Financial Management in Not-for-Profit Businesses - Faculty

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					Chapter 30

    Financial Management in
    Not-for-Profit Businesses
Topics in Chapter
n   For-profit (investor-owned) vs. not-for-
    profit businesses
n   Goals of the firm
What are the key features of
investor-owned firms?
n   Owners (shareholders) are well defined,
    and they exercise control by voting for
    the firm’s board of directors.
n   Firm’s residual earnings belong to the
    owners, so management is responsible
    to the owners for the firm’s profitability.
n   Firm is subject to taxation at the
    federal, state, and local levels.
What is a not-for-profit
n   One that is organized and operated
    solely for religious, charitable, scientific,
    public safety, literary, or educational
n   Generally, qualify for tax-exempt status.
Investor-Owned vs. Not-for-
Profit Businesses
n   Not-for-profit corporations have no
    shareholders, so all residual earnings
    are retained within the firm.
n   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.
Goals for Investor-Owned and
Not-for-Profit Businesses
n   Because not-for-profit firms have no
    shareholders, they are not concerned with
    the goal of maximizing shareholder wealth.
n   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.
Is the WACC relevant to not-
for-profit businesses?
n   Yes. The WACC estimation for not-for-
    profit firms parallels that for investor-
    owned firms.
WACC for Investor-Owned and
Not-for-Profit Businesses
n   Because not-for-profit firms pay no
    taxes, there are no tax effects
    associated with debt financing.
n   A not-for-profit firm’s cost of equity, or
    cost of fund capital, is much more
    controversial than for an investor-
    owned firm.
What is fund capital?
n   Not-for-profit firms raise the equivalent
    of equity capital, called fund capital, by
    retaining profits, receiving government
    grants, and receiving private
n   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.
Implementation Problems with
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.
Capital Budgeting for Not-for-
n   The financial impact of each capital
    investment should be fully understood in
    order to ensure the firm’s long-term financial
n   Substantial investment in unprofitable
    projects could lead to bankruptcy and
    closure, which obviously would eliminate the
    social value provided by the firm to the
What is social value?
n   Social value are those benefits realized
    from capital investment in addition to
    cash flow returns, such as charity care
    and other community services.
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.
n   “Roll overs”
Not-for-Profit Health Care and
Municipal Bonds
n   Not-for-profit firms cannot issue
    municipal bonds directly to investors.
    The bonds are issued through some
    municipal health facilities authority.
n   The authority acts only as a conduit for
    the issuing corporation.
Sources of Fund Capital
n   Excess of revenues over expenses
n   Charitable contributions
n   Government grants
Impact of Non-access to
Equity Markets
n   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.
n   In 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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