cost of capital for farm entities: an application to farms in ......typically, the cost of capital...
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Cost of Capital for Farm Entities: An Application to Farms in Southwestern,
Minnesota Farms 2004-2007
Ryan Statz
Abstract
This paper introduces and analyzes the cost of capital theory and its importance in traditional financial management. We discuss its role, importance, and different approaches in determining an appropriate cost of capital for farm entities in Southwestern, Minnesota using FinBin data from 2004‐2007. The approaches outlined in this report can be expanded upon for use in the cost of capital identification for any business entity.
AgStar Scholar Research Report Department of Applied Economics
University of Minnesota August 2009
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The Cost of Capital Concept
Financial management is an integral part of managing any type of business or
organization. The quality of financial management can be the difference between a
thriving business with growth potential and a digressing business on its way to
collapsing. Financial managers play an important role in determining the cost of capital.
Understanding the cost of capital and how it might be determined is the primary
objective of this paper.
Typically, the cost of capital is defined as, “the opportunity cost of an investment
or the rate of return that a company would otherwise be able to receive at the same
level of risk as the investment that has been selected.” (Investorwords.com, 2009).
Therefore, the cost of capital is both a measure that a company can use to evaluate its
financial performance, and an indicator of the cost of financial resources that the
company is using. It is important that businesses know their cost of capital.
Broadly speaking, business assets are financed typically by a combination of debt
capital and equity capital. Therefore, the corresponding cost of debt and the cost of
equity are components of the overall cost of capital of a business. In many cases the
cost of capital is defined as the weighted average after‐tax cost of capital (WACC). That
is, the weighted average cost of debt capital and cost of equity capital. This would be
the appropriate cost of capital to use when discounting the cash flows of an investment
project that is financed using debt and equity in proportions that reflect the overall
market value capital structure of the firm.1
1 Many capital budgeting applications utilize the cost of capital to assess the Net Present Value (NPV) of the prospective investment. The NPV process includes forecasting the incremental cash flows of the project and discounting those cash flows using the appropriate cost of capital. Depending on how the cash flows are defined, one would use the cost of equity capital, or the cost of debt capital, or the WACC to discount the cash flows to their present values. The present values are summed and if the sum is greater than the costs of the project, the project is profitable.
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The cost of capital is a vital financial and economic concept because of the
multiple roles it plays in discounting the cash flows of a business. Ideally, it captures
both the time costs of money and the risk premiums that investors require on their
investments. For example, the cost of capital can be used 1) to identify and analyze
profitable and financially feasible capital investment projects, 2) to evaluate the
alternative uses of cash (i.e., investments in new or replacement operations or
production assets, dividend payouts, stock repurchases, etc.), 3) to compare and analyze
alternative financing and capital structure strategies, 4) to evaluate merger and
acquisition opportunities, and 5) to assess value of a firm.
Approaches to Determining the Cost of Capital
When determining the cost of capital, one can take either an informal approach
or a formal approach to the problem. An informal approach is sometimes used when
the financial manager has a great deal of experience in the particular business or
industry setting. The manager uses “sound judgment” and insight to make subjective
estimates that are thought to closely reflect the opportunity cost of financial resources.
The formal and informal approaches to determining the cost of capital can differ to a
high degree and this can add uncertainty when assessing the overall financial standing
of a business. While the formal approach to the cost of capital problem can be difficult,
time consuming, and in some cases lead to incomplete information, the process of doing
so allows financial managers to ask “the right questions” and become more aware of the
range of issues or factors that could play a role in future financial decisions. In addition,
using a formal approach leads to a value that uses both the actual cost of debt and the
cost of equity versus simply using “sound judgment” or intuitively determining the costs
of debt and equity capital.
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Informal approaches may be preferred in cases where the financial manager
lacks, lacks critical financial information, the cash flows are difficult to forecast, or
possibly because the cost of capital is just difficult to determine. Informal approaches to
determining the cost of capital arise for a number of reasons, but possibly the primary
reason is the fact that the cost of capital can be difficult to calculate, particularly the
cost of equity portion. As a result, informal approaches to determining the cost of
capital eventually lead to many financial decisions being made subjectively.
A formal approach to the cost of capital problem relies more heavily on
objectively determined, market price data. For a publically traded company the cost of
equity can be directly derived using this publically known capital market information.
