ce recovery plant implementation
Financing Guidelines For Municipal Officials
guides for
municipal officials
planning and overview
technologies risks
and contracts markets
accounting format
procurement
further assistance
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SW1574
An environmental protection publication in the solid waste
management series (SW-157.4). Mention of commercial products does
not constitute endorsement by the U.S. Government. Editing and
technical content of this report were accomplished by the Resource
Recovery Division of the Office of Solid Waste Management Programs.
Single copies of this publication are available from Solid Waste
Management Information Materials Distribution, U.S. Environmental
Protection Agency, Cincinnati, Ohio 45268.
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This publication is part of a special series of reports prepared
by the U.S. Environmental Protection Agency's Office of Solid Waste
Management Programs. These reports are designed to assist municipal
officials in the planning and implementation of processing plants to
recover resources from mixed municipal solid waste.
The title of this series is Resource Recovery Plant Implementation:
Guides for Municipal Officials. The parts of the series are as follows:
1. Planning and Overview (SW-157.1)
2. Technologies (SW-157.2)
3. Markets (SW-157.3)
4. Financing (SW-157.4)
5. Procurement (SW-157.5)
6. Accounting Format (SW-157.6)
7. Risks and Contracts (SW-157.7)
8. Further Assistance (SW-157.8)
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CONTENTS
Page
Introduction 1
The Role of Financing in the Decision-making Process 2
Financing Al ternatives 3
Project Financing 4
Municipal Revenue Bonds
Pollution Control Revenue Bonds
General Obligation Financing 9
Other Long-term Financial Instruments 10
Leasing
Leverage Leasing
Comparative Costs 12
Participants in the Capital Formation Process 15
Financial Consultants 15
Investment Banking Firms 18
Bond Counsel 19
Resource Recovery and the Current Capital Markets 19
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RESOURCE RECOVERY PLANT IMPLEMENTATION:
GUIDES FOR MUNICIPAL OFFICIALS
FINANCING
by Robert E. Randol*
State and local governments annually spend around $35 billion to
purchase all forms of capital equipment. In the future, solid waste
management will make demands for an increased share of these public
funds. It is estimated that in the next 10 years between $1.0 to $7.5
billion will be spent to construct new disposal and resource recovery
facilities and to maintain and upgrade existing ones. This immense
capital improvement and acquisition program results, in part, from the
need to conform to new Federal and State regulations, the development of
more capital-intensive systems, and growing public concern for the
environment. Financing such expenditures has become an increasingly
complex and demanding task for local governments.
This publication will briefly describe the financing options
available to cities, states, and other public instrumentalities. The
discussion will provide practical information in simple language that
will include:
• A discussion of the role of financial management in the decision-
making issues.
• A description of the financial mechanisms—their characteristics,
advantages, and disadvantages.
• An identification of the costs—not only the interest costs, but
also all other directly associated front-end costs, such as
legal fees, bond counsel fees, consulting engineering fees,
election costs, and investment banking fees;
•A description of the action—a description of the major parti-
cipants outside of the local political jurisdiction who are
involved in the financing decision.
Rather than specific recommendations, general guidance is provided
concerning the use of alternative financing methods. The appropriateness
of a specific method is dependent on the characteristics of the individual
procurement and the types of contracts negotiated between the public and
private sectors.
*Mr. Randol is a financial analyst with the Resource Recovery Division,
Office of Solid Waste Management Programs, U.S. Environmental Protection
Agency.
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In this publication, contracts and their effect on financing will
be discussed where appropriate. They will also be discussed in the
Implementation Guide publication entitled Contracts and Risks. It
should be noted that contracts and finance are interrelated; the investi-
gations and decisions in one area should proceed simultaneously with
those in the other.
Although the motivation for writing this publication is to describe a
local government's options for financing resource recovery plant
facilities, these options are also appropriate for almost any capital-
intensive projects costing more than $500,000. Instruments that might
be used to finance purchases in the $10,000 to $500,000 range will not
be described. The major financing options appropriate for this range
are capital budget allocations, funds from previously authorized general
obligation (GO) bonds, conventional leases, bank borrowings, and note
issues.
THE ROLE OF FINANCING IN THE DECISION-MAKING PROCESS
Public financial management addresses three specific questions:
What to buy--a decision involving technology;
How much to spend—a decision involving planning and economics;
How to finance the project.
