978-1305632295 Chapter 30 Solution Manual

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Chapter 30

Financial Management in Not-for-Profit Businesses

ANSWERS TO END-OF-CHAPTER QUESTIONS

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

30-2 No. The asymmetric information theory refers to a preferred “pecking order” of

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

30-4 a. Without access to tax-exempt debt, all of the benefits to using debt for a not-for-profit

b. No. Managers of not-for-profit firms do not have the same degree of flexibility as

Answers and Solutions: 30 – 1

website, in whole or in part.

30-5 Since not-for-profit businesses are expected to provide a social value in addition to an

To perform this analysis, the social value of a project must be quantified in some

Obviously, such determinations are very subjective. For example, the social value of a

30-6 Since most not-for-profit firms have a myriad of different products or services, a new

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

Answers and Solutions: 30 – 2

website, in whole or in part.

MINI CASE

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

Mini Case: 30 – 3

website, in whole or in part.

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,

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

b. Now consider the cost of capital estimation process.

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

businesses?

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

Mini Case: 30 – 4

website, in whole or in part.

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,

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

Mini Case: 30 – 5

website, in whole or in part.

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

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

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 values 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

Mini Case: 30 – 6

website, in whole or in part.

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

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

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

Mini Case: 30 – 7

website, in whole or in part.

e. Not-for-profit businesses have access to many of the same long-term financing

sources as do investor-owned firms.

e. 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

Not-for-profit health care firms cannot issue municipal bonds directly to investors.

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

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

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

Mini Case: 30 – 8

website, in whole or in part.

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

Mini Case: 30 – 9

website, in whole or in part.