Yet, while the formal method reduces the level of subjectivity, there is no general
consensus on how the cost of equity capital should be derived for nontraded companies
where the current market price per share of equity capital is not available. Farm equity
is not traded, so an objective market‐based measure of the value of equity (price per
share) does not exist. Even when market price data is used, additional assumptions may
need to be made about future earnings in traded and in nontraded companies, since the
growth of earnings is a key determinant in most “growth models” that are used in the
formal approach. Because of this, the true cost of equity for a nontraded business can
be more difficult to derive and alternative means of calculating a reasonable estimate
must be devised.
The remaining sections of this report will outline and describe two approaches
that can be used to determine an appropriate cost of equity for nontraded firms,
particularly farms. The report will examine and analyze two formal approaches – the
discounted cash flow (DCF) method, and the opportunity cost of funds (OCF) method,
we will illustrate how each might be used to determine the appropriate overall cost of
capital.
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Opportunity Cost of Funds (OCF) Method
Because of the problems cited in regards to determining the cost of equity
capital for non‐publically traded firms, many operations that fall under this category
have relied on the OCF method to assist in their cost of equity calculation. The OCF
approach focuses on identifying the costs and returns on investment alternatives. That
is, the cost of equity capital would be related to the alternative uses of capital or
investment opportunities that fall into the same industry and a similar risk level as the
investment at hand.
The OCF differs from the traditional DCF approach. The DCF approach focuses on
the right hand side of the balance sheet, which indicates the proportions of debt and
equity capital. Stated another way, the DCF approach tends to focus on the alternative
sources of capital and their costs, and the OCF approach focuses on the alternative uses
and their rates of return.
The OCF approach is significant because it emphasizes and spotlights the
characteristics of the asset and the uncertainty of the net returns the investment will
bring in over the course of the project’s life. Assessing the relative risk level of an
investment project can be a bit of a concern, but many financial managers have enough
experience and knowledge in the industry to complete the analysis. In other cases
information regarding the risk class on alternative capital usually can be obtained by
viewing information regarding similar projects or similar industry firms.
Indeed, there is a degree of subjectivity in using the OCF approach. However,
the degree of subjectivity is much smaller in relation to many of the alternative informal
approaches. Subjectivity in this approach can arise in determining and identifying what
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is believed to be an acceptable rate of return or in how one determines what is similar.
Determining the rate of return can depend and be a combination of a variety of factors
depending on the industry and the investment at hand. If someone wishes to use this
method and accepts the fact that there is a slight degree on subjectivity, the next step
would be to identify the rate of return. Once an acceptable rate of return (the hurdle
rate) has been established, the process is very straight forward. The rate of return is
then compared with the calculated internal rates of return on the investments and the
acceptable projects are identified.
The advantages to using this approach are that it is relatively easy to use and
implementation can be made to any financial analysis plan. In addition, it allows for
other criteria to be analyzed and eventually entered into the final decision regarding
which projects are acceptable and which are not.
Discounted Cash Flow (DCF) Method
By using observed current dividend and market price data and estimates of what
investors expect as the future rate of dividend growth, the DCF method is a market‐
based approach to estimating the cost of capital. Because the current market price per
share of equity capital is not available for nontraded firms, the model requires different
assumptions to be made regarding the expected growth of earnings and dividends.
However, in doing so the model will allow for modification to account for different
growth indicators and varying growth in the future.
Using this method, the cost of equity is defined as the sum of the dividend yield
and growth rate of share price. The traditional constant growth model for calculating
the cost of equity (ke) is,
Ke = (Div1 / P0) + gD
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where Div1 is the dividend one year later, P0 is the price per share today, and gD is the
expected annual growth of dividends.
The long‐run growth rate for earnings can be derived from the forecasted
profitability and growth of cash flows. Then, assuming a constant expected dividend
payout rate, the rate of growth of dividends can be approximated by the rate of growth
of earnings. Thus, the sustainable growth rate is one measure we can use to estimate
the growth rate of dividends (gd).
The sustainable growth rate is the maximum rate of growth a company can
maintain without changing their debt‐equity ratio or financial leverage position. The
sustainable growth rate is used because in many cases, changing financial leverage
positions (especially adding new equity) can be expensive. We define the sustainable
growth rate gs as,
(gs) = (ROE * b) / (1 – ROE * b)
where ROE is the return on equity and is calculated by dividing net income by
shareholders equity. The variable b is the retention rate and is equal to 1 minus the
dividend payout rate (the fraction of annual earnings retained by the company).
By using the sustainable growth rate as the dividend rate (gd), the constant DCF
method can be used with an observed stock price to derive an estimate of the cost of
equity capital Ke.