The first two questions often are not treated as financial
considerations, although they should be since their answers affect the
financing choice. For example, if a high-risk technological option
were chosen for a project, the financing mechanism would reflect this
uncertainty, and a high rate of return or a risk-reducing type of
financing would be needed to attract investors. Similarly, the size
of the financing also affects the choice of the financial option. The
means of financing purchases that cost less than $500,000 differ from
those that cost more.
Financing is one of the important considerations in resource
recovery procurement. Financing decisions are often difficult. For
this reason, it is recommended that financial experts become an integral
part of the Resource Recovery Task Force in order to give advice early
in the decision-making process. The reasons for this recommendation are:
• Quick Feedback. A financial adviser can act as an early screening
agent in evaluating the financial risks of specific resource
recovery systems and implementation plans.
• Expert Advice. The financial community can give expert, and
often free advice, especially if the bond offering will be
negotiated rather than competitively bid.
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• Time Saved. Some financing mechanisms (particularly leverage
leasing and pollution control revenue bonds) require Internal
Revenue Service (IRS) rulings if they are to be utilized.
Therefore, early groundwork is necessary if these mechanisms are
to be used without delay. Also, the contracts between the
public and private sectors for resource recovery plant procurement
require lengthy negotiations. Financing is a central part of
these contracts, and early consideration can help expedite the
ultimate negotiations.
The third factor, that of time saved, is particularly important.
Recent experience has shown that negotiation of contracts for resource
recovery systems is difficult. For example, the State of Connecticut
has had an eight-person staff, plus an investment banker and a general
counsel, working for nearly one year to finalize its contract for a $50
million resource recovery system. Contract-signing delays increase
capital costs. The following, hypothetical situation shows the costs of
delays. A $50 million purchase is delayed for 3 months because of
financing complications. The private sector's bid price escalates with
an inflation index (an average of 1 percent per month). Therefore, as a
result of delay and inflation, the capital cost of the facility increases
by $1.5 million, or $16,000 per day.
FINANCING ALTERNATIVES
Basically, local governments draw capital for purchasing facilities
and equipment from two sources: current revenues and borrowings.*
Current revenue, or capital budget financing, is based upon the
"pay as you go" philosophy; that is, all purchases are fully paid for as
they are made. This practice is common in the solid waste area. It is
used mainly to purchase collection vehicles and solid waste disposal
sites. Its principle advantage over other forms of financing is its
simplicity. It requires few institutional, informational, analytical, or
legal arrangements. However, it is dependent upon the community's
ability to raise surplus capital, and, therefore, may not be feasible to
finance "big ticket," capital-intensive purchases.
Borrowing is the local government's second alternative for financing
purchases of equipment and facilities. Borrowing options may be divided
into three categories.
*A third alternative is to contract with private enterprise for the
service, thereby shifting the capital-raising burden to the private firm.
With the exception of pollution control revenue bonds, this option will
not be discussed, but it warrants consideration as a potentially feasible
and attractive alternative.
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• Short-term options--(l to 5 years) to purchase assets that cost
less than $500,000.
• Medium-term options--(5 to 10 years) to finance capital purchases
between $500,000 and $1,000,000.
• Long-term options--(10 to 30 years) to finance capital purchases
over $500,000.
Unless a local government generates large revenue surpluses, short-and
medium-term financing alternatives have a limited place in funding capital-
intensive purchases, such as resource recovery systems. The repayment of
the principal of the loan is often too heavy a drain on the local govern-
ment's cash flow. Examples of short-and medium-term borrowing
instruments are bank loans and most leasing agreements.* Bank loans are
often used to finance front-end planning and some of the construction
costs of expensive facilities. Leasing, though not typically classified
as a borrowing instrument, functions in the same manner, especially if
the local government has the right to purchase the asset at fair market
value after the stipulated number of lease payments. Neither of the two
examples is usually an attractive alternative to long-term asset financing.
Long-term municipal financial alternatives can be categorized into
two broad types: revenue bond (project) financing and general obligation
financing. Within each category, specific financing mechanisms exist.
Figure 1 groups the basic public and private long-term debt financing
options into project and general obligation categories. Grouping
financial instruments in this or any other way is hardly clear-cut, and
a certain amount of editorial license has been applied. Some of the
financial instruments may have characteristics of another category,
depending upon the contractual liability the contracting parties assume.
Project Financing
With project financing, the bond principal and the interest repayment
are guaranteed by expected project revenues (dump fees and recovered
product sales). The expected revenues must offset all future operating
and capital recovery costs.
