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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







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







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.

cost of capital for farm entities: an application to farms in ......typically, the cost of capital...

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