Financial Management in Not-for-Profit Businesses Chapter 30 Financial Management in Not-for-Profit Businesses

Topics in Chapter For-profit (investor-owned) vs. not-for-profit 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-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.

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 not-for-profit businesses? Yes. The WACC estimation for not-for-profit firms parallels that for investor-owned 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 investor-owned 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-for-Profits 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 con-sidered necessary, the firm may have to take on more than the optimal amount of debt capital.