Abstract The cost of capital is important in the financial management of agricultural cooperatives. A measure of the cost of capital is required when evaluating various aspects of

strategic business plans, e.g., selecting a financial leverage position, calculating the

profitability of alternative investment opportunities, measuring economic value-added,

and comparing various merger and acquisition plans. The task of determining the

appropriate cost of capital to use requires a careful analysis of the effect of alternative

financing choices which are open to a cooperative.

This report considers the close relationship between the cost of capital and capital

structure. Ways are examined to determine the cost of capital by a cooperative. The

report sequentially identifies: principles of capital structure and cost of capital, guidelines for capital structure choice, and applications of these guidelines through cooperative case examples. These applications are a starting point for cooperatives to develop

capital positions and consider alternative assumptions about financing sources and

their potential impacts on the overall cost of capital.

To determine the overall cost of capital for a selected capital structure, a cooperative

must first determine its cost of equity capital. The cost of equity capital cannot be

derived directly from the market, as in the case of a publicly traded firm. Thus, there is

no ideal method for determining the cost of capital for a cooperative. So an innovative

approach is needed. The opportunity cost of funds approach relates the cost of capital

to the rates of return from alternative uses of capital (i.e., the assets side of the balance sheet). The focus is on the expected (or required) rates of return from alternative

investments which reflects the degree of risk involved. The discounted cash flow

approach relates the cost of capital to the alternative sources of capital (i.e., the liabilities and equity capital side of the balance sheet). The component costs of equity and

debt capital are combined into an overall cost of capital for the cooperative. Both

approaches require making some assumptions to determine the cost of equity capital

for a cooperative.

Key Words: cooperatives, cost of capital, capital structure, equity capital, discounted

cash flow, economic value added, financial leverage.

Cost of Capital for Agricultural Cooperatives

Glenn Pederson, Professor

University of Minnesota-Twin Cities Campus

Department of Applied Economics

Rural Business-Cooperative Service

RBS Research Report 163

September 1998

Price: domestic-$5.50; foreign-$6.50
Contents Cost-of-Capital and Capital Structure Issues ................................l

Management Issues ............................................... .

The Cost-of-Capital Concept ........................................2

The Cost-of-Capital Problem ........................................2

Objectives ....................................................... .

ScopeandOrganization ............................................ .

Changing Capital Structure of Agricultural Cooperatives .......................3

Changes in Capital Structure ........................................3

The Largest 100 Agricultural Cooperatives .............................8

Identifying the Determinants of Cooperative Capital Structure .................. .9

A Checklist of Factors ............................................. .9

Agricultural Cooperatives ..........................................lO

Cooperative Objectives ............................................l 1

Developing Approaches to the Cost of Capital ..............................12

Discounted Cash Flow ............................................14

Applying Cost of Capital Concepts to Agricultural Cooperatives .................15

Opportunity Cost of Funds Approach .................................15

Application of the OCF Approach ....................................15

Discounted Cash Flow Approach ....................................17

Application of the DCF Approach ....................................17

EconomicValueAdded............................................2 2

Conclusions ....................................................... ..2 4
Highlights Membership capital in a cooperative has a cost, but what is that cost? Cooperatives

face the problem of how to determine that cost. Solving the problem presents a challenge because the cost of equity capital in a cooperative cannot be derived directly

from the capital market like a publicly traded company. The situation is further complicated by the ownership characteristics of a cooperative because the cost of capital

should reflect the alternative investment choices of members, as well as the firm. In

this report, logical and innovative approaches to making these important determinations of cost of capital are presented along with pros and cons on their applicability to

agricultural cooperatives.

The report also studies the changing capital structure (long-term debt and equity) of

agricultural cooperatives in the Upper Midwest during the period 1984-l 994. Results

indicate a general, but gradual decline in the proportion of equity capital among all

cooperatives, regardless of type. Significant variability exists, however, between cooperative types. An inverse relationship generally is found to exist between the proportion

of equity and cooperative size. This study of capital structure provides a useful backdrop for considering cost-of-capital issues.

Note: The material on cooperative taxation presented in this report is only to provide information to persons interested in the tax treatment of cooperatives and does not represent official policy of the U. S. Department of Agriculture, the Internal Revenue Service, the U.S.