Typical mechanisms that may be grouped under project financing are
municipal revenue bonds, industrial revenue or development bonds, and
*Leasing can sometimes act as a long-term "borrowing" source.
Lease terms for equipment usually run less than 5 years, whereas leases
for real estate generally run for longer periods. Lease rates range
between 10 and 18 percent, although it is possible at times to negotiate
lower interest rates.
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Figure 1
FINANCIAL OPTIONS
Public Financial
Instruments
Private Financial
Instruments
Project
Financings
General Obligation
Financings
Revenue Bonds
Municipal General
Obligation
Pollution Control
Revenue Bonds
(without pledge of
corporate general
obligation)
Corporate Bonds
Pollution Control
Revenue Bonds
Cwith pledge of
corporate general
obligation)
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pollution control revenue bonds.* The specific characteristics of
municipal revenue bonds and pollution control revenue bonds will be
summarized below.
Municipal Revenue Bonds. Municipal revenue bonds are long-term,
tax-exempt obligations issued directly by municipalities, authorities,
or quasi-public agencies. Project revenues are pledged to guarantee
repayment of the debt. Municipalities have used revenue bonds to finance
such services as bridges, sewers, and housing projects.
The typical revenue bond is negotiated rather than competitively
underwritten. A negotiated offering differs from a competitive offering
in that the city negotiates with one underwriter to determine what
profit the underwriter will make.+ Negotiated interest rates are generally
higher than competitive interest rates. However, some of these extra
costs are offset by the free advice the investment banker provides
during its examination of the project and its preparation of the revenue
bond circular and official statement.
A revenue bond circular and official statement summarize for prospec-
tive purchasers of the bond the necessary information about the project.
The documents may take many months to prepare and will contain a
great deal of information about the project's technical and economic
feasibility. Usually, the local government will hire a "third party"
consultant to confirm the investment banker's estimates of costs and
revenues.
Characteristics of municipal revenue bonds include:
•Voter approval is not required. Usually, referendums are not
necessary to approve issuance of a revenue bond. Decisions may
be made directly by municipal officials. This may reduce the
incremental delays and costs which result from a citizen vote.
•Municipal debt limitations usually do not apply. Since projects
are not backed by the taxing power of a city, revenue bonds often
are not constrained by a city's current debt ceiling, which is a
function of its tax base.
*The major distinctions between industrial revenue bonds (IRB's) and
pollution control revenue bonds (PCRB's) are that IRB's, under most circum-
stances, can only be used to raise a maximum of $5 million in capital.
This money must be targeted for industrial development. With PCRB's, capital
limitations do not apply, but the bonds must finance pollution control equip-
ment.
+Bidders may not respond to competitive offerings for technically complex
or risky projects because the expected returns from the underwriting may not
sufficiently offset the initial bidding costs.
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•Financial responsibility is encouraged. Prospective bond purchasers
act as a check on the financial soundness of the project being
financed.
•Revenue bond issuance requires detailed information. Revenue bond
issuance requires detailed documentation including a summary of the
project's technology, products, and economic viability. This
summary (called an official statement) is necessary because
prospective buyers must have sufficient information to assess the
adequacy of the projected revenue stream. This complexity makes
the cost of issuing revenue bonds relatively high compared to 60
bonds.
•The minimum size offering is $1 million. Revenue bonds are generally
not suitable for financing projects that cost less than $1 million
due to their high fixed "front-end" administrative and transaction
costs. (These costs will be discussed later in this section.)
•Interest rates are higher than those of general obligation bonds.
Interest rates on revenue bonds are approximately 30 to 45 basis
points* higher than on similarly rated general obligation bonds.
Revenue bonds pay higher interest rates because the investor assumes
a higher risk when he invests in them. In some cases, revenue
bonds, through contractual obligations, have been designed to have
the risk attributes of GO bonds. Then, interest rates are comparable
to those of GO bonds.+
•They may only be used to finance one project. A revenue bond may
only be used for single project financing. In general, the
mechanism is issued only when a major project, requiring long-term
capital, is to be managed by an independent authority or by a
distinct city agency, and only when the service provided will
generate enough revenue to operate and maintain the facility,
as well as to pay the interest and principal on the debt.
*A basis point equals 1/100 of a percent. Therefore, if revenue bonds
interest rates at 7.10 percent and GO rates are 6.75 percent, there is a
35 basis point differential. The spreads are derived from data published
by the "Daily Bond Buyer," New York, New York.
