FM11 Ch 30 Financial Management in Not-for-Profit Businesses

30 - 1

For-profit (investor-owned) vs.
not-for-profit businesses

Goals of the firm
CHAPTER 30
Financial Management in
Not-for-Profit Businesses
30 - 2

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.
What are the key features of
investor-owned firms?
30 - 3

One that is organized and operated
solely for religious, charitable,
scientific, public safety, literary, or
educational purposes.

Generally, qualify for tax-exempt

status.
What is a not-for-profit corporation?
30 - 4

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.
What are the major control differences
between investor-owned and
not-for-profit businesses?
30 - 5

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.
How do goals differ between investor-
owned and not-for-profit businesses?
30 - 6

Yes. The WACC estimation for
not-for-profit firms parallels that
for investor-owned firms.
Is the WACC relevant to not-for-profit
businesses?
30 - 7

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 investor-
owned firm.
Is there any difference between the
WACC formula for investor-owned
firms and that for not-for-profit
businesses?
30 - 8
Not-for-profit firms raise the equivalent
of equity capital, called fund capital, by
retaining profits, receiving government
grants, and receiving private
contributions.
What is fund capital?
30 - 9

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.
How is the cost of fund capital
estimated?
30 - 10

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
similar risk.
Is the trade-off theory of capital
structure applicable to not-for-profit
businesses?
(More )
30 - 11

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.

30 - 12
The asymmetric information theory is not
applicable to not-for-profit firms, since
they do not issue common stock.
Is the asymmetric information theory
applicable to not-for-profit businesses?
30 - 13

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.
What problems do not-for-profit
businesses encounter when they
attempt to implement the trade-off
theory?
30 - 14

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.
Why is capital budgeting important to
not-for-profit businesses?
30 - 15
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.
30 - 16

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.
How can the net present value method
be modified to include the social value
of proposed projects?
30 - 17
Which of the three project risk
measures stand-alone, corporate, and

market is relevant to not-for-profit
businesses?
(More )

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 not-for-profit firms offer
a wide variety of products and services.
30 - 18

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.
30 - 19

A quantitative measure of corporate
risk.

Measures the volatility of returns on
the project relative to the firm as a
whole.
What is a corporate beta?
30 - 20
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.
How does a corporate beta differ from
a market beta?
30 - 21

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.
How is project risk actually measured
within not-for-profit businesses?
30 - 22

Bonds issued by state and local
governments.

Municipal bonds are exempt from
federal income taxes and state
income taxes in the state of issue.
What are municipal bonds?
30 - 23


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.
How do not-for-profit health care
businesses access the municipal
bond market?
30 - 24

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 )
30 - 25

Because credit enhancement raises the
bond rating, interest costs are reduced.
However, the issuer must bear the added

cost of the bond insurance.