Ke = (Div1 / P0) + gs = (Div1 / Po) + [(ROE * b) / (1 – ROE * b)]
A Hypothetical Example
With the following assumptions, we could use the DCF method to calculate the
cost of equity. Let’s assume:
A company is expected to pay out $0.75/share 1 year from today and the book
value is currently $10/share.
The company expects a 17% return on equity (ROE = .17)
The company follows a constant 40% dividend payout policy (b = (1 ‐.40) = .60)
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Then, Ke = ($.75 / $10) + (.17 X .60) / (1 – .17 X.60) = .1886 = 18.86%
It is important to note that calculating the cost of equity capital is only half the
solution in estimating the overall cost of capital for the firm. The average cost of capital
(WACC) is the weighted average after‐tax costs of debt and equity capital. The weights
reflect the percentages of the market value of debt and equity in the capital structure of
the firm. That is,
WACC = Kd X (D/ (D+E)) + Ke X (E/ (D+E))
where Kd is the after‐tax cost of debt, (D/(D+E)) is the proportion of debt in the overall
total capital structure, Ke is the cost of equity capital, and (E/(D+E)) is the proportion of
equity in the overall total capital structure2. Using the hypothetical figures from above,
we also assume that the proportion of debt capital is 40% of the total capitalization and
the after‐tax cost of debt is 6%. Using the cost of equity capital calculated from above
(18.86%), the WACC is 13.72%.
WACC = (.06 * .40) + (.1886 * .60) = .1372 => 13.72%
Applying the DCF Approach to Agriculture
Because the DCF approach relies on information that can be obtained directly
from companies financial statements, it provides us with an alternative method in
determining the cost of equity capital for nontraded companies. Thus, we will utilize
this approach in calculating and analyzing the cost of equity capital for Southwestern
Minnesota farms. The Southwestern region includes counties: Cottonwood, Jackson,
Lincoln, Lyon, Martin, Murray, Nobles, Pipestone, Redwood, Rock, and Yellow Medicine.
Appendix I illustrates Median Net Farm Income by region. While farm earnings
improved in every region from 2006 to 2007, the Southwestern Region followed the
2 Note that, (D / D+E) + (E / D+E) = 1
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reoccurring trend from 2006, and again led all regions with the highest median earnings
in 2007.
Our constant growth equation states that the cost of equity capital is the sum of
expected dividend rate of return (or yield) and the sustainable growth rate,
Ke = (Div1 / P0) + gs
However, because farms don’t conceptually work the same traded other firms do, they
don’t have traditional dividends or farm stock from which we can obtain an observed
share price, the equation must be manipulated to work around our three constraints.
Although farms do not pay out traditional dividends, by employing a few
assumptions a dividend yield can still be calculated. A modification can be made to our
constant growth model to reflect the dividend yield estimate. The dividend yield is
calculated as:
Dividend Yield (Div / Po) = [(1 – Retention Rate) * Net Income] / (Market Value
of Equity) In this case we can assume that [(1 – Retention Rate) * Net Income], is the farm’s
hypothetical dividend had there been a dividend paid out. We can assume that the
retention rate is the percentage of net income that is reinvested by the farmer. The
retention rate can be calculated by dividing the farmer’s “earned net worth” for the
year by the net income for that year.3
The Market Value of Equity portion of the equation represents the price of a
share. This can be reasoned by the fact that because we don’t have farm stock to obtain
a market price per share, we can essentially put a market price on each dollar of net
income by analyzing how much each dollar of net income impacts the market value of
equity. Here, we assume the farm is made up of only 1 share of stock, and thus all net
income goes into directly affecting the price of this 1 share.
3 Broadly speaking, most finance literature states that the portion of net income that is not retained for the business is paid out to shareholders in the form of dividends. In addition to non-retained net income being used as dividends, it can also be used to pay down debt
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The sustainable growth rate portion of the equation, that is (gs) =
(ROE X b) / (1 – ROE X b) will not need to be modified or adjusted in estimating the cost
of equity capital for farms
Farm Examples
With the slight manipulation to our original constant growth rate equation, we
can use FinBin’s financial database for Minnesota farms to obtain all of our required
data.4
Table 1 reflects the variables we need in using the modified constant growth
equation in estimating our cost of equity capital. The 2007 data is divided up and
categorized by gross farm income level to reflect the size differences between
Southwest Minnesota farms.