+An example was the funding of the Harrisburg, Pennsylvania incinerator
project. The city government created a "paper" solid waste authority whose
only function was to hold le§al title to the incinerator and to be directly
responsible for the bonds. The City, then, signed a non-cancellable con-
tract with the authority, with stipulated payments in the exact amount of
the bond payment schedule. Because of that arrangement, investment advisors
and the capital markets viewed the incinerator bonds as general obligation
bonds. The bonds were rated as such and carried the same negotiated interest
rate as Harrisburq's municipal GO bonds.
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Nashville, Tennessee, used municipal revenue bonds to fund the
Nashville Thermal Transfer Corporation, a non-profit corporation. The
Corporation raised $16 million to fund construction of its resource
recovery system which sells to downtown buildings steam for heating and
chilled water for air conditioning. Nashville was able to sell its
revenue bond to investors because of very strong marketing contracts it
secured from the State. The marketing contracts are for purchase of the
project's products and are non-cancellable. Essentially, they make the
project as safe an investment as many general obligation bonds.
Pollution Control Revenue Bonds (PCRB's). Pollution control
revenue bonds are long-term, tax-exempt obligations issued by a public
instrumentality on behalf of a private enterprise.* The instrumentality
acts as a vehicle through which a corporation may obtain low-cost
financing.
PCRB's are secured by the assets of the corporation and by the
projected revenues of the project. The credit-rating of the corporation
determines the cost to that corporation of an industrial revenue bond.
Interest rates on industrial and pollution control revenue bonds are
over 50 basis points higher than those on GO bonds. Correspondingly,
they are nearly 200 basis points below the current corporate debt rate.+
To make the bonds marketable, PCRB's often require a corporate guarantee
of the debt service payments. If this pledge is made by a corporation
with sufficient financial assets to guarantee the bonds, PCRB's may also
be viewed as general obligation- type financings, albeit general obliga-
tions of private corporations.
The same characteristics that apply to municipal revenue bonds
also apply to PCRB's. Three other characteristics that were not described
are:
•The local government technically owns the facility. With a PCRB,
the locaY government technically owns both the facility and the
equipment, which it then leases to the private firm. The lease
payments are tailored to meet the scheduled payments of principal
and interest on the bonds. If the payments between the corporation
and the local government are structured as an "installment sale", or
as a "financing lease", the corporation may claim ownership for tax
purposes. This gives the corporation tax benefits in the form of
accelerated depreciation or investment tax credits. The savings
from tax ownership should be passed on to the local government in
the form of lower service fees.
*The use of PCRB's is defined extensively in Section 103 of the IRS'
Rules and Regulations.
+The First Boston Corporation. Tax-exempt Pollution Control Financing.
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•They have seldom been used. PCRB's have seldom been used to finance
post-consumer solid waste facilities. Administrative complexities
and broadly defined tax guidelines frequently require IRS rulings
which can delay financing by 6 months.* However, Section 103(c)
of the IRS Rules and Regulations does indicate that PCRB's may be
used to finance resource recovery facilities as long as 65 percent
of the waste input is post-consumer waste and the post-consumer
waste is deemed "valueless".
•They require long-term contracts. A major stumbling block to
using industrial revenue bonds for financing solid waste facilities
is whether or not a community may sign a long-term contract with
a minimum supply of solid waste. While for security, these issues
require long-term agreements, many States do not permit communities
to enter into lengthy service contracts. This problem was recently
solved by New York State which now allows its cities (with the
exception of New York City) to make major long-term contractual
commi ttments.
General Obligation Financing. The basic instrument for municipal
general obligation financing is a general obligation bond. With general
obligation financing, the capital market evaluates the credit-worthiness of
a local government (or corporation) and does not specifically evaluate
the technical and marketing risk of a particular project. This is
different from project financing. Until more technical and economic
information on resource recovery systems is developed, GO bonds may have
the most market acceptance and will have a correspondingly lower interest
rate compared to alternative tax-exempt instruments.
General Obligation Bonds. General obligation bonds are long-term,
tax-exempt obligations secured by the full-faith-and-credit of a political
jurisdiction which has the ability to levy taxes. In most cases, the
full-faith-and-credit clause pledges the general revenue of that jurisdic-
tion.
