Financial Management in Not-for-Profit Businesses
ANSWERS TO END-OF-CHAPTER QUESTIONS
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.
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.
not-for-profit firms have no common stock, this theory is not applicable.
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
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.
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.
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.
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
Obviously, such determinations are very subjective. For example, the social value of