Table 1. Constant Growth Equation Variables – Southwest, Minnesota Farms, 2007 Gross Income - $250,001-500,000 $500,001-1,000,000 Over $1,000,000 Number of Farms - 147 107 62 Net Income $ 145,948 $ 247,108 $ 352,822
ROE 21% 21.6% 15.1%
Earned Net Worth $ 117,408 $ 205,069 $ 311,046
M.V. of Equity $ 844,749 $ 1,089,090 $ 2,004,608
Retention Rate, b (117,408 / 145,948) = 80.45%
(205,069 / 247,108) = 82.99%
(311,046 / 352,822) = 88.16%
Sources: FinBin
Table 2 uses the data from Table 1 to calculate the cost of equity calculations. The cost
of equity calculation, results in the following cost of equity capital values; 23.71%,
25.70%, and 17.44% for gross income farms $250,001‐500,000, $500,001‐1,000,000,
and greater than $1,000,000, respectively. By analyzing the variables for each gross
income group, we can interpret our results.
4 www.finbin.umn.edu/
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Table 2. Cost of Equity Calculation, 2007 Ke = (Div1 / P0) + gs = [(1 – Retention R) * Net Income] / (MV of E) + (b * ROE)/(1 – b * ROE) Gross Income Calculations Ke
250,001‐500,000 (1 ‐ .8045) * 145,948] / (844,749) + (.8045 X .21) / (1 ‐ .8045 X .21) = 23.71%
500,001‐1,000,000 (1 ‐ .8299) * 247,108] / (1,089,090) + (.8299 X .216) / (1‐ .8299 X .216) = 25.70%
Over 1,000,000 (1 ‐ .8816) * 352,822] / (2,004,608) + (.8816 X .151) / (1 ‐ .8816 X .151) = 17.44%
At first glance, we can see that there is a degree of variability with the cost of
equity results. The gross farm income group variables differ. But what specifically leads
to these the cost of equity differences? The first step in deciphering our results is to look
at the constant growth equation. We can break the equation into two parts, the
dividend yield and the sustainable growth rate. Table 2‐1 represents the calculations for
each part of the equation.
Table 2‐1. Dividend Yield and Sustainable Growth Rate Calculations – Southwest, Minnesota, 2007
Gross Income Dividend Yield Sustainable Growth Rate Ke
$ 250,001‐500,000 .0338 = 3.38% .2033 = 20.33% 23.71%
$ 500,001‐1,000,000 .0386 = 3.86% .2184 = 21.84% 25.70%
Over $ 1,000,000 .0208 = 2.08% .1536 = 15.36% 17.44%
By breaking up the constant growth equation we can distinguish the driving
factors that lead to the variation in the cost of equity values for the three income
groups. The dividend yield portion seems to be very stable, varying between 3.86% ‐
2.08% between the three gross farm income groups. This clearly shows that most of the
variation in the cost of equity values is coming from the sustainable growth rate portion
due to variability in the farm’s earnings. The sustainable growth rate differs by up to
6.5%, much greater than the variability of the dividend yield. There are significant
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differences in the earnings relative to the total equity between the three groups, the
ROE measure, which reflects earnings (ROE = Net Income / Equity). By referring to Table
1, we see that the gross farm income group with the highest ROE ($500,001 –
$1,000,000 with 21.6%), also has the highest cost of equity (25.70%), and the group with
the lowest ROE ($250,001 – $500,000 with 15.1%) also has the lowest cost of equity
(17.44%). This leads to a conclusion that generally, the higher the ROE, the higher the
cost of equity.
The same process can be done to find the cost of equity capital for Southwest,
Minnesota farms in 2004. This analysis will give us an idea of how the cost of equity
varies from year to year when different financial variables are reported.
Like any business, financial status of the individual farms’ will differ depending
on a variety of factors including: varying commodity prices, weather, crop yield, local
and aggregate supply and demand, etc. Another factor affecting the FINBIN financial
data from year to year is that different individual farms are moving in and out of the
different FINBIN income groups. The FinBin data does not track these movements – it
only reports data of the farms that fall into that group for that specific year.
Table 3 details the different financial variables reported in 2004 for each gross
income group needed for the cost of equity calculations.
