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Alternative financing relieves the pressure for municipalities

by Donald Ross

Provincial downloading, amalgamation, shrinking budgets and resistance to increasing debt are putting many municipalities under pressure. At the same time, there is increasing pressure from taxpayers to hold or lower taxes while providing more services and municipal upgrades. Trying to do more without unduly burdening taxpayers, some municipalities are discovering that traditional funding methods don't always accommodate their new business reality, so alternative forms of financing are becoming more important.

Alternative financing offers more flexibility than traditional funding models. Flexibility in:

  • financing terms and structures to allow for both predictable and unpredictable change;
  • payment schedules;
  • pay-per-use tracking and other forms of allocation;
  • operating leases to move asset financing from the capital budget to the operating budget; and
  • off balance sheet transactions to improve ratios for future borrowing.

Traditionally, banks and other major lenders would offer municipalities fixed-term level payment, debenture-based funding. As some municipalities have discovered, there are several challenges with this type of financing.

Often the financing agent will require a large transaction to justify the debenture, $10 million and more, when only $2-$5 million may be required. Once a debenture is financed, the term, repayment schedule and rate are fixed. If a municipality received an unforeseen influx of capital, through land or building sale or development fees, there is no mechanism for retiring the debenture early. If a debenture is issued for a 7-year term, how can a municipality then use the funds to purchase assets, such as computers, that will be replaced in three or four years? When significant infrastructure expenditures are required for projects that will be utilized for many years to come (costing $20-$75 million), a 10-year debenture can become a burden on the current taxpayers in the short term rather than spreading it over all users.

Many municipalities are looking toward non-traditional financing methods to help them deal with the demands of extreme budgetary pressure. Financing alternatives include: operating leases, capital leases, sale/leaseback and asset-based financing. These financing options allow municipalities to finance assets over their useful life. An added benefit to leasing certain assets is the cash savings provided in the first years through various methods and the smoothing out of the capital purchase curve.

A capital lease is a financing contract where the asset title transfers to the lessee automatically at the end of the lease or following a pre-arranged purchase option. For accounting purposes it is treated as a loan - it is assumed the intention all along was to own the asset. The asset is considered owned by the lessee who makes lease payments from their capital budget. This eliminates the possibility of moving the asset off the balance sheet but can also be structured with flexible or irregular payments and can be used to match costs to cash flow.

An operating lease, or residual value lease, is essentially a lease with a "fair market value" purchase option or "no bargain" purchase option. The lessor maintains ownership of the asset throughout the term and there is no requirement for the lessee to purchase it at the end of the lease. The lease payments come from the lessee's operating budget and, at the end of the term, the lessee can return the asset without further obligation, extend the lease at a negotiated rate or purchase the asset at the then current fair market value. As the leasing company shoulders some risk in this type of transaction, the municipality [lessee] does not finance 100 percent of the asset cost, but merely pays to use it or rents it. The option to return, renew or purchase at the end of the lease period is easier to make based on market conditions and the municipality's needs. In terms of flexibility, an operating lease does allow for an off balance sheet transaction with flexible payments if required and should be structured with terms that closely match the asset life.

In a sale/leaseback situation, the lessor purchases an asset or pool of assets that have been recently purchased by a municipality and the lessor leases these assets back to the municipality. This is usually done on an operating lease basis, providing incremental short-term cash and the flexibility to move certain assets off the balance sheet. There is also some flexibility when it comes to arranging terms and payment schedule.

Finally, a truly flexible form of funding is asset-based financing. It allows the title of the asset to remain with the lessee and may be structured to qualify as an off balance sheet transaction. The term of the financing can also be extended beyond traditional debenture terms. As a result, the cost burden is spread over a longer term and can be offset by various flexible income structures, unlike debenture financing, to ensure the cost of the asset is spread more evenly over its projected life-span and shared among all users.

Technology financing is really about improving asset management - matching the right lease to the type of equipment or assets being acquired. In addition, this type of service can help to streamline the lessee's administrative load because the lessor takes responsibility for the managerial functions of the lease.

Asset-based financing is about developing more creative ways to finance larger capital projects. What this means for municipalities is that a customized financing program can be developed for projects such as new community facilities, utility expansions or other infrastructure upgrades. Asset-based financing also offers increased flexibility including: repayment structure, early pay out and/or term adjustment options.

When determining the best type of financing for any given project, municipal decision-makers can only benefit by exploring all the various financing options available.


Donald Ross is an OPS and municipal market specialist at MFP Financial Services Ltd. in Mississauga, Ontario.

 

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