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

A not-for-profit firm’s cost of equity, or cost of fund capital, is much more controversial than for an investor-owned firm.. Not-for-profit firms raise the equivalent of equity capi

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?

One that is organized and operated solely for religious, charitable,

scientific, public safety, literary, or educational purposes.

Generally, qualify for tax-exempt

status.

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?

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.

owned and not-for-profit businesses?

Yes. The WACC estimation for

not-for-profit firms parallels that

for investor-owned firms.

Is the WACC relevant to 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

investor-owned firm.

WACC formula for investor-owned

firms and that for not-for-profit

businesses?

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?

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.

estimated?

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?

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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.

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?

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.

businesses encounter when they

attempt to implement the trade-off

theory?

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?

Social value are those benefits realized from capital investment in addition to cash flow returns, such as charity care and other community services.

 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?

measures stand-alone, corporate, and market is relevant to not-for-profit

businesses?

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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.

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.

A quantitative measure of corporate risk.

Measures the volatility of returns on the project relative to the firm as a

whole.

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?

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.

within not-for-profit businesses?

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?

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.

businesses access the municipal

bond market?

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 )

Because credit enhancement raises the

bond rating, interest costs are reduced However, the issuer must bear the added cost of the bond insurance.

Excess of revenues over

expenses

Charitable contributions

Government grants

What are a not-for-profit business’s

sources of fund capital?

The lack of access to equity capital

effectively imposes capital rationing, so the firm may not be able to under-take all projects deemed worthwhile.

In order to invest in projects con-sidered

necessary, the firm may have to take on more than the optimal amount of debt

capital.

common stock have on a not-for-profit

business’s capital structure and

capital budgeting decisions?

In general these tasks are the same

regardless of the type of ownership.

However, the unique features of

not-for-profit organizations especially the lack of financial flexibility creates

some minor differences in

implementation.

What unique problems do

not-for-profit businesses encounter in financial analysis and planning and short-term financial management?