Table 3. Constant Growth Equation Variables – Southwest, Minnesota Farms, 2004 Gross Income - $250,001-500,000 $500,001-1,000,000 Over $1,000,000 Number of Farms - 152 71 28 Net Income $ 63,775 $ 111,451 $ 360,534
ROE 10.1% 14.1% 21.8%
Earned Net Worth $ 43,039 $ 75,567 $ 244,926
M.V. of Equity $ 599,588 $ 792,944 $ 1,776,402
Retention Rate, b ( 43,039/ 63,755) = 67.5%
(75,567 / 111,451) = 67.8%
(244,926 / 360,534) = 67.9%
Sources: FinBin
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Table 4. Cost of Equity Calculation 2004 Ke = (Div1 / P0) + gs = [(1 – Retention R) * Net Income] / (MV of E) + (b * ROE)/(1 – b * ROE) Gross Income Calculations Ke
250,001‐500,000 [(1 ‐ .675) * 63,775] / (599,588) + (.675 * .101) / (1 ‐ .675 * .101) = 10.78%
500,001‐1,000,000 [(1 ‐ .678) * 111,451] / (792,944) + (.678 * .141) / (1 ‐ .678 * .141) = 15.10%
Over 1,000,000 [(1 ‐ .679) * 360,534] / (1,776,402) + (.679 * .218) / (1 ‐ .679 * .218) = 23.89%
Table 4 uses the data from Table 3 to illustrate the cost of equity calculations. By
inputting the variables from Table 3 into the constant growth equation, we derive the
following cost of equity values shown in Table 4; 10.78%, 15.10%, and 23.89% for the
gross farm income groups. The 2004 cost of equity results, provide us with even more
variation than we saw in the 2007 data. In 2004, the Ke differ by close to 13%. Upon
further review, we can see that gross farm income groups have a much lower cost of
equity in 2004 and the farms with gross farm income greater than $1,000,000 have a
much higher average cost of equity. This can be attributed to the fact the variables
reported in the two years for each group are significantly different. For instance, notice
the significant variability in average net farm income for the $250,001 ‐ $500,000
income group between the two years ($145,948 in 2007 versus $63,775 in 2004).
Table 4‐1. Dividend Yield and Sustainable Growth Rate Calculations – Southwest, Minnesota, 2004
Gross Income Dividend Yield Sustainable Growth Rate Ke
$ 250,001‐500,000 .0346 = 3.46% .0732 = 7.32% 10.78%
$ 500,001‐1,000,000 .0453 = 4.53% .1057 = 10.57% 15.10%
Over $ 1,000,000 .0652 = 6.52% .1737 = 17.37% 23.89%
By analyzing Table 4‐1, the dividend yield portion provides fairly stable results
ranging by 3% (6.52% ‐ 3.46%) between the three groups. Again, we can attribute most
of the variation in the cost of equity to the sustainable growth rate portion of the
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constant growth equation. Here, we see the sustainable growth rate varying by roughly
10% (17.37% ‐ 7.32%) between the three groups. The key factor in the sustainable
growth rate is the ROE value. Due to the substantial differences in earnings relative to
the total equity, the ROE values between the three groups differ considerably. Similar to
the 2007 data and following our previous argument, the group with the highest ROE
(over $1,000,000) with an ROE of 21.8% also has the highest cost of equity (23.89%). The
group with the lowest ROE ($250,001 ‐ $500,000) with an ROE of 10.1% also has the
lowest cost of equity (10.78%).
Overall, the two different years provide us with different cost of equity values for
each gross farm income group. This is because there is a lot of variability in the data
from year to year. It is apparent that the income group’s performances vary at different
rates in good and bad years within the agriculture industry. For instance, during a highly
profitable year for the overall agricultural industry such as 2007, smaller income farms
may outperform bigger income farms in proportion to their size. However, in less
profitable years such as 2004, smaller income farms may underperform bigger income
farms in proportion to their size. Net income for the over $1,000,000 gross income
farms seems to be much more stable and deviates less for the set of years selected.5
With the financial data being more or less volatile from one income group to the
next, our data will follow and will lead to a large amount of variation from year to year.
This is causing a lot of noise and inconsistency within the cost of equity values. In order
to get a more accurate picture reflecting the cost of equity values for the three income
groups, we will need to average out a wider range of data. In doing so, the averages
should deviate much less from there overall long‐term averages providing us with a
much truer cost of equity that can be used going forward.
5Appendices I and II illustrate the Median Net Farm Income differences from region to region and year to year respectively. Although slightly more profitable then all other individual regions, the Southwestern Region’s Median Net Farm Income is proportionately similar to the upward trend seen in the overall Minnesota Median Net Farm Income chart.
