could result in losses for investors.

Certificates of obligation are another form of debt financing that are more like loans than bonds. The certificate of obligation is a written promise to pay a debt which is typically backed by the government credit worthiness and is payable by taxes or by revenues from a project. As a loan, this form of debt is relatively safe but does carry more risk than a bond because of the risk of default (O’Sullivan et al, 2003).

A contractual obligation is an agreement made between a public entity and a person or company that promises money based on the delivery of a service or good (O’Sullivan et al, 2003). This type of debt is conditional “upon providing a service or good in exchange for monies paid” (O’Sullivan et al, 2003). An example of this can be seen when construction projects for roads or highways are entered between a construction company and state. The work must be paid for per the contractual agreement and it is often used for contracting out public services such as prison cafeteria food service and other jobs (O’Sullivan et al, 2003).

Commercial paper is a short term public debt that is used to raise money for projects. These forms of debt are used to raise money when a loan is not needed or financing is short in nature such as under a year (O’Sullivan et al, 2003). This form of debt is like a loan as is paid typically based on current interest rates (O’Sullivan et al, 2003). This is a relatively safe investment because it is contractual in nature.

Capital leases are another type of debt that is a form of lease that transfers ownership when the leasing period has ended. This form of debt allows the for the lessee to take advantage of the assets value but they must also deal with the depreciation and risk (O’Sullivan et al, 2003). The capital lease is not an expense since the interest rate is the only cost that can be written off on taxes (O’Sullivan et al, 2003). A capital lease must meet specific qualifying criteria to be considered a capital lease which include:

1. The life of the lease is 75% or greater of the assets useful life.
2. The lease contains a purchase agreement for less than market value.
3. The lessee gains ownership at the end of the lease period.
4. The present value of lease payments is greater than 90% of the asset’s market value (Investopedia, 2012).

Capital leases are often used when government is using private buildings for specific programs such as offices or warehouses. The program may need space and rather than providing the program cash it may extend a low-cost capital lease that provides the program with space as a long-term commitment.

Notes payable are another form of debt financing that are payable to banks and credit companies in a formal agreement. Notes payable have specific interest rates and terms of repayment that must be met. Typically, notes payable are between borrowers both institutional and consumer (O’Sullivan et al, 2003). These are the highest risk investment due to default.

Conclusions

There are a variety of debt instruments available for public services and programs with each having different payment and terms. These forms of funding are used in different situations to entice specific types of investors as well as different levels of investment. A bond is a longer term investment but is likely to only bring in institutional investors. In contrast, loans are more enticing to banks and investors because they may have higher interest rates along with higher risk. Depending on the project and the amount of money needed, a choice of debt financing is made that will accomplish the job but also to pay the debt in reasonable manner.

References

Investopedia. (2012). definition of ‘capital lease’. Retrieved from http://www.investopedia.com/terms/c/capitallease.asp

O’Sullivan, Arthur; Sheffrin, Steven M. (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 197, 507

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