A typical GO bond is offered competitively for sale to bidders. A
competitive bid solicitation invites investment banking houses and banks
(underwriters) to make sealed bids for the right to purchase and resell
the bonds. Usually, underwriting syndicates are formed by groups of firms
to purchase the entire issue. The bidder offering the lowest net interest
cost to the jurisdiction wins the right to place the bonds with its
customers.
*Four rulings are pending as of June 1975. There is uncertainty
regarding the type of resource recovery facility the IRS will deem eligible
for PCRB financing. Thus, PCRB financing may not be available in many
cases.
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Interest rates on GO bonds vary according to the credit-rating of
the jurisdiction issuing the bonds, as well as the availability of monev
in the capital market. Credit-ratings are made for a fee by Standard &
Poor's Corporation and Moody's Investors Services, Inc. Currently,
interest rates vary between 6 and 8 percent. Current rates are published
every Friday in the "Daily Bond Buyer."
Characteristics of general obligation bonds include:
• Voter approval required. Typically, voter approval is necessary.
• Low interest rates. GO bonds carry the lowest coupon (interest)
rate of any financial instrument and, also, have a low effective
interest rate* compared to other long-term debt instruments. The
interest rate is low because investor risk is minimal resulting
from guarantees by the city's tax-collecting capacity.
• Minimum offering size. The effective minimum offering size for GO
bonds is approximately $500,000. General obligation bonds can be
used to finance any project approved by the voters. Therefore, if
a project costs less than $500,000 and a local government would like
to finance it through GO bonds, several projects will be grouped
for a single offering.
Chicago, Illinois, and Ames, Iowa, are examples of cities which have
issued general obligation bonds to fund their resource recovery systems.
Other Long-term Financial Instruments. There are two other long-term
financial instruments that may be used in the future in the municipal
sector to finance medium-to long-term use of capital equipment. They are
leasing and leverage leasing.
Leasing. Traditional leasing is being used frequently by local
governments to finance medium-term use of capital equipment. A lease
arrangement involves a third party (lessor), who purchases an asset
with his own money, and the local government (lessee), who rents use of
the asset. Within this arrangement, it is possible to institute a sub-
lease from the local government to the private operator for operation
of the resource recovery system. Usually, the length of leases does not
extend beyond 5 years, although recently some leases have been made for
20 years.
*The "effective interest rate" may be defined as the interest rates
on the actual capital received. This calculation may be determined by
dividing the yearly interest payments by the net proceeds a city receives
from a particular financing option. Examples of the net amount of money
a local government may expect to receive are presented later in this
paper.
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Leasing characteristics are:
• Demand on municipal capital outlays is reduced. It allows the
local government to use an asset without forcing the city to raise
the capital "down payment" necessary to purchase the asset. The
city pays for use of the equipment in yearly payments.
• Lease financing can be instituted rather quickly. There are few
institutional roadblocks that may delay the financing.
• Lease rates are high. Currently, rates are ranging between 10 and
18 percent of the capital cost of the equipment. This contrasts
with lower effective interest rates on tax-exempt bonds.
• After the termination of the lease, the local government will neither
own nor control the facility. This disadvantage can be reduced if.
in the leasing contract, the local government stipulates options to
either renew the lease or purchase the asset at fair market value at
the end of the contract.
Leverage Leasing. Leverage leasing is technically not a financial
instrument; rather, it is a financial package that combines several
financial mechanisms. Leverage leasing is a complex mechanism to initiate
that requires lengthy, convoluted rulings. It involves two major partici-
pants, a financial intermediary (lessor), and a local government (lessee).
It differs from traditional leasing in that both the lessor and the local
government provide capital funds to purchase the asset. Usually, the
lessor puts up 20 to 30 percent of the cost of the asset, and the local
government finances the remaining portion through a typical borrowing
method.
The leverage leasing concept is based upon the benefits (lower long-
term capital and interest costs) that accrue to a city if a financial
intermediary, corporation or individual, is interposed between a long-term
source of capital and the local government. The financial intermediary
purchases the tax advantage of ownership which cannot be utilized by a
local government, by charging the local government a very low interest rate
on its share of the cost of the asset.* The low interest rate is possible
because of the depreciation and investment tax credit accompanying tax
ownership of the asset. Essentially, the depreciation and tax credit act
to shelter the financial intermediary's other income, which allows it to
receive an adequate after-tax return on its initial investment in the
asset.
*Lower than GO bond interest rate.
