Financial Management in Not-for-Profit Businesses - HUTECH by hcj


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        CHAPTER 30
    Financial Management in
    Not-for-Profit Businesses

nFor-profit (investor-owned) vs.
 not-for-profit businesses
nGoals of the firm
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      What are the key features of
        investor-owned firms?

nOwners (shareholders) are well
 defined, and they exercise control by
 voting for the firm’s board of directors.
nFirm’s residual earnings belong to the
 owners, so management is responsible
 to the owners for the firm’s
nFirm is subject to taxation at the
 federal, state, and local levels.
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 What is a not-for-profit corporation?

nOne that is organized and operated
 solely for religious, charitable,
 scientific, public safety, literary, or
 educational purposes.
nGenerally, qualify for tax-exempt
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What are the major control differences
    between investor-owned and
     not-for-profit businesses?

nNot-for-profit corporations have no
 shareholders, so all residual earnings
 are retained within the firm.
nControl 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 investor-
 owned and not-for-profit businesses?

nBecause not-for-profit firms have no
 shareholders, they are not concerned
 with the goal of maximizing
 shareholder wealth.
nGoals 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

 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

nBecause not-for-profit firms pay no
 taxes, there are no tax effects
 associated with debt financing.
nA not-for-profit firm’s cost of equity,
 or cost of fund capital, is much more
 controversial than for an investor-
 owned 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
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    How is the cost of fund capital

nThe cost of fund capital is an
 opportunity cost to the not-for-profit
nIt 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
nNot-for-profit firms’ optimal capital
 structures should be based on the
 tradeoffs between the benefits and
 costs of debt financing.
nNot-for-profit firms have about the
 same effective costs of debt and
 equity as investor-owned firms of
 similar risk.                       (More...)
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nThe 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?
n The major problem is their lack of
  flexibility in raising equity capital.
n Not-for-profit firms do not have access to
  the typical equity markets. It’s harder for
  them to raise fund capital.
n 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?

nThe financial impact of each capital
 investment should be fully understood
 in order to ensure the firm’s long-term
 financial health.
nSubstantial 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?
n 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.
n 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

nCorporate 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.               (More...)
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nStand-alone risk would be relevant
 only if the project were the only
 one the firm would be involved
nMarket risk is not relevant at all,
 since not-for-profit firms do not
 have stockholders.
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      What is a corporate beta?

nA quantitative measure of corporate
nMeasures the volatility of returns on
 the project relative to the firm as a
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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?
n 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.
n 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?

n Bonds issued by state and local
n 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?

nNot-for-profit firms cannot issue
 municipal bonds directly to
 investors. The bonds are issued
 through some municipal health
 facilities authority.
nThe 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?

nCredit enhancement is, simply, bond
 insurance that guarantees the
 repayment of a municipal bond’s
 principal and interest.
nWhen 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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nBecause credit enhancement raises
 the bond rating, interest costs are
 reduced. However, the issuer must
 bear the added cost of the bond
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What are a not-for-profit business’s
     sources of fund capital?

nExcess of revenues over
nCharitable contributions
nGovernment 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?
nThe lack of access to equity capital
 effectively imposes capital rationing,
 so the firm may not be able to under-
 take all projects deemed worthwhile.
nIn order to invest in projects con-
 sidered 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-for-
     profit businesses encounter in
  financial analysis and planning and
   short-term financial management?

nIn general these tasks are the same
 regardless of the type of ownership.
nHowever, the unique features of not-
 for-profit organizations--especially
 the lack of financial flexibility--
 creates some minor differences in

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