In both types of organizations, it’s become a more visible and important component of the strategic planning process. FP&A professionals’ involvement in capital budgeting and planning is critical and, if performed effectively, helps to narrow the gap between strategic planning and execution. Traditional capital project appraisal techniques are based on discounted cash flow (DCF) analysis, where weighted average cost of capital (WACC) is a key factor. Small fluctuations in cost of capital can create huge swings in discounted cash flow figures strongly affecting strategic decisions about future capital investments and acquisitions.
WACC calculations are based on the cost of debt and equity. That’s relatively straightforward for publicly traded companies. It’s a lot less so for nonprofits; they frequently don’t have debt and never have equity.
That was the conundrum faced by Brenda Hodo-Iddris, director of corporate finance and business strategy for nonprofit education organization Step Up for Students, when she set out on a quest to up FP&A’s game on how to help her organization make smarter decisions on investing its funds.
According to Hodo-Iddris, a couple of drivers prompted Step Up for Students to start looking at how to calculate WACC:
- First, the nearly half-a-billion dollar organization was reaching a certain level of maturity where it needed a robust measure to help make investment and capital expenditure decisions. “We have a sophisticated business model that requires high-level analytics,” Hodo-Iddris said. “We look at ROI, capital models and NPV,” she said. “It’s customary to lay WACC on top of that.”
- Second, as part of a new fundraising effort, the organization began to receive more multiyear grants that required the finance team to discount the cash flow to net present value and incorporate a WACC component. But the organization faced a common hurdle for nonprofit institutions: It didn’t have debt and it didn’t have equity. So what could it do?
The key to calculating WACC for a nonprofit is figuring out what to use to mimic the cost of debt and equity.
One way to consider the cost of debt is to look at similar nonprofits that have outstanding debt and use their debt cost, according to the CFO of one nonprofit. But it’s important to remember that “nonprofits don’t pay tax, so there is no tax effect (benefit) related to the debt component of the capital structure,” he said.
As to the cost of equity, his organization refers to “fund capital,” which is capital from retained earnings, contributions, and/or grants. “The cost of fund capital can be thought of as an opportunity cost; approximated by the return the nonprofit could realize if it were invested in securities of similar risk,” this CFO explained. “A nonprofit’s opportunity cost of fund capital should increase as more debt is used (more debt generally increases risk of financial distress; generally similar to expectation for investor-owned firms).
According to Tony Relvas, director, EPM Transformation at The Hackett Group, for nonprofits, the cost of debt is a little more straightforward. If an organization has debt, “they can use their current cost of servicing the debt as the starting basis rate for WACC. If they don’t, they can use publicly traded organizations as a proxy.”
The hard part is trying to figure out the equity component. They can start the process by examining the return on investment capital, i.e., what is the required rate of return. If a nonprofit board of directors has a mandate that an organization annually return $1 million of its assets through scholarships or other various charitable avenues and its assets base (i.e. invested capital) is $10 million, requiring a 10 percent annual return. “That works most easily for foundations whose purpose is to generate income, and less easily for institutions whose goal is to invest their funds in developing health or education programs,” Relvas said. “Those kinds of institutions should look at their operating budget and given X annual budget figure out that they should be putting in play X percent of that capital and keeping X percent in revenue to continue to operate so that they can continue to pay what they’ve committed to pay based on their mission.”
“If you’re only looking at the lower rate of return, you run the risk of making the wrong kinds of investments,” Relvas cautioned. “Organizations need to think about reaching a higher rate of return to make the right investment decisions to maximize the return on any given grant.” Unlike for-profit companies, they’re not responsible to shareholders and the public, they are responsible to the donors. The donors need to see that they are making the right choices to make their investments sustainable overtime. “While you don’t have the market to answer to, you still have the opportunity cost of not having invested in better projects,” Relvas said.