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Leverage leasing characteristics are:
• It is new and legally complex. There have only been three leverage
leases of municipal funds. Therefore, at least initially, lengthy
IRS rulings will be required, taking possibly 6 to 9 months;
• At the end of the lease, the facility is owned by the lessor and
not by the local government.This disadvantage will probably be
minimal since, after 20 years (the term of the lease), the technology
will most likely be obsolete. The local government can further
minimize this disadvantage by stipulating options (as in all lease
contracts) to purchase the facility at fair market value at the end
of the lease or to renew the lease;
• Demand on municipal capital funds is reduced. A substantial portion
of a project's required capital is supplied by a third party;
• Interest charges are reduced. Tax advantages available to a third
party lessor permit him to supply capital at a very low cash return,
while still maintaining his adequate, all-important, after-tax return.
Table 1 shows how leverage leasing lowers the initial cost for a
simplified $1 million, 20-year financing.
COMPARATIVE COSTS
Comparing the costs of different financial mechanisms is Implicit in
making financial decisions. When comparing costs, it will not suffice to
review interest rates as they seldom represent the true cost a local
government must pay on the borrowed capital. Rather, the local government
should compare the "effective interest cost" and the "effective debt
service rate" on the funds it finances.
The "effective debt service rate" may be defined as the yearly cost
of the interest payments plus the yearly repayment of capital (capital
recovery payment) divided by the amount of capital the local government
actually received from the project. In making this calculation, it is
important to note that, if a local government floats $10 million 1n bonds,
the local government will not receive $10 million.* Depending on the
financial mechanism, the local government can expect to receive 90 to 95
percent of the funds it financed.
Table 2 compares the cost of using GO bonds, revenue bonds, and
revenue bonds with leverage leases to float a $10 million issue. The net
proceeds a city is to receive will be reduced by the "front-end" costs
*The commissions and legal fees a local government must pay are
summarized in Table 2.
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TABLE 1
LEVERAGE LEASING
Borrowing Approach
Source
Debt*
Equity
Total
Principal
$1,000,000
-0-
$1,000,000
Payment
$80,240
-0-
$80,240
Rate
6.25%
-0-
6.25%
Leverage Leasing Approach
Principal
$ 700,000
300.000
$1,000,000
Payment
$61,760
Rate
6.25%
17.410* 1.5
$79,170 4.88%
*Debt financed by typical PCRB. The 6.25% rate is arbitrary.
+Cash payment required on lessor's $300,000 equity capital for 5% after
tax return. Tax advantages transferred are without cost to municipal lessee.
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TABLE 2
$10 MILLION FINANCING
Serial General
Obligation Bonds
Revenue Bond
Municipal Leverage Leasing
Revenue $7M by Revenue Bonds
Bond* $3M by Lessor
I. FRONT-END COSTS
Rating Agency Fees
Commission to Underwriter
Counsel to Underwriter
Counsel to City
Bond Counsel
Accountants Fees
Initial Trustee Fees
Printing and Engraving
Third Party Engineer
and Accountant
Debt Service Reserve
Election Cost
TOTAL
II. NET PROCEEDS TO CITY
$ 3,000
150,000
5,000
10,000
18,000
8,000
6,000
30,000
X+
230,000
$9,170,000
$ 848,000
III. YEARLY COST TO CITY*
GO Bond--5.75%
Revenue Bonds—6.25%
Leverage Leasing--4.88%*
IV. EFFECTIVE DEBT SERVICE RATE§ 8.7%
5,000
250,000
7,000
10,000
35,000
8,000
6,000
40,000
60,000
817,000
$1,238,000
$8,762,000
$ 883,000
10%
5,000
170,000
7,000
11,000
30,000
8,000
6,000
35,000
60,000
572,000
904,000
$9,096,000
$ 788,000
8.6%
*IRB costs are not detailed, since all costs are passed on to the
involved corporation.
+Election costs are unknown.
^This is the dollar amount the city would have to pay to retire and
pay the interest on the debt. It was assumed that a city made steady
payments for the life of the financing to retire the debt. The payments
were made semi-annually for twenty years.
The assumed interest rate for each debt instrument was arbitrary.
The actual rate will vary according to the credit-worthiness of a project
(or city) and the current capital market conditions.
*The 4.88% rate is the weighted average cost of capital.
'The Effective Debt Service Rate is the yearly percentage cost to the
city. It was calculated by dividing the yearly cost (interest plus debt
retirement) by the net proceeds a city received.