Department of the Treasury, or any other Government agency.

111
Cost of Capital for Agricultural Cooperatives

Glenn Pederson, Professor

University of Minnesota-Twin Cities Campus

Department of Applied Economics

I-Cost-of-Capital and

Capital Structure Issues

In the course of managing a cooperative, boards

of directors and managers frequently encounter situations which raise questions about the appropriate capital structure and cost of capital to use. This section

identifies and discusses some of the management

issues, the cost of capital concept, and the problem

faced by cooperatives.

Management Issues

Cooperative Capital Constraints. Access to capital is

a complex and strategic issue. Selection of either internally generated capital (e.g., retained earnings) or

externally-acquired capital (e.g., stock or debt) as a

source of funds implies an explicit (interest or dividend) cost of each source and/or an opportunity cost

of capital (due to alternative uses of those funds).

Hence, the cost of capital to a cooperative is never

zero, regardless of the source. When capital is constrained, the cost of each additional unit increases

sharply and may become extremely high.’ Thus, cooperatives which find that their capital is significantly

constrained, may find that they must forego investment projects which would be profitable under less

restrictive financial circumstances.

Use of Financial Leverage. The increased variability

of interest costs and farm income in the early 1980s

communicated a significant amount of uncertainty

about earnings to agricultural cooperatives. When

earnings are uncertain, decisions on the use of finan1 The additional increment to capital comes at an extremely high

cost once the cooperative encounters a constraint on borrowing or

the ability to issue equity capital.

cial leverage and the appropriate amount of financial

(cash and noncash) reserves to maintain, and evaluating the cost of maintaining those reserves, can be difficult. It appears that the largest cooperatives have been

gradually reducing their use of debt capital since the

mid-1980s in order to strengthen their equity capital

positions. Yet, smaller farmer cooperatives have continued to increase use of nonequity capital forms in

recent years. So what motivates these changes in capital structure and what are the implications for cooperatives of different sizes and types?

Evaluating Investment Opportunities. As plant and

equipment investments age, and technological

improvements make existing production assets relatively less efficient, cooperatives are periodically faced

with the decision of how to finance efficiency-generating (e.g., cost-reducing or capacity-expanding) capital

improvements by internal or external means. In recent

years, cooperatives have also been asking how to raise

the funds needed to invest in value-added (revenueenhancing) ventures. For example, new cooperative

capital structures such as “closed-membership cooperatives” are being formed. To finance these ventures,

new equity instruments are being used, e.g., equity

participation units which provide the owners with net

patronage-sourced income in the form of patronage

refunds from the operations. While these “stock-like”

instruments may help overcome the traditional constraint on internally generated equity capital, a cooperative may not fully perceive the cost of this source of

capital.

Measuring Economic Value Added. As cooperatives

seek to identify and evaluate alternative business ventures and their contribution to member capital, they

have increasingly measured the pay-off in terms of the

economic value added (EVA). The EVA is the residual

income which remains after adjusting net returns on

1
investment for the cost of capital. The EVA reflects the

cooperative’s true economic profit and, as such, it

incorporates information about capital structure and

the opportunity cost of capital. The EVA shows the

extent to which the cooperative has contributed to

shareholder-member value.

Cooperative Mergers and Consolidations. As cooperatives merge and become part of larger operating entities, their capital positions also change. Reorganization

is frequently pursued with an eye on economies of

size, scale and scope. The financial transactions are

often quite large, so they involve significant issues of

capital restructuring and the need to determine the

cost of capital for the acquiring firm or the new entity.

The resulting cost of capital is more difficult to determine because alternative capital structures may be

considered.

The Cost-of-Capital Concept

The cost of capital is an important economic and

financial concept because of the multiple roles it plays

in management: identifying profitable and financially

feasible investments and uses of cash (e.g., investments in new or replacement production assets, selecting a trade financing policy, payment of dividends and

stock repurchases, etc.), comparing the profitability

and liquidity effects of alternative financing strategies

(e.g., leveraging and leasing), and assessing the value

of the firm, to name a few.

Patterson (1995) suggests that the “cost of capital” may be misleading as a financial concept because

it focuses attention on the right side of the balance

sheet and the assumed (debt and equity capital)

financing mix. Rather, the focus should be placed on

the “opportunity cost” of a decision to invest in a

given asset. Thus, the cost of capital would be related

to the alternative uses of capital, and not to its sources.

