FINANCING II

CAPITAL SOURCES

Once the project’s capital requirements are known, the borrower must identify sources of capital.  While bonds are a leading source of capital, others are frequently used in place of, or in addition to, bonds.  These sources include: the sale of property owned by the issuer (asset sale); funds appropriated by state or federal agencies for capital projects (capital appropriations); an appropriation from the issuer’s own operating funds (cash); public or private grants; or other forms of borrowing such as bank loans.  All of this information will be included in the Official Statement under the heading “Proposed sources of funds.”

Securing other sources of capital can make the project more attractive to investors or affordable for the borrower.  For example, infrastructure projects in rural areas are often partially subsidized by grants that reduce the total amount that must be borrowed and the level of debt service.  When other sources of capital are part of the finance package, investors may require that the other funds be pre-approved or that some assurance is provided that such funds are forthcoming.

RECOMMENDATION: Investigate other proposed sources of capital and make sure that proposed uses are appropriate

Obtaining capital is difficult and time-consuming, and the capital generally comes with many strings attached.  If other sources of capital are proposed as part of a finance package, it is important to know whether the funds have already been committed, what criteria the project would have to meet, and what the process and timeline are for securing the funds. 

Agencies that make capital appropriations or grants may have strict requirements for using and reporting on the funds, and their involvement could place the project under different regulations (e.g. federal involvement in a capital project can place the project under the jurisdiction of the National Environmental Policy Act).  Granting agencies may be unaware of project features that might create problems and it is important to make sure that these agencies are fully informed to prevent future problems.
 

REVENUE SOURCES

Where will money to pay back the bonds come from?

After finding sources of capital, the borrower must come up with a revenue stream that will cover both bond payments (debt service) and operating expenses with enough left over to provide a margin of safety.  There are three revenue sources that are used, individually or in combination, to repay bonds: the operating budget of the issuer or sponsoring agency (general funds); taxes or fees earmarked specifically for the project (special taxes/fees); and income generated by the project itself (project revenues). 

Project revenues are often, but not always, considered the least secure source of funds for debt repayment, since the success of the project cannot be assured.  As a consequence, investors may expect project revenues to be pledged to debt repayment before being used for any other purpose, including meeting operating expenses.  Even so, interest rates on bonds backed solely by project revenues may be high, especially if the property that would go to investors in the event of a default cannot easily be leased or sold (e.g., a prison).  Borrowers may try to bring down the interest rates by pledging a backup source of revenue, such as a sales tax, to cover any shortfall in project revenues.

RECOMMENDATION: Examine revenue projections to determine whether they are realistic and conduct an independent analysis, if necessary

It is not uncommon for revenue projections to rest on overly optimistic assumptions about the demand for, and the costs of, the services to be provided.  This is especially likely when the project in question is new.  The same can be true of special taxes or fees pledged as a primary or backup source of revenue.  For example, bonds for new housing or commercial development are occasionally backed by tax revenues from a special tax district authorized to levy taxes within a specific geographic area.  However, if the district’s tax base is too small, it will be impossible to generate enough revenue off the handful of residents or businesses in the area.

An independent analysis can be commissioned or conducted by community residents, using available information and reasonable assumptions. This analysis can be disseminated to elected officials, the financial community and the public at large in order to further discussion on the wisdom of the proposal.

RECOMMENDATION: Examine pledges of revenue for bond repayment to determine the potential impact of a shortfall

If revenues fall short of expectations, there can be serious consequences for the issuer, sponsoring agency and local community.  If bonds are backed by general funds or special taxes, a shortfall may trigger a tax increase and/or force cuts in other services.  Even if bonds are backed only by project revenues, there is often an impact on the sponsoring agency and other project participants.  Because bondholders generally hold the first right ( lien) on project revenues, a shortfall means the project may be unable to meet its other obligations, including paying bills to vendors and reimbursing the sponsoring agency for expenses incurred as part of the project.