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that are outlined in Table 2. These proceeds are the actual dollar amounts
available to purchase a facility. The costs that are outlined are based
on general assumptions and are only approximations. It has been assumed
that the debt would be for 20 years at the stated interest rates and that
it would be retired in steady yearly payments for the term of the
financing.
Bond interest rates vary according to money market conditions and
the bond's investment attractiveness determined by the rating agencies.
The lower the rating assigned by Moody's or Standard & Poor's, the higher
the interest rate required to attract investors.
In order to attract investors, medium-grade bonds offer a higher
yield than prime-grade bonds (Table 3). For example, in August 1974, the
average spread between interest rates for prime-and medium-grade bonds
was 50 basis points. For a hypothetical 20-year, $40 million financing,
an extra 50 basis points would cost a project an additional $2.6 million
over the life of the project.
Figure 2 illustrates the impact of different interest rates on the
cost per ton of building and operating a $40 million, 1000-ton-per-day
resource recovery facility. The plant's expected throughput is 310,000
tons per year. Operating cost has been assumed to be $6 per ton. Figure 2
reflects the significant impact debt service has in contributing to the
overall cost of operating a recovery system.
PARTICIPANTS IN THE CAPITAL FORMATION PROCESS
Many different actors may become involved when a local government
attempts to obtain funds to finance a resource recovery system. The
exact role played by each party is a direct function of the type of
borrowing method that is employed. In the following paragraphs, the roles
of the financial consultant, the investment banker, and the bond counsel
are discussed.
Financial Consultants. Frequently, an outside financial consultant
will assist the local government in choosing a particular financing
mechanism or the specific variations most suited to the circumstances.
Typically, this task may be performed by independent consultants, com-
mercial banks, attorneys, accounting firms, or investment banking firms.
Sometimes an outside party performs two separate functions, that of
a financial advisor and that of an underwriter. In this situation, it may
be difficult for the advisor to provide completely objective analysis
since when acting as an underwriter he may realize greater fees by
recommending certain types of financial mechanisms. This risk will be
minimized if a local government compares all real and associated costs
for each of the financing mechanisms.
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CD
a
o
o
CD
CO
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Cost/Ton
$19-
$18.
$17.
$16.
$15.
$14-
$13-
$12.
$11-
$10-
$ 9.
$ 8-
$ 7.
$ 6.
FIGURE 2
DEBT SERVICE FUK VARIOJS INTEREST RATES
AS IT AFFECTS TOTAL COST PER TON
7%
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A financial consultant's primary role is to help a local government
prepare its bond offering. A financial consultant's responsibility
includes gathering all necessary data, preparing the bond circular,
advising on timing and marketing methods, and recommending bond terms
(e.g. maturity schedules, interest payment dates, call features,* and
bidding limitations).
In a competitive offering, underwriters are invited to submit sealed
bids through advertisements in appropriate journals with the selection
variable being the lowest effective interest rate. The local government
must, then, do its own preparatory work or hire a financial consultant
to do it. For a negotiated offering, most of this preparatory work is
done by the investment banker. In many small or medium-size cities,
municipal officials do not have the time or the specialized financial
knowledge required to prepare offerings. An outside financial consul-
tant is, then, a necessity.
Many regional investment bankers make a practice of calling on
municipal officials within their localities on a routine basis in order
to become involved in the financial decision-making process as early as
possible. One of their hopes is to persuade the municipality to use a
negotiated underwriting (in those states where this is legal) with their
own firms serving as the underwriter. On a straight interest rate basis,
it appears that a negotiated underwriting may cost more than competitive
offering. However, the costs may not necessarily be higher since some
services will be performed without charge by the investment banker. For
instance, when underwritings are done on a negotiated basis, frequently
the investment banker will act as the initial financial consultant and
charge no fee. Also, his bond counsel may provide free legal advice
because he is assured of participation in the closing of the bond.
A financial consultant can be compensated in several different ways.
If an independent firm or individual is hired, the charges will generally
be a direct function of his efforts. If an investment banker is chosen,
he will receive his profit from the management fees in the underwriting
(the issuance of the bond).
Investment Banking Firms. The role played by investment banking
firms, insofar as interaction with a community is concerned, is straight-
forward. Their function is to act as a financial intermediary that
purchases bonds from the issuing city or other governmental unit and,
in turn, sells them to the ultimate investor. The underwriter assumes
the market risk of price fluctuations during this period and also fulfills
a distribution function.