The opportunity cost approach to determining the cost

of capital is important because it emphasizes the characteristics of the asset and the uncertainty of the net

returns of the investment over the life of the asset.

However, evaluating the profitability of a capital

investment or the advantages of alternative financing

strategies requires the company to determine the cost

of capital based on the alternative funding strategies

and the component cost of each method of financing.

Defenders of the cost-of-capital concept find it necessary to have such a measure to discount the cash flows

of a project and to perform the required profitability or

feasibility analysis.

The Cost-of-Capital Problem

The cost-of-capital problem has a couple of

dimensions.2 First, there is no general consensus on

how to determine the cost of equity capital.

Alternative assumptions can be made about future

earnings, and the growth of earnings is a key factor in

most “growth models.” One of the central questions

that relates to cooperatives is the cost of capital for a

firm whose equity capital is not traded and whose

growth is also uncertain.

The finance literature outlines approaches used

by corporations whose equity securities (stocks) are

actively and frequently traded in highly efficient capital markets. Thus, in the case of a corporation, dividends or cash flow per share and the market price of

the stock may be used to derive the cost of equity capital. Cooperative stock is not traded, so an objective,

market-based measure of the value of a share is not

available (or even explicitly known). Therefore, the

true cost of capital is difficult (but not impossible) to

determine. Alternative means must be used to develop

a reasonable estimate.

Secondly, the cost of equity capital is in actuality

the opportunity cost of funds to cooperative members.

This adds complexity to the derivation of a cost of

equity capital because the range of financial alternatives members may consider is potentially quite

diverse. This report recognizes that added complexity,

but doesn’t deal with it explicitly.

Objectives

The general objective of this report is to apply the

concepts of modern financial theory to identify the

appropriate cost of capital for agricultural cooperatives. The specific objectives are:

l to identify the relationships between the cost

of capital and capital structure, and

l to examine ways of determining the cost of

capital.

Scope and Organization

The report has four remaining sections: a review

of recent changes in capital structure of agricultural

cooperatives, an identification of the factors that are

thought to influence cooperative capital structure, a

review of alternative approaches and methods used in

* Estenson (1995) suggests that the financial leverage question

facing cooperatives involves considering four perspectives: the cost

of capital, the influence of the business cycle, owner philosophy and

commitment, and competitive advantage within the industry.

2
measuring the cost of capital, and applications of the

opportunity cost approach and the discounted cash

flow approach to selected agricultural cooperatives.

II-Changing Capital Structure of

Agricultural Cooperatives

This section evaluates recent trends in farmer

cooperative financing strategies and changes in financial and capital structure. 3 Trends are identified and

evaluated in terms of differences in cooperative types

and sizes. These trends reflect changes in the underlying components of capital structure and the cost of

capital.

Changes in Capital Structure

Changes in cooperative capital structure during

1989-1994 were studied, using financial data for

Midwest farmer cooperatives in Minnesota, Wisconsin,

Michigan and North Dakota. Additional comparisons

are made using summary data from 1984-95 for the

largest 100 cooperatives in the U.S. The farmer cooperatives data are used to derive annual percentages of

debt and equity capital. The cooperatives are sorted

and ranked according to cooperative type and size.

Where cooperatives are ranked by size, the means of

the ratios are reported according to quartiles.4 In addition, subcategories of debt and equity capital are

reported according to cooperative type (or function) in

order to investigate differences in debt-equity composition.

To obtain consistent estimates of changes in capital structure, the cooperatives are first assembled into

cohort groups.5 The cooperatives are classified according to type (or major function&grain, petroleum farm

Financial structure refers to all sources of financing, including

short-term and long-term liabilities and equity capital. Capital

structure refers just to long-term liabilities and equity capital as

sources of funds, excluding short-term debt used to finance

working capital.

The distributions of financial ratios are generally recognized to be

quite skewed by extremely high values, so measures such as

quartiles are used to statistically summarize the data. These

“nonparametric statistics” are generated by ranking the

cooperatives by size (e.g., total assets) and then grouping them

into quartiles (quartile 1 is the O-25% size group, quartile 2 is the

26-50% group, etc.). The intra-quartile mean of each ratio is

calculated and reported

These cohort groups contain the same cooperatives for each year,

thereby eliminating the variability associated with changes in

which cooperatives are being evaluated.

supply, other farm supply, and other marketing. These

subgroups allow looking at changes over time and differences in financial structure across cooperative types.

