Chapter 31
Financial Management in Not-for–Profit Businesses
ANSWERS TO END-OF-CHAPTER QUESTIONS
31-1 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
31-2 No. The asymmetric information theory refers to a preferred “pecking order” of
31-3 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
31-4 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
31-5 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.
31-6 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
31-7 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
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
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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-
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
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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
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-
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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
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
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
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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
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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
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?
Answer: The three major sources of fund capital are (1) the excess of revenues over expenses
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
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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
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