Financial Management in Not-for-Profit Businesses

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Chapter 31

• Financial Management inNot-for-Profit Businesses

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Topics in Chapter

• For-profit (investor-owned) vs. not-for-profit
  businesses
• Goals of the firm

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What are the key features ofinvestor-owned firms?

• Owners (shareholders) are well defined, and they
  exercise control by voting for the firms board
  of directors.
• Firms residual earnings belong to the owners, so
  management is responsible to the owners for the
  firms 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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Investor-Owned vs. 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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Goals for 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
  firms 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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WACC for Investor-Owned and 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 firms 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 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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Trade-off Theory of Capital Structure and
Not-for-Profits

• 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.

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• The firms 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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Asymmetric Information Theory and Not-for-Profits

• The asymmetric information theory is not
  applicable to not-for-profit firms, since they do
  not issue common stock.

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Implementation Problems with 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. Its 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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Capital Budgeting for Not-for-Profits

• The financial impact of each capital investment
  should be fully understood in order to ensure the
  firms 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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NPV and Social Value

• 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 projects
  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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Project Risk and Not-for-Profits

• Corporate risk, or the additional risk a project
  adds to the overall riskiness of the firms
  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.

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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 projects market beta is a similar quantitative
  measure of a projects market risk, but it
  measures the volatility of project returns
  relative to market returns.

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Measuring Project Risk at Not-for-Profits

• Not-for-profit firms often use the projects
  stand-alone risk, along with a subjective notion
  of how the project fits into the firms 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 firms 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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Not-for-Profit Health Care and 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.

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Credit Enhancement and the Cost of Debt

• Credit enhancement is, simply, bond insurance
  that guarantees the repayment of a municipal
  bonds principal and interest.
• When issuers purchase credit enhancement, the
  bond is rated on the basis of the insurers
  financial strength rather than the issuers.

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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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Sources of Fund Capital

• Excess of revenues over expenses
• Charitable contributions
• Government grants

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Impact of Non-access to Equity Markets

• 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.

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Financial Analysis, Planning and Working Capital
Management

• 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.