Comparison of Cooperatives by Type. Assets, liabilities and equity capital are reported as percentages of

total assets in Table 1. These indicators are used to

identify changes in asset and capital structure. When

all cooperatives in the sample were considered regardless of size, the percentage of equity capital declined

only slightly during 1989-94. The mean debt ratio (debt

as a percent of total assets expressed as a ratio) across

the sample of Midwest cooperatives is generally higher than those reported by Eversull and Chesnick (1995)

for local farm supply and marketing cooperatives during 1983-90.6 By comparison, the mean debt ratios

reported by Chesnick and Kraenzle (1997) for local

farm supply and marketing cooperatives during 1994-

95 are only slightly lower than our result for Midwest

farm supply and marketing cooperatives. They report

ratios of 0.45 - 0.50 in 1994-95 compared to our estimate of 0.59 for the combined set of marketing and

local farm supply cooperatives in 1994. Among marketing cooperatives the debt ratios are closer at 0.53 -

0.62 in 1995, reported by Chesnick and Kraenzle, compared with this report’s estimate of 0.65 in 1994.7

The trend of capital structure does change significantly over time when viewed according to the different cooperative types. For example, the equity positions of grain marketing and general farm supply

cooperatives declined, while the percentage of equity

capital increased for marketing cooperatives after

1993. There are also significant differences in equity

capital positions between cooperative types. For example, petroleum cooperatives have the lowest leverage

(highest relative equity capital) position, while agricultural marketing cooperatives have relatively higher

financial leverage (lower equity capital) positions. The

lower equity capital observed among marketing cooperatives is partially explained by the nature of their

operations. They carry significant levels of payables to

6 For example, Chesnick and Eversull report mean debt-to-asset

ratios of 0.20 - 0.28 for their local farm supply and marketing

cooperatives. This compares with about 0.30 - 0.50 among the

Midwest farm supply and marketing cooperatives in our data set

for 1989.

7 Observed differences in debt ratios are due to many factors, such

as location and size of the cooperatives analyzed. For example, the

Midwest local farm supply cooperatives in this study’s sample

were significantly larger (in total assets). Marketing cooperatives

were somewhat smaller than those analyzed by Chesnick and

Kraenzle.

3
Table l-Mean assets, liabilities and equity capital by cooperative type, 1989 and 1994.

Year Total Current Other Fixed Current Long-term Equity

assets assets assets assetsa liabilities liabilities” capital

($000) ----_-____________________ ___ _____~~~~~~~~~~~~~~~~_~___________ (Percent-) ------____________________ _____ ______ _____________________

Grain (N = 126)

1989 24,141 58.9

1994 51,157 62.5

11.7 29.4 45.6 8.1 46.3

13.4 24.0 51.0 7.4 41.6

Other Marketing (N = 52)

1989 2,044 53.1

1994 2,854 54.4

18.0 28.9 37.1

16.3 29.4 41.4

Farm Supply-Petroleum (N = 58)

29.3 33.6

21.4 37.2

1989 15,584 49.2

1994 12,858 45.1

27.3 23.5 23.9

29.8 25.2 26.3

Farm Supply-Other (N = 188)

6.4 69.7

7.2 66.6

1989 32,122 49.3 22.0 28.7 33.8 17.2 49.0

1994 35,495 52.3 19.9 27.9 38.4 27.0 34.6

All (N = 424)

1989 23,799 52.4 18.7 28.9 36.8 23.5 39.8

1994 33,049 53.8 17.9 28.3 40.4 23.1 36.5

a Fixed assets includes real estate, plant and equipment. Long-term liabilities includes long-term loans, and notes payable, leases and industrial revenue bonds, and other long-term sources. Equity capital includes common stock, allocated equity and unallocated equity.

farmers for the raw farm products that are purchased

for processing. These liabilities are a substantial part of

their overall funds.