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Table 5. Constant Growth Equation Variables – Southwest, Minnesota Farms, 2004‐2007 Averages Gross Income - $250,001-500,000 $500,001-1,000,000 Over $1,000,000 Number of Farms - 593 354 174 Net Income $ 100,596 $ 174,042 $ 370,637
ROE 15% 17.8% 18.0%
Earned Net Worth $ 91,037 $ 137,630 $ 281,903
M.V. of Equity $ 697,316 $ 923,473 $ 1,924,785
Retention Rate, b (91,037 / 100,596) = 90.5%
(137,630 / 174,042) = 79.1%
(281,903 / 370,637) = 76.1%
Sources: FinBin
Table 5 reflects the arithmetic average for all our constant growth equation
variables in between years 2004 – 2007 for each gross income group. Notice how much
our 2004 and 2007 net income values for gross income group $250,001 – $500,000
actually deviate from the group’s four year average. It is a significant amount and when
not accounted for, will lead to an inconsistent sometimes inaccurate cost of equity
value. Our goal here is to capture a more accurate cost of equity value by significantly
decreasing the variation that occurs from year to year with the different income groups.
Table 6. Cost of Equity Calculation 2004-2007 Averages Ke = (Div1 / P0) + gs = [(1 – Retention R) * Net Income] / (MV of E) + (b * ROE)/(1 – b * ROE) Gross Income Calculations Ke
250,001‐500,000 [(1 ‐ .905) * 100,596] / (697,316) + (.905 * .15) / (1 ‐ .905 * .15) = 17.01%
500,001‐1,000,000 [(1 ‐ .791) * 174,042] / (923,473) + (.791 * .178) / (1 ‐ .791 * .178) = 20.33%
Over 1,000,000 [(1 ‐ .761) * 370,637] / (1,924,785) + (.761 * .18) / (1 ‐ .761 * .18) = 20.47%
By inputting the variables from Table 5 into the constant growth equation, we
derive the following cost of equity values shown in Table 6; 17.018%, 20.33%, and
20.47% for gross income farms $250,001‐500,000, $ 500,001‐1,000,000, and greater
than $ 1,000,000 respectively. By using the four year arithmetic average for all of the
constant growth equation variables, we see the cost of equity variable converge
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significantly between the three groups varying by approximately 3.5% (20.47% ‐
17.01%). In the past, the cost of equity values between the three groups varied by
roughly 13% (23.89% ‐ 10.78%) in 2004 and by nearly 6.5% (23.71% ‐ 17.44%) in 2007.
Because the financial status of the individual farms differs significantly from year to
year, there were high levels of variability. However, using a four year average for the
data in the constant growth equation for each gross farm income group decreases the
variability between the groups. The four year average provides us with a much more
stable calculation. This calculation leads to values that will provide us with much more
accuracy that can be used with more confidence moving forward in the future.
WACC Cost of Debt Applications
With the cost of equity calculations complete for the three gross farm income
groups for 2004, 2007, and the 2004‐2007 averages, concentration can be put on
deriving the cost of debt (Kd) portion of the final WACC calculations. The WACC
represents the overall cost of capital and is the weighted‐average of the after‐tax costs
of debt and equity capital, where the weights are the percentages of the term debt and
equity capital components in the capital structure of the farm or company.
Algebraically, the average cost of capital is,
WACC = Kd X (D/ (D+E)) X (1 – t) + Ke X (E/ (D+E))
where Kd is the after‐tax cost of term debt, (D/(D+E)) is the proportion of term debt in
the overall total capital structure, t is the marginal tax rate, Ke is the cost of equity
capital, and (E/(D+E)) is the proportion of equity in the overall total capital structure6.
6 The total capital structure is the sum of debt capital and total equity capital of the farm. Note that, (D / D+E) + (E / D+E) = 1. For consistency purposes, included in the debt capital portion is non-farm debt. Also, deferred liabilities are excluded from our total debt and equity capital.
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We can go about finding the tax rate a few different routes. A simple way to find
the rate is to look at the before and after‐tax earnings and calculate the tax rate that is
implied by those numbers. Unfortunately, that would be the average tax rate paid and it
would be lower than the marginal tax rate. For our purposes, it is more appropriate to
use the marginal tax rate. The marginal tax rate can be derived by using the combined
state and federal tax rate that applies to the respective taxable income level. It’s also
important to note that we would not use the gross farm income value in deriving state
and federal tax rate.
One additional complication arises when deriving the marginal tax rate. A farmer
is technically a “self‐employed person,” so s/he must also pay Social Security tax on
their earnings. Meaning, the true marginal tax rate would be the state income tax rate
plus the federal income tax rate plus the Social Security tax rate. However, a problem
arises in deriving this calculation. A farmer may have additional tax deductions on the
federal return to estimate the taxable earnings for Social Security tax contributions. For
simplicity, we will exclude the Social Security tax rate from the composite marginal tax
rate in our example.
