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For-profit (investor-owned) vs. not-for-profit businesses

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Title: For-profit (investor-owned) vs. not-for-profit businesses


1
CHAPTER 30 Financial Management inNot-for-Profit
Businesses
  • For-profit (investor-owned) vs. not-for-profit
    businesses
  • Goals of the firm

2
What are the key features ofinvestor-owned firms?
  • Owners (shareholders) are well defined, and they
    exercise control by voting for the firms board
    of directors.
  • Firms residual earnings belong to the owners, so
    management is responsible to the owners for the
    firms profitability.
  • Firm is subject to taxation at the federal,
    state, and local levels.

3
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.

4
What are the major control differences between
investor-owned andnot-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.

5
How do goals differ between 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
    firms mission statement. They generally relate
    to providing some socially valuable service in a
    financially sound manner.

6
Is the WACC relevant to not-for-profit businesses?
  • Yes. The WACC estimation for not-for-profit
    firms parallels that for investor-owned firms.

7
Is there any difference between the WACC formula
for investor-owned firms and that for
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 firms cost of equity, or cost
    of fund capital, is much more controversial than
    for an investor-owned firm.

8
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.

9
How is the cost of fund capital estimated?
  • 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.

10
Is the trade-off theory of capital structure
applicable to not-for-profit businesses?
  • 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.

(More...)
11
  • The firms 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.

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 they do
    not issue common stock.

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. Its 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.

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
    firms 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.

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.

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 is considered,
    the total net present value of the project equals
    the standard net present value of the projects
    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.

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 firms
    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...)
18
  • Stand-alone risk would be relevant only 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.

19
What is a corporate beta?
  • A quantitative measure of corporate risk.
  • Measures the volatility of returns on the project
    relative to the firm as a whole.

20
How does a corporate beta differ from a market
beta?
  • A projects market beta is a similar quantitative
    measure of a projects market risk, but it
    measures the volatility of project returns
    relative to market returns.

21
How is project risk actually measured within
not-for-profit businesses?
  • Not-for-profit firms often use the projects
    stand-alone risk, along with a subjective notion
    of how the project fits into the firms 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 of
    business as the firms other operations.

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.

23
How do not-for-profit health care businesses
access the municipalbond market?
  • 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.

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
    bonds principal and interest.
  • When issuers purchase credit enhancement, the
    bond is rated on the basis of the insurers
    financial strength rather than the issuers.

(More...)
25
  • Because credit enhancement raises the bond
    rating, interest costs are reduced. However, the
    issuer must bear the added cost of the bond
    insurance.

26
What are a not-for-profit businesss sources of
fund capital?
  • Excess of revenues over expenses
  • Charitable contributions
  • Government grants

27
What impact does the inability to issue common
stock have on a not-for-profit businesss capital
structure and capital budgeting decisions?
  • 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.

28
What unique problems do not-for-profit businesses
encounter in financial analysis and planning and
short-term financial management?
  • In general these tasks 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.
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