Comparison of Cooperatives by Size. Capital structure differences among cooperatives relate to size differences. The ratios of various types of assets, liabilities and equity capital (to total assets) are reported by

total asset size group in Table 2. It shows the total

assets of the cooperatives used to rank the cooperatives by size and group them into quartiles. The cooperatives in quartile 1 had average total assets of

$912,000 in 1989, and $1,194,000 in 1994. The reported

ratios are the means of the ratios for the cooperatives

in each quartile. Because the same cooperatives are

included in both years, direct comparisons can be

made within quartiles and across quartiles.

Financial leverage (the debt-to-total assets ratio)

tends to increase with cooperative size. This is illustrated by the significant decrease in the ratio of equity

capital from quartile 1 (small cooperatives) to quartile

4 (large cooperatives). Other differences in asset and

debt capital structure are also significant between

cooperative-size groups. For example, the proportion

of long-term liabilities among small cooperatives is

just 3.8 percent in 1994, but that proportion increases

to 6.7 percent, 7.8 percent, and 24.3 percent as cooperative size increases. Thus, it appears that size and type

of cooperative are factors associated with changes in

cooperative capital structure during 1989-94.

Petroleum cooperatives appear to have a significantly lower leverage position than agricultural marketing cooperatives. Dividing total assets by the number of cooperatives indicates the average size of marketing cooperatives is much larger. This implies that

cooperative size is a critical underlying factor that

influences capital structure. It may be more important

than cooperative type in explaining the observed differences in capital structure. Statistical tests for differ4
Table n-Mean assets and liabilities by cooperative size, 1989 and 1994.”

Year Total Current Fixed Other Current Long-term Equity

assets assets assets assets liabilities liabilities capital

($000) _____________________________________________________________(~e~ce”t)_____________________________________________________________

Quartile 1

1989 912 51.1 23.5 25.4 22.8 2.4 74.8

1994 1,194 52.6 23.4 24.0 26.9 3.8 69.4

Quartile 2

1989 2,041 52.0 21.1 26.9 31.6 4.0 64.4

1994 2,899 49.8 25.7 24.6 32.4 6.7 61 .O

Quartile 3

1989 3,516 54.0 19.9 26.1 34.4 4.4 61.2

1994 5,386 55.2 20.3 24.5 39.0 7.8 53.2

Quartile 4

1989 88,727 52.4 18.6 29.0 37.1 24.9 38.0

1994 122,719 53.8 17.6 28.6 40.8 24.3 34.9

a Cooperative size is measured by total assets.

ences in the mean leverage positions of the cooperatives by asset size quartile and by type were highly

significant in each of the years analyzed. This indicates

that the means reported for each size and type subgrouping in Table 1 (and subsequent Tables 2-6) is significantly different from those reported in each of the

other subgroups.

A regression analysis was also conducted to

determine if a statistically significant relationship

exists between variations in capital structure and cooperative size during 1988-1995. Two alternative measures of cooperative capital structure were used: the

term debt/total assets ratio and the term debt/total

equity ratio. Two alternative indicators of cooperative

size also were used: average total sales and average

total assets. A significant, positive relationship was

found.8 This was also true for the average term

debt/average total assets ratio of each cooperative in

relation to the level of average total assets. The relationship between cooperative type and debt used was

also studied. Cooperative type was not found to be a

significant predictor of capital structure when the

8 Even though the model predicted a relatively low proportion of

the overall variation in the debt ratio across cooperatives, the

results were significant.

cooperative size variable was included in the model.

Thus, it is concluded generally that the proportion of

term debt used by farmer cooperatives is positively

related to increases in cooperative size.

In Table 2 trends are reported for mean percentages of assets and liabilities by cooperative size category. The mean percentages clearly indicate that there is

a significant difference between the lower levels of

long-term liabilities in the small cooperatives (in quartile 1) compared with the higher levels in the large

cooperatives (quartile 4). Moreover, that relationship

was maintained throughout the 6-year period. A similar pattern is illustrated by the mean proportions of

equity capital. Small cooperatives have significantly

higher mean proportions of equity capital than larger

cooperatives. The pattern shows that as cooperative

total assets increase (from quartile 1 to quartile 41, the

proportion of equity capital decreases.

