Planning the Optimum Use of Funds for Capital Works: Financial Planning Model

This report was produced for the Urban Water Research Association of Australia, a now discontinued research program.

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Planning the Optimum Use of Funds for Capital Works: Financial Planning Model

Report no. UWRAA 149

September 1998


Changes in the economic and political environment, social attitudes and technological developments have shifted the primary focus of the Australian water industry from asset and resource development to asset and resource management. The management of assets must be determined by customer driven levels of service(for example, cost efficiency and productivity gains) and overall system performance objectives (such as, required debt to equity ratios and real rates of return on assets). In addition, asset management must be closely linked to demand management strategies, such as those of water metering, pricing, customer information and user education.

Capital expenditure on assets can be funded from a number of sources, including rates and charges, funds provided through depreciation provisions, reserves, contributions from developers and other third parties, subsidies and grants from other agencies and levels of government, and by way of borrowings. The appropriate mix of revenue and borrowings does not always seem to receive the level of attention required. There is a view that there is an optimum capital structure for utilities and that this capital structure has important implications for the medium to long term level of costs which need to be funded by users.

The aim of this UWRAA funded project was to develop a financial planning model to assist urban water agencies to plan the optimization of funds for new capital works and for asset renewal and replacement over a 10-20 year time horizon. The model was to be designed so as to permit agencies to assess the impact of alternative funding strategies on capital structure and prices, consistent with external constraints and policies. Specifically, a capability to address issues such as financial risk exposure, asset replacement, return on assets, and reserves policy was to be structured into the model. Measures of performance of an agency, in terms of its ability to achieve business, financial and economic objectives under alternative funding strategies, was to be an added feature of the model.

It was assessed that critical to the success and practical application of the model would be the ability of the user to clearly define constraints, policy variables, and exogenous factors beyond the direct control of an agency (such as the cost of debt).

In this project, attention was to be concentrated on modelling agency financial structure. It was envisaged that in a later project, more emphasis would be placed on causal modelling of costs and revenues.

The model was to be developed for use on personal computers using commercially available software, in the first instance. A user’s manual to accompany the model would be produced. This report is intended to perform both the role of a user manual and the project report. The model’s application has been demonstrated by applying it to the financial planning of a hypothetical urban water supply agency as a case study.

In summary, the overall objective of the project is to enhance the financial planning and financial management capabilities of water agencies by developing a financial planning model for use by agency managers. The specific objective is to permit managers to rapidly assess the impact of alternative proposed funding strategies for capital investments over a 10-20 year time horizon on the capital structure of their agency.

The primary benefit is seen as the enhanced financial planning capability afforded water agency managers, which, if taken advantage of, could lead to improved capital structuring of the agencies, with eventual pricing and service level benefits for customers. The application of the model should be readily transferable to other urban water agencies in Australia.

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