*Call provisions allow bonds to be retired early if interest rates
drop drastically in the future.
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The investment banking community's contact with a local government
depends on whether or not the bond underwriting is to be competitive or
a negotiated bid. If competitive, it is not unusual for an underwriting
syndicate to submit a bid without any direct contact with the local
government. If the local government chooses to negotiate the underwriting,
the investment banker acts as a financial consultant.
An investment banker charges a fee which is a percentage of the total
bond underwriting. This fee can vary, of course, but on issues less than
$5 million, 2 percent of the total issue is a common rate. It is a
smaller percentage for larger bonds. The commission is usually segmented
into three categories: a management, an underwriting, and a selling fee.
Bond Counsel. Another important party is the bond counsel. His main
role is to render an opinion regarding the validity of a bond offering.
This legal opinion is required on all municipal bond issues. The counsel
must determine whether the bond issue is in compliance with all constitu-
tional, statutory and charter provisions applicable to the local government
issuing the bond. The fee charged by the bond counsel, like that of a
financial consultant, is a function of his time and the size and complexity
of the underwriting. Generally fees for general obligation bonds are
somewhat less than for revenue bonds of comparable size. A typical bond
counsel's fee for a medium-sized revenue bond($10 to $20 million) may
range between .3 percent and .4 percent of the gross amount of the issue.
RESOURCE RECOVERY AND THE CURRENT CAPITAL MARKETS
Resource recovery technology and markets for recovered products are
still in an early stage of development. Technological, market, and local
institutional uncertainties result in economic uncertainty for recovery
plants. Economic uncertainty dissuades potential investors.
Because of economic conditions in 1974 and 1975 (capital shortages,
high inflation, and recession), capital financing has been difficult for
many projects. When capital markets are weak, financing can be very
difficult for smaller, less secure companies (Baa rated and less) and for
more economically risky projects. In 1975, the Federal Reserve Bank is
expected to expand the money supply. An expanded money supply will make
more capital available. However, most experts continue to predict a
significant capital shortfall over the next 10 years.
Availability of funds for financing___res_ourc_e_j'_ecgve_ry_systerns
Debt financing for resource recovery plants will be difficult to obtain
unless the debt is viewed by investors as "secure," i.e., backed by thefull-
faith-and-credit" of a municipality or by a corporation with a substantial
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financial base.* Project financing will be difficult to obtain, but may
be available depending upon the strength of the contractual obligations
that secure the bonds.
Capital markets are expected to be able to supply funds through general
obligation bonds. Thus, public agencies which are willing to extend their
general obligation debt for financing resource recovery systems should not,
in general, be significantly affected by capital unavailability. Decisions
of municipal officials on GO bond financing of recovery plants will hinge
on several questions. One is whether the municipality is willing to assume
the full capital responsibility and associated risk for a plant. Some
municipalities would be willing to assume this risk (some already have),
while others will undoubtedly be reluctant.
Of course, if a municipality assumes the responsibility of financing
a system through its GO credit, it may have a significant impact on the
debt load it is currently carrying. This impact will probably not be so
great as to push it past its statutory debt ceiling, but it might require
an increase in taxes, a politically unpopular move.
The impact on a municipality's debt load can be shown by data
derived from Federal Reserve statistics. In 1973, the average per capita
long-term debt obligation of State and local governments combined was $735
and for local governments was $480. A city with a population of 500,000
would have approximately $240 million in outstanding debt. If this city
built a 1 ,000-ton-per-day resource recovery plant, costing about $50 million,
it would effectively increase the city's debt load by 20 percent. This
increase is sure to make many cities cautious about providing capital
for plant construction.
QmnhJ?e 1mEuCt Of/ Łef?urce Cecovery Plant °n a municipality's debt load
emphasizes the need of the municipality to explore the full range of
capital financing mechanisms, to involve financial experts early in the
decision-making process in order to minimize effective interest costs to
institut1onal arrangements, and to nze risk in
of resource recovery facilities.
*Nearly every corporation in the resource recovery area does not have
the balance sheet depth to assume absolute liability for more than one or
two recovery systems. Therefore, the role of the private sector in financing
resource recovery plants may be severely constrained.
+The significance of this data is skewed by the probability that a major
city's current per capita debt is significantly higher than the nation's
average per capita debt.
4U.S. GOVERNMENT PRINTING OFFICE:1975 631-404/475 1-3
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