Table 7. Weighted‐Average Cost of Capital Estimates – Southwest, Minnesota Farms, 2007 Gross Income ‐ $250,001‐500,000 $500,001‐1,000,000 Over $1,000,000
Proportion of Debt Capital .2294 .2445 .2687
Cost of Debt Capital .0676 .0696 .0793
Proportion of Equity Capital .7706 .7555 .7313
Estimated Cost of Equity Capital .2371 .2570 .1744
Estimated Marginal Tax Rate .4185 .4285 .4285
Average Cost of Capital .1917 .2039 .1397
Sources: FinBin
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Table 7.1. Weighted‐Average Cost of Capital Estimates – Southwest, Minnesota Farms, 2004 Gross Income ‐ $250,001‐500,000 $500,001‐1,000,000 Over $1,000,000
Proportion of Debt Capital .2799 .2602 .2645
Cost of Debt Capital .0593 .0455 .1412
Proportion of Equity Capital .7201 .7398 .7355
Estimated Cost of Equity Capital .1078 .1510 .2389
Estimated Marginal Tax Rate .4185 .4285 .4285
Average Cost of Capital .0873 .1185 .1870
Sources: FinBin
Table 7.2. Weighted‐Average Cost of Capital Estimates – Southwest, Minnesota Farms, 2004‐2007 Averages Gross Income ‐ $250,001‐500,000 $500,001‐1,000,000 Over $1,000,000
Proportion of Debt Capital .2492 .2717 .2590
Cost of Debt Capital .0638 .0572 .09186
Proportion of Equity Capital .7508 .7283 .7410
Estimated Cost of Equity Capital .1701 .2033 .2047
Estimated Marginal Tax Rate .4185 .4285 .4285
Average Cost of Capital .1370 .1570 .1653
Sources: FinBin
Table 7, 7.1, and 7.2 illustrate the Average Cost of Capital (WACC) calculation for
each gross farm income group in the three time periods by breaking up the calculation
into its five respective components.
For the purpose of illustration nonfarm debt and equity are included in the
calculations for the debt and equity capital proportions. For example, total debt in 2007
for the “over $1,000,000” gross farm income group, is calculated as
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$198,190 (Total Intermediate Debt)
+ $531,441 (Total Long‐Term Debt) + $115,212 (Nonfarm Debt) = $844,843 (Total Debt)
Total Debt ($844,843) is then divided by the total capitalization of the combined farm
and nonfarm entities. Total capitalization is the sum of total debt capital and total
equity capital. For the “over $1,000,000” gross farm income group, equity capital totals
$2,298,813. Thus, total capitalization equals $3,236,711 (=$937,898 + $2,298,813)
making the proportion of Debt Capital equal to 0.290 (=$937,898 / $3,236,711). Because
the debt and equity capital proportions must equal 1, the proportion of equity capital
will equal .710 (=1 ‐ .290).
The after‐tax cost of debt capital is the effective rate the farm pays on term debt.
Using the 2007 data in Table 7 for the “over $1,000,000” gross income farm group, the
cost of debt capital is calculated as
(Interest Due on Term Debt) / (Intermediate Debt + Long‐Term Debt + Principal Due on Term Debt) = $57,861 / $822,868 = 7.03%. Similar to the cost of equity calculations for each gross farm income group in
each of our three data sets, the average cost of capital values also vary by a significant
amount. Much of the variability can be tied to the fact that because the equity capital
proportions are significantly greater then the debt capital proportions, the average cost
of capital are heavily reliant on the respective cost of equity values – thus also varying
the WACC values between the gross income groups from year to year. Also contributing
to the variability, though to much less of an extent is the slight variability in the cost of
debt capital values going from year to year. For example, because debt and equity
proportions are fairly similar for each gross farm income group in 2004, and because the
$250,001 – $500,000 group also had the lowest cost of equity by a considerable
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amount, it results in having in also having the lowest average cost of capital by a
significant amount.
In 2007, the $500,001 – $1,000,000 gross farm income group recorded the
highest estimated average cost of capital. However in 2004, the over $1,000,000 gross
farm income group recorded the highest estimated average cost of capital (.1906).
These results tend to favor the trend of the average of cost of capital being heavily
reliant on the cost of equity values associated with them. Meaning in 2007, the
$500,001 – $1,000,000 gross farm income group also had the highest cost of equity.
Likewise, in 2004 the over $1,000,000 group also had the highest cost of equity.
