Download IFM7 Chapter 27

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CHAPTER 27
Financial Management in
Not-for-Profit Businesses
For-profit (investor-owned) vs.
not-for-profit businesses
Goals of the firm
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What are the key features of
investor-owned firms?
Owners (shareholders) are well
defined, and they exercise control by
voting for the firm’s board of directors.
Firm’s residual earnings belong to the
owners, so management is responsible
to the owners for the firm’s profitability.
Firm is subject to taxation at the
federal, state, and local levels.
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What is a not-for-profit corporation?
One that is organized and operated
solely for religious, charitable,
scientific, public safety, literary, or
educational purposes.
Generally, qualify for tax-exempt
status.
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What are the major control differences
between investor-owned and
not-for-profit businesses?
Not-for-profit corporations have no
shareholders, so all residual earnings
are retained within the firm.
Control of not-for-profit firms rests
with a board of trustees composed
mainly of community leaders who
have no economic interests in the firm.
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How do goals differ between investorowned and not-for-profit businesses?
Because not-for-profit firms have no
shareholders, they are not concerned
with the goal of maximizing
shareholder wealth.
Goals of not-for-profit firms are
outlined in the firm’s mission
statement. They generally relate to
providing some socially valuable
service in a financially sound manner.
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Is the WACC relevant to not-for-profit
businesses?
Yes. The WACC estimation for
not-for-profit firms parallels that
for investor-owned firms.
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Is there any difference between the
WACC formula for investor-owned
firms and that for not-for-profit
businesses?
Because not-for-profit firms pay no
taxes, there are no tax effects
associated with debt financing.
A not-for-profit firm’s cost of equity,
or cost of fund capital, is much more
controversial than for an investorowned firm.
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What is fund capital?
Not-for-profit firms raise the equivalent
of equity capital, called fund capital, by
retaining profits, receiving government
grants, and receiving private
contributions.
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How is the cost of fund capital
estimated?
The cost of fund capital is an
opportunity cost to the not-for-profit
firm.
It is the return the firm could realize
by investing the capital in securities
of similar risk.
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Is the trade-off theory of capital
structure applicable to not-for-profit
businesses?
Not-for-profit firms’ optimal capital
structures should be based on the
tradeoffs between the benefits and
costs of debt financing.
Not-for-profit firms have about the
same effective costs of debt and
equity as investor-owned firms of
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similar risk.
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The firm’s opportunity cost of fund
capital should rise as more and more
debt is used, and the firm should be
subject to the same financial distress
and agency costs from using debt as
encountered by investor-owned firms.
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Is the asymmetric information theory
applicable to not-for-profit businesses?
The asymmetric information theory is
not applicable to not-for-profit firms,
since they do not issue common stock.
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What problems do not-for-profit
businesses encounter when they attempt
to implement the trade-off theory?
 The major problem is their lack of
flexibility in raising equity capital.
 Not-for-profit firms do not have access to
the typical equity markets. It’s harder for
them to raise fund capital.
 It is often necessary for not-for-profit
firms to delay worthy projects because of
insufficient funding, or to use more than
the theoretically optimal amount of debt.
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Why is capital budgeting important to
not-for-profit businesses?
The financial impact of each capital
investment should be fully understood
in order to ensure the firm’s long-term
financial health.
Substantial investment in unprofitable
projects could lead to bankruptcy and
closure, which obviously would
eliminate the social value provided by
the firm to the community.
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What is social value?
Social value are those benefits realized
from capital investment in addition to
cash flow returns, such as charity care
and other community services.
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How can the net present value method
be modified to include the social value
of proposed projects?
 When the social value of a project is
considered, the total net present value of
the project equals the standard net
present value of the project’s expected
cash flow stream plus the net present
social value of the project.
 This requires the social value of the
project provided over its life to be
quantified and discounted back to Year 0.
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Which of the three project risk
measures--stand-alone, corporate, and
market--is relevant to not-for-profit
businesses?
Corporate risk, or the additional risk
a project adds to the overall
riskiness of the firm’s portfolio of
projects, is the most relevant risk for
a not-for-profit firm, since most notfor-profit firms offer a wide variety of
products and services.
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Stand-alone risk would be relevant
only if the project were the only
one the firm would be involved
with.
Market risk is not relevant at all,
since not-for-profit firms do not
have stockholders.
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What is a corporate beta?
A quantitative measure of corporate
risk.
Measures the volatility of returns on
the project relative to the firm as a
whole.
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How does a corporate beta differ from
a market beta?
A project’s market beta is a similar
quantitative measure of a project’s
market risk, but it measures the
volatility of project returns relative to
market returns.
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How is project risk actually measured
within not-for-profit businesses?
 Not-for-profit firms often use the
project’s stand-alone risk, along with a
subjective notion of how the project fits
into the firm’s other operations, as an
estimate of corporate risk.
 Corporate risk and stand-alone risk
tend to be highly correlated, since most
projects under consideration tend to be
in the same line of business as the
firm’s other operations.
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What are municipal bonds?
 Bonds issued by state and local
governments.
Municipal bonds are exempt from
federal income taxes and state
income taxes in the state of issue.
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How do not-for-profit health care
businesses access the municipal
bond market?
Not-for-profit firms cannot issue
municipal bonds directly to
investors. The bonds are issued
through some municipal health
facilities authority.
The authority acts only as a
conduit for the issuing corporation.
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What is credit enhancement, and what
effect does it have on debt costs?
Credit enhancement is, simply, bond
insurance that guarantees the
repayment of a municipal bond’s
principal and interest.
When issuers purchase credit
enhancement, the bond is rated on
the basis of the insurer’s financial
strength rather than the issuer’s. (More...)
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Because credit enhancement raises
the bond rating, interest costs are
reduced. However, the issuer must
bear the added cost of the bond
insurance.
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What are a not-for-profit business’s
sources of fund capital?
Excess of revenues over
expenses
Charitable contributions
Government grants
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What impact does the inability to issue
common stock have on a not-for-profit
business’s capital structure and
capital budgeting decisions?
The lack of access to equity capital
effectively imposes capital rationing,
so the firm may not be able to undertake all projects deemed worthwhile.
In order to invest in projects considered necessary, the firm may have
to take on more than the optimal
amount of debt capital.
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What unique problems do not-forprofit businesses encounter in
financial analysis and planning and
short-term financial management?
In general these tasks are the same
regardless of the type of ownership.
However, the unique features of notfor-profit organizations--especially
the lack of financial flexibility-creates some minor differences in
implementation.