Liability Structure and Cooperative Function. In

Table 3, various sources of cooperative long-term liabilities are expressed as percentages of total long-term

debts. Grain marketing and farm supply petroleum

cooperatives used more loans from the Bank for

Cooperatives. Other farm supply cooperatives (excluding petroleum supply) and other agricultural marketing cooperatives tended to use notes payable. For

5
Table &Mean percentages of long-term liabilities by cooperative type, 1989 and 1994.

Year Total long-term Bank for

liabilities cooperatives

Notes

payablea

Leases and gov’t

funded debt

Other

liabilitie9

($000) ~~~~~~~~______ _ ___~~~~~~~~~~~~ ---------- ___~~~~~~~~ (in percent) __________ _____________ _______ _______________________

Grain (N = 126)

1989 1,945 51.4 4.6 33.5 10.5

1994 3,790 64.5 17.1 6.9 11.5

Other Marketing (N = 52)

1989 598 10.9 47.0 15.8 26.3

1994 610 34.8 39.7 7.4 18.1

Farm Supply-Petroleum (N = 58)

1989 1,002 43.0 7.4 7.5 42.2

1994 925 84.9 5.1 3.9 6.2

Farm Supply-Other (N = 188)

1989 5,509 14.2 49.6 5.1 31.2

1994 9,587 8.7 41.4 3.2 46.7

All (N = 424)

1989 5,583 13.2 46.1 13.7 27.1

1994 7,624 21.6 40.0 5.1 33.3

a Notes payable includes: general notes payable, customer notes and accounts, and regional cooperative accounts.

b Other liabilities includes: deferred taxes, deferred employee compensation, and deferred compensation to marketing customers.

cooperatives as a whole, notes payable is the dominant

form of long-term debt. While notes include borrowing

from the Bank for Cooperatives, the proportions borrowed from other sources and other long-term borrowings from the Bank for Cooperatives were increasing

also. The decline of Bank for Cooperatives financing of

other farm supply cooperatives during 1993-94 is the

exception to this trend. The use of leases and industrial

development bond financing has also declined significantly.

Comparisons of Liability Structure by Cooperative

Size. Table 4 shows the structure of long-term liabilities

according to size of cooperative. The size grouping is

based on the outstanding amount of total long-term

liabilities. The greatest differences occur between the

cooperatives in quartile 4 and the three other quartiles.

Notes payable are used more frequently by cooperatives which hold relatively large amounts of long-term

debt (i.e., quartile 4), while the other size classes of

cooperatives more often use Bank for Cooperatives’

loans. The trend away from using leases and government-funded debt (e.g., industrial revenue bonds) is

most obvious among cooperatives in quartile 4. These

cooperatives also significantly decreased their average

volume of long-term debt in recent years.

Comparisons of Equity Capital by Cooperative

Function and Size. Equity capital is reported as allocated equity (common stock and other allocated equity)

and unallocated equity by cooperative type in Table 5,

and by equity size in Table 6. Grain cooperatives had

the least common stock, while other (general) farm

supply cooperatives had more common stock. The proportions of other allocated equity were somewhat

higher among grain and other marketing cooperatives

than among the farm supply petroleum and other farm

supply groups. When divided into quartiles by size

(Table 6), the proportion of common stock is significantly higher and the other allocated equity is somewhat lower among the largest cooperatives.

In summary, although the time series of financial

data on smaller farmer cooperatives reported in Tables

1-6 is relatively short, the data suggest that there are

6
Table d--Mean percentages of long-term liabilities by cooperative size, 1989 and 1994”

Year

Total Bank

long-term for

liabilities cooperatives

Notes

payable

Leases and

gov’t

funded debt

Other

liabilities

($000) ____________________________________________________(i~ percent)______________________________________________________

Quartile 1

1989 35 64.4 19.5 5.0 11.2

1994 60 71.9 14.3 3.0 10.8

Quartile 2

1989 115 54.7 21.7 7.4 16.2

1994 239 77.1 12.7 2.0 8.2

Quartile 3

1989 212 54.0 21.3 11.4 13.3

1994 504 67.6 15.3 5.1 12.0

Quartile 4

1989 26,358 12.6 46.5 13.7 27.2

1994 24,154 20.4 40.7 5.2 33.8

a Cooperatives are sorted into size classes using total assets, not total liabilities. See descriptions of liability categories in the previous table.