The 2004 – 2007 averages followed in similar fashion. The over $1,000,000 group
recorded the largest cost of equity which was a contributing factor to its average cost of
capital resulting in the highest value of the three groups, .1603 – compared to .1329 for
the $250,001 – $500,000 group and .1514 for the $500,001 ‐ $1,000,000 gross farm
income group. Additionally, the over $1,000,000 gross farm income group also had the
largest cost of debt of the three groups. This value, although to less of an extent also
contributes to the average cost of capital value being the largest of the three groups.
One possible reason that they have larger average cost of debt values, is because they
are bigger in terms of gross income; thus allowing for larger lines of credit to service
their needs. Oftentimes, larger lines of credit carry somewhat higher interest rates than
term loans which the smaller gross farm income groups may rely on.
Like our cost of equity calculations for each gross farm income group from year
to year, we are presented with a large degree of variability in our estimated average
cost of capital values. From 2004 to 2007, the $501,000 – 1,000,000 gross farm income
group’s average cost of capital ranges from .1185 in ’04 to .2039 in ’07 – a range of
.0835. With all the variability from year to year, the farmer is faced with a difficult
decision on which value to use for planning and capital budgeting purposes. This task
gets especially more difficult when combined with all of the future uncertainty
presented in the agricultural industry.
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Also like our cost of equity calculations, the 2004 – 2007 average cost of capital
provides us with a much more stable value. By using a four year average, variability in
the input values going from year to year is greatly reduced. The final average cost of
capital can provide farmers with a much more accurate indication of their true average
cost of capital used in their planning and capital budgeting decisions. It is important to
note that this only a four year average, adding more years to the average would most
likely provide us with an even more accurate number.
Conclusions
Whether it be used for identifying and analyzing profitable and financially feasible
capital investment projects, evaluating the alternative uses of cash (i.e., investments in
new or replacement operations or production assets, dividend payouts, stock
repurchases, etc.), comparing and analyzing alternative financing and capital structure
strategies, evaluating merger and acquisition opportunities, or to assess the value of a
firm – the cost of capital plays a vital financial and economic role in the financial
management of any business.
Depending on the situation, there are a number of different formal and informal
approaches that can be used to determine the appropriate cost of capital value. The
formal and informal approaches can differ to a high degree and this can add uncertainty
when assessing the overall financial standing of a business. While the formal approach
to the cost of capital problem can be difficult, time consuming, and in some cases lead
to incomplete information, the process of doing so allows financial managers to ask “the
right questions” and become more aware of the range of issues or factors that could
play a role in future financial decisions. In addition, using a formal approach leads to a
value that uses both the actual cost of debt and the cost of equity versus simply using
“sound judgment” or intuitively determining the costs of debt and equity capital used
with the informal approach. However, because the formal approach in most cases relies
on capital market information to derive the cost of equity capital, a problem arises when
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the cost of capital needs to be determined for a nontraded firm where the current
market price per share of equity capital is not available.
The report examines and analyzes two different formal approaches to solving
this problem – the discounted cash flow (DCF) method, and the opportunity cost of
funds (OCF) method. There is no ideal method for determining the cost of equity capital
and depending on the situation, both approaches have positive and negative
characteristics and can ultimately lead to varying conclusions. Too demonstrate, a case
application is applied to analyze and illustrate how farms can use the discounted‐cash
flow approach to determine the cost of equity capital. The case uses University of
Minnesota’s FinBin – a farm financial database for data from Southwestern Minnesota
farms from 2004‐2007. The cost of capital identification process using the DCF method
is outlined for three different gross income farm groups. Using three different size
groups that cover a span of 4 years, we are given a chance to see a number of different
situations and obstacles that can arise using this method. We are also given a chance to
see what portions of the cost of capital play a big role in effecting the final value from
one group to the next or from one year to the next.
These cases serve as a preliminary starting point for farms to use in determining
and understanding the potential impacts and effects of the overall cost of capital model
on their capital structures, financing sources and alternatives, capital budgeting
decisions, and valuation assessments.
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Appendix I
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Appendix II
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Bibliography
"Cost of Capital." InvestorWords.com. 7 Apr. 2009. Available at: http://www.investorwords.com/1153/cost_of_capital.html Center for Farm Financial Management. "FINBIN – Farm Financial Database," University
of Minnesota, April 2009. Available at: http://www.finbin.umn.edu/ Nordquist, Dale. “FINBIN – Report on Minnesota Farm Finances”. The Center for Farm
Financial Management, University of Minnesota, April 2008. Pederson, Glenn. "Cost of Capital for Agricultural Cooperatives". USDA, Rural Business
Cooperative Service, September 1998.