Chapter 30 Financial Management in Not-for-Profit Businesses

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Chapter 30
Financial Management in
Not-for-Profit Businesses
Topics in Chapter


For-profit (investor-owned) vs. not-forprofit businesses
Goals of the firm
What are the key features of
investor-owned firms?



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 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.
Investor-Owned vs. Not-forProfit 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.
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 firm’s mission statement. They generally
relate to providing some socially valuable
service in a financially sound manner.
Is the WACC relevant to notfor-profit businesses?

Yes. The WACC estimation for not-forprofit firms parallels that for investorowned firms.
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 firm’s cost of equity, or
cost of fund capital, is much more
controversial than for an investorowned firm.
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.

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



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.
Capital Budgeting for Not-forProfits


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.
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.
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.
“Roll overs”
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.
Sources of Fund Capital



Excess of revenues over expenses
Charitable contributions
Government grants
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 considered necessary, the firm may have to
take on more than the optimal amount
of debt capital.
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