Table S-Mean percentages of allocated and unallocated equity by cooperative type, 1989 and 1994.

Year

Total equity

capital

Common

stock

Other allocated

equity capital

Unallocated

equity capital

($000) _____ ________ _____ ________ ______ ________ (in percent)____ ______ _________________________ _____

Grain (N = 126)

1989 11,177 1.0 81.1 17.8

1994 21,281 1.6 73.8 24.6

Other Marketing (N = 52)

1989 687 5.3 67.1 27.6

1994 1,061 4.7 75.5 19.8

Farm Supply-Petroleum (N = 58)

1989 10,862 9.1 65.1 25.7

1994 8,563 7.7 61.8 30.5

Farm Supply-Other (N = 188)

1989 15,740 23.2 55.0 21.9

1994 12,281 19.4 54.3 26.2

All (N = 424)

1989 9,472 11.6 64.0 24.4

1994 12,063 11.0 65.9 23.1

7
significant differences in capital structure between

cooperatives generally by size and selectively by type.

The percentage of debt capital increases with cooperative size. This corresponds with the results from previous studies among corporations operating outside of

agriculture. Secondly, the highest equity capital positions are maintained by farm supply petroleum cooperatives, followed (in descending order) by grain,

other farm supply, and other (nongrain) marketing

cooperatives. Among agricultural cooperatives, notes

payable is the dominant source of long-term debt

financing. Moreover, the proportion of notes payable

used by the largest cooperatives is significantly above

that used by medium- and small-sized cooperatives.

The capital structure of cooperatives appears to have

changed somewhat in recent years. For example, the

proportion of equity capital has declined gradually

during 1989-94. Although no major trend has emerged

in the use of long-term debt, the share of leases and

government-funded debt diminished in the early

1990s.

The Largest 100 Agricultural Cooperatives

In contrast with the observed capital structure

trends among smaller Midwest cooperatives, the capital structure of the largest 100 cooperatives in the U.S.

has shifted gradually toward increased use of equity

capital and away from long-term debt during 1984-95

(Table 7). The proportion of equity capital increased

gradually from 33.8 percent in 1984 to 37.3 percent in

Table &Mean percentages of allocated and unallocated equity by cooperative size, 1989 and 1994.

Total equity Common Other allocated Unallocated

Year capital stock equity capital equity capital

($000) ____ ____--________ _ ____________ __ _______ (in percenr)_____ _______ ________ _____ _________ _____

Quartile 1

1989 682 6.1 72.7 20.7

1994 828 5.5 70.9 23.6

Quartile 2

1989 1,315 6.6 71.7 21.7

1994 1,768 4.7 70.0 25.3

Quartile 3

1989 2,152 4.6 70.5 24.9

1994 2,864 3.0 71.6 25.5

Quartile 4

1989 33,726 12.3 63.1 24.6

1994 42,806 11.9 65.2 22.9

Table +Proportions of assets, liabilities and equity capital in the Top 100 Cooperatives, 1984-95.

Total

Year assets Current Other Fixed Current Long-term

(millions) assets assets assets liabilities liabilities

1984 $16,567 0.552 0.123 0.325 0.411 0.251

1986 $15,506 0.537 0.126 0.337 0.393 0.247

1988 $17,139 0.568 0.127 0.305 0.427 0.217

1990 $18,116 0.553 0.145 0.302 0.407 0.220

1992 $18,903 0.543 0.139 0.318 0.410 0.220

1994 $20,463 0.560 0.151 0.289 0.422 0.205

1995 $23,220 0.569 0.149 0.282 0.428 0.199

Source: Compiled from US. Dept. of Agric., Farmer Cooperatives, various issues.

Equity

capital

0.338

0.361

0.356

0.373

0.371

0.373

0.373

8
Table s-Equity capital of the Top 100 Cooperatives, 1984-l 995.

Common Preferred

Equity stock stock

Year (in 000) (W (W

1984 $5,629 16.4 21.3

1986 $5,590 13.6 21.1

1988 $6,095 12.3 19.2

1990 $6,750 11.8 17.2

1992 $7,005 8.8 8.8

1994 $7,731 7.2 18.1

1995 $8,216 6.9 19.8

a Other allocated equity includes: allocated retained earnings and per-unit retains.

