FM11 Ch 30 Financial Management in Not-for-Profit Businesses

30 - 1  For-profit (investor-owned) vs. not-for-profit businesses  Goals of the firm CHAPTER 30 Financial Management in Not-for-Profit Businesses 30 - 2  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 are the key features of investor-owned firms? 30 - 3  One that is organized and operated solely for religious, charitable, scientific, public safety, literary, or educational purposes.  Generally, qualify for tax-exempt status. What is a not-for-profit corporation? 30 - 4  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. What are the major control differences between investor-owned and not-for-profit businesses? 30 - 5  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. How do goals differ between investor- owned and not-for-profit businesses? 30 - 6 Yes. The WACC estimation for not-for-profit firms parallels that for investor-owned firms. Is the WACC relevant to not-for-profit businesses? 30 - 7  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. Is there any difference between the WACC formula for investor-owned firms and that for not-for-profit businesses? 30 - 8 Not-for-profit firms raise the equivalent of equity capital, called fund capital, by retaining profits, receiving government grants, and receiving private contributions. What is fund capital? 30 - 9  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. How is the cost of fund capital estimated? 30 - 10  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. Is the trade-off theory of capital structure applicable to not-for-profit businesses? (More ) [...]... insufficient funding, or to use more than the theoretically optimal amount of debt 30 - 14 Why is capital budgeting important to not-for-profit businesses?  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... 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 30 - 28 What unique problems do not-forprofit businesses encounter in financial analysis and planning and short-term financial management?  In general these tasks are.. .30 - 11  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 30 - 12 Is the asymmetric information theory applicable to not-for-profit businesses? The asymmetric information theory is not applicable to not-for-profit firms, since... bond rating, interest costs are reduced However, the issuer must bear the added cost of the bond insurance 30 - 26 What are a not-for-profit business’s sources of fund capital?  Excess of revenues over expenses  Charitable contributions  Government grants 30 - 27 What impact does the inability to issue common stock have on a not-for-profit business’s capital structure and capital budgeting decisions?... same line of business as the firm’s other operations 30 - 22 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 30 - 23 How do not-for-profit health care businesses access the municipal bond market?  Not-for-profit firms cannot issue municipal bonds directly to investors The bonds... conduit for the issuing corporation 30 - 24 What is credit enhancement, and what effect does it have on debt costs?  Credit enhancement is, simply, bond insurance that guarantees the repayment of a municipal bond’s principal and interest  When issuers purchase credit enhancement, the bond is rated on the basis of the insurer’s financial strength rather than the issuer’s (More ) 30 - 25  Because credit... 30 - 21 How is project risk actually measured within not-for-profit businesses?  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  Corporate risk and stand-alone risk tend to be highly correlated, since most projects under consideration tend to be in the same line... to Year 0 30 - 17 Which of the three project risk measures stand-alone, corporate, and market is relevant to not-for-profit businesses?  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 (More ) 30 - 18 ... stock 30 - 13 What problems do not-for-profit businesses encounter when they attempt to implement 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... obviously would eliminate the social value provided by the firm to the community 30 - 15 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 30 - 16 How can the net present value method be modified to include the social value of proposed projects?  When the social value of a project . 30 - 1  For-profit (investor-owned) vs. not-for-profit businesses  Goals of the firm CHAPTER 30 Financial Management in Not-for-Profit Businesses 30 - 2  Owners (shareholders). investor- owned and not-for-profit businesses? 30 - 6 Yes. The WACC estimation for not-for-profit firms parallels that for investor-owned firms. Is the WACC relevant to not-for-profit businesses? 30. theory? 30 - 14  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