WHY COST‐REIMBURSED NOT‐FOR‐PROFITS USE DEBT FINANCING DESPITE THE ABSENCE OF TAX INCENTIVES

This paper explains why cost‐reimbursed not‐for‐profits (NFPs) have incentives to use debt financing when purchasing capital assets. When the purchase is internally financed (i.e., through retained earnings), NPV is negative and the NFP lacks incentives for efficient investment. But when financed through debt with reimbursed (‘passed through’) interest, earlier reimbursed depreciation recovery relative to delayed principal costs can lead to positive NPV and excessive reimbursement. This analysis may thus help explain an empirical regularity, namely that NFPs tend to be highly leveraged despite the absence of tax shields or the availability of internal funds. This regularity cannot be explained either by the ‘trade‐off’ or by the ‘pecking order’ theories of capital structure.