Other Unalallocated located

equity equity

(W W)

45.6 16.6

50.5 14.8

53.3 15.3

54.4 16.6

66.9 15.3

57.5 17.1

54.1 19.2

1995. The corresponding decrease in long-term liabilities was from 25.1 percent in 1984 to 19.9 percent in

1995. Due to the higher proportion of equity capital,

the overall financial structure also shows a reduction

in debt in the total financing of the cooperatives. Total

liabilities decreased from 66.2 percent in 1984 to 62.7

percent in 1995. As the proportion of long-term liabilities has declined, the proportion of short-term liabilities has slightly increased.

One could argue that a comparison of the 100

largest cooperatives with Midwest cooperatives is

biased, because the latter group is dominated by smaller

cooperatives. However, the largest Midwest cooperatives (those in quartile 4) also reflect a gradual shift

toward proportionately less equity capital. A common

characteristic of the largest 100 cooperatives and

Midwest cooperatives is the shift toward short-term liabilities in place of long-term liabilities. This may be

motivated by the decline in interest rates which has

been observed in the latter 1980s and in the 199Os, as

expectations about inflation declined and remained low.

The changing equity capital position of the top

100 cooperatives during 1984-1995 indicates a shift

away from common stock toward other allocated equity capital as a source of equity financing (see Table 8).

Although cooperatives have continued to expand their

volume of business with nonmembers, the proportion

of unallocated equity capital among the top 100 cooperatives has remained relatively stable.

Ill-Identifying the Determinants of

Cooperative Capital Structure

This section investigates the choice of a cooperative capital structure within the context of the general

finance literature. Some of the key controversies and

findings of previous studies are summarized.

A Checklist of Factors

The general finance literature has focused on the

concept of an optimal capital structure.9 Yet, a precise

determination of an optimal capital structure is difficult and, in practice, the choice of a capital structure

may be dependent on several interrelated factors,

some of which may be specific to a company. Brigham

and Houston (1998) suggest a checklist of factors

which firms generally consider when making capital

structure decisions (Table 9). They suggest that the

ultimate goal of a firm is to maintain financial flexibility (i.e., adequate reserve borrowing capacity). The factors they identify align closely with those in the general finance literature.

Although it is possible to determine a firm’s optimal capital structure, as a practical matter it cannot be

estimated with precision. Financial officers tend to

treat the optimal capital structure as a range of values

(say 35-45 percent debt), rather than as a single value

(40 percent debt), and the target capital structure lies

within a range.

9 The study of capital structure was sparked by Modigliani and

Miller (1958) who proposed that choosing a capital structure is

irrelevant to the maximizing objectives of the firm. They suggested

that the value of a company could be derived by capitalizing a

fixed, expected return using an expected rate of return. Because

the expected return and its rate are assumed not to vary with the

method of financing used (Le., equity versus debt), the implication

is that the choice of a capital structure is irrelevant to the value of

the firm. Most analysts argue that capital structure does matter

and the growing literature on capital structure choice since 1958

has focused on analyzing the other factors which should be

considered: economic and financial trade-offs (Miller, 1977; Myers,

1984 and 1993; Barclay, Smith and Watts, 1995), asymmetric

information (Ross, 1977) , agency costs (Jensen and

Meckling,l976), and market interaction (Jensen and Meckling,

1976).

9
Table g-Checklist of factors which may influence capital structure choice

Factor

Sales stability

Asset structure

Operating leverage

Growth rate

Profitability

Taxes

Description

A firm with more stable sales can safely add debt and incur higher fixed charges.

Firms with assets which are suitable as collateral tend to use debt more heavily.

A firm with less operating leverage is better able to use more financial leverage.

Faster-growing firms must rely more heavily on external capital.

Firms with higher rates of return tend to be able to finance more of their investments with

internally-generated funds.

A firm with a higher tax rate has greater deductibility of interest expense and a greater incentive to use debt.

Control

Management attitudes

Lender attitudes

Market conditions

Internal conditions

Financial flexibility

If management is insecure, it may use debt to maintain control of the firm.

More aggressive managements use more debt in the quest for higher profits.

Managements will use lender advice in determining the appropriate degree of financial leverage to use.

When financial market conditions are causing interest rates on debt instruments to be high,

there is an incentive to