Chapter 30
Financial Management in Not-for-Profit Businesses

30-1 The major difference in ownership structure is that investor-owned firms have well-defined owners, who own stock in the business and exercise control over the firm through the proxy mechanism. Conversely, not-for-profit firms do not have stockholders. Control rests in a board of trustees comprised mostly of community leaders who have no direct economic interest in the firm. Because of this ownership structure difference, the goals of investor-owned and not-for-profit firms are quite different as well.

30-2 No. The asymmetric information theory refers to a preferred "pecking order" of financing by corporate managers, with new common stock being the least preferred because of the negative signals that new stock issues typically send to investors. Since not-for-profit firms have no common stock, this theory is not applicable.

30-3 No. The break in an investor-owned firm's MCC schedule is due to the higher cost involved with issuing new common stock once the firm's retained earnings has been exhausted. Since not-for-profit firms do not have common stock, there are no such breaks in their MCC schedules. In fact, all of a not-for-profit firm's fund capital, which includes retained earnings, grants from government entities, and private contributions, have a common opportunity cost to the firm, which is the return that could be expected from investing in the stock of a similar type investor-owned company.

30-4 a. Without access to tax-exempt debt, all of the benefits to using debt for a not-for-profit firm would disappear. Thus, in accordance with MM capital structure theory, and considering financial distress and agency costs related to debt, the firm's optimal capital structure would be zero debt.

b. No. Managers of not-for-profit firms do not have the same degree of flexibility as investor-owned firms in raising equity capital. Thus, it is often necessary for not-for-profit firms to use more than the theoretically optimal amount of debt when new fund capital cannot be obtained for needed services.

30-5 Since not-for-profit businesses are expected to provide a social value in addition to an economic benefit, project analysis must consider social value along with expected cash flows. The summation of a project's net present social and cash flow values is its total net present value (TNPV). If the TNPV is ? 0, then the project is deemed acceptable.
To perform this analysis, the social value of a project must be quantified in some manner for each year of the project's life, and then discounted back to Year 0. This requires the not-for-profit firm to quantify the social value of the services provided by the project in each year, and to determine the discount rate that is to be applied to those services.
Obviously, such determinations are very subjective. For example, the social value of a service could vary based on who benefits from it. The proper discount rate for a social value stream is also a controversial topic. While few organizations attempt to quantify these benefits, not-for-profit organizations should attempt to do so when evaluating proposed projects given their social-benefit orientation.

30-6 Since most not-for-profit firms have a myriad of different products or services, a new project's contribution to the riskiness of the overall firm's portfolio of projects, or its corporate risk, is the most relevant risk. Stand-alone risk would be relevant if the firm had only one project. Market risk does not apply to not-for-profit firms since shareholder wealth maximization is not their primary goal.

30-7 No. If perfect information existed, then all potential buyers and bond insurance companies would have the same full knowledge of the risks inherent in the not-for-profit firm's bond. Accordingly, an equilibrium rate would be established for the firm's bond based on this risk. Since no asymmetric information exists within the market, it would not be possible to obtain rates lower than this equilibrium level. Even if the not-for-profit firm purchased insurance to obtain AAA bond rates, the insurance company would charge a fee which effectively would eliminate this interest savings. Thus, under an efficient information scenario, the savings in interest provided by the insurance would be exactly offset by the fee required by the insurer.


Sandra McCloud, a finance major in her last term of college, is currently scheduling her placement interviews through the university's career resource center. Her list of companies is typical of most finance majors: several commercial banks, a few industrial firms, and one brokerage house. However, she noticed that a representative of a not-for-profit hospital is scheduling interviews next week, and the position--that of financial analyst--appears to be exactly what Sandra has in mind. Sandra wants to sign up for an interview, but she is concerned that she knows nothing about not-for-profit organizations and how they differ from the investor-owned firms that she has learned about in her finance classes. In spite of her worries, Sandra scheduled an appointment with the hospital representative, and she now wants to learn more about not-for-profit businesses before the interview.
To begin the learning process, Sandra drew up the following set of questions. See if you can help her answer them.

a. First, consider some basic background information concerning the differences between not-for-profit organizations and investor-owned firms.

1. What are the key features of investor-owned firms? How do a firm's owners exercise control?

Answer: Investor-owned firms have three primary characteristics: (1) the owners (shareholders) of the firm are well defined, and they exercise control by voting for the firm's board of directors; (2) the firm's residual earnings belong to the owners, so management is responsible to this single, well-defined group for the firm's profitability; and (3) the firm is subject to taxation at the federal, state, and local levels.

a. 2. What is a not-for-profit corporation? What are the major control differences between investor-owned and not-for-profit businesses?

Answer: A not-for-profit corporation is one that is organized and operated solely for religious, charitable, scientific, public safety, literary, or educational purposes. Generally, not-for-profit firms qualify for tax-exempt status. Not-for-profit corporations differ from investor-owned corporations in that they have no shareholders, and hence 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.

a. 3. How do goals differ between investor-owned and not-for-profit businesses?

Answer: Since not-for-profit firms have no shareholders, they are not concerned with the goal of maximizing shareholder wealth as are investor-owned firms. The goals of not-for-profit firms are usually outlined in the mission statement of the firm, and they generally relate to providing some socially valuable service in a financially sound manner.

b. Now consider the cost of capital estimation process.

1. Is the weighted average cost of capital (WACC) relevant to not-for-profit businesses?

Answer: Yes. In general, the WACC estimation for not-for-profit firms parallels that for investor-owned firms.

b. 2. Is there any difference between the WACC formula for investor-owned firms and that for not-for-profit businesses?

Answer: There are two major differences. First, since not-for-profit firms pay no taxes, there are no tax effects associated with debt financing. Second, a not-for-profit firm's cost of equity, or cost of fund capital, is much more controversial than for investor-owned firms.

b. 3. What is fund capital? How is the cost of fund capital estimated?

Answer: Unlike investor-owned firms that raise equity capital by selling new common shares and retaining earnings, not-for-profit firms raise the equivalent of equity capital, called fund capital, by retaining profits, receiving government grants, and receiving private contributions. The cost of fund capital is an opportunity cost to the not-for-profit firm; namely, the return the firm could realize by investing the capital in securities of similar risk. For example, the opportunity cost of fund capital to a not-for-profit hospital would be the return it could realize by investing in the securities of a comparable investor-owned hospital.

c. Just as in investor-owned firms, not-for-profit businesses use a mix of debt and equity (fund) financing.

1. Is the trade-off theory of capital structure applicable to not-for-profit businesses? What about the asymmetric information theory?

Answer: As with investor-owned firms, not-for-profit firms' optimal capital structures should also 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 (since they have access to the tax-exempt debt market) and equity as investor-owned firms of similar risk. Thus, we would expect the trade-off theory of capital to be equally applicable to not-for-profit firms; 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.
The asymmetric information theory, however, is not applicable to not-for-profit firms, since they do not issue common stock.

c. 2. What problem do not-for-profit businesses encounter when they attempt to implement the trade-off theory?

Answer: The major problem encountered by not-for-profit firms in implementing the trade-off theory is their lack of flexibility in raising equity capital. Not-for-profit firms do not have access to the typical equity markets. Thus, it's harder for them to raise fund capital, via government grants and private contributions, than it is for investor-owned firms to issue new common stock. As a consequence, 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.

d. Consider the following questions relating to capital budgeting decisions.

1. Why is capital budgeting important to not-for-profit businesses?

Answer: Capital budgeting is important to not-for-profit firms because 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.

d. 2. What is social value? How can the net present value method be modified to include the social value of proposed projects?

Answer: Social value are those benefits realized from capital investment in addition to cash flow returns, such as charity care and other community services. 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. This requires the social value of the project provided over its life to be quantified and discounted back to year 0. There is much subjectivity in this process, but it is prudent for not-for-profit businesses to consider the net present social value of projects under consideration as part of their standard capital budgeting procedures.

d. 3. Which of the three project risk measures--stand-alone, corporate, and market--is relevant to not-for-profit businesses?

Answer: Corporate 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. Stand-alone risk would only be relevant 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.

d. 4. What is a corporate beta? How does it differ from a market beta?

Answer: The corporate beta is a quantitative measure of corporate risk; it is the slope of the corporate characteristic line, which is the regression line that results when the project's returns are plotted on the y axis and the returns on the firm's total operations are plotted on the x axis. A project's corporate beta measures the volatility of returns on the project relative to the firm as a whole (or relative to the firm's average project, which has a beta of 1.0). 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 returns on the market.

d. 5. In general, how is project risk actually measured within not-for-profit businesses? How is project risk incorporated into the decision process?

Answer: In most instances, it is very difficult to develop accurate assessments of a project's corporate risk. Thus, 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. This practice is not inappropriate. 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. Thus, incorporation of risk into investment decisions is a somewhat subjective process but nonetheless is one that should be conducted.

e. Not-for-profit businesses have access to many of the same long-term financing sources as do investor-owned firms.

1. What are municipal bonds? How do not-for-profit health care businesses access the municipal bond market?

Answer: Municipal bonds are bonds issued by state and local governments. The primary difference between municipal bonds and corporate or treasury bonds is that municipal bonds are exempt from federal income taxes and state income taxes in the state of issue.
Not-for-profit health care firms cannot issue municipal bonds directly to investors. Rather, the bonds are issued through some municipal health facilities authority. The authority has no obligation regarding the payment of principal or interest, but acts only as a conduit for the issuing corporation.

e. 2. What is credit enhancement, and what effect does it have on debt costs?

Answer: Credit enhancement is, simply, bond insurance that guarantees the repayment of a municipal bond's principal and interest. When issuers purchase credit enhancement from insurers, the bond is rated on the basis of the insurer's financial strength rather than the issuer's. Since credit enhancement raises the bond rating, interest costs are reduced. However, the issuer must bear the added cost of the bond insurance.

e. 3. What are a not-for-profit business's sources of fund capital?

Answer: The three major sources of fund capital are (1) the excess of revenues over expenses (retentions), (2) charitable contributions, and (3) government grants.

e. 4. What impact does the inability to issue common stock have on a not-for-profit business's capital structure and capital budgeting decisions?

Answer: The inability to issue common stock has a significant impact on a not-for-profit firm's financial flexibility. First, the lack of access to equity capital effectively imposes capital rationing, so the firm may not be able to undertake all projects deemed worthwhile. Second, in order to invest in projects considered necessary, the firm may have to take on more than the optimal amount of debt capital.

f. What unique problems do not-for-profit businesses encounter in financial analysis and planning? What about short-term financial management?

Answer: In general, financial analysis and planning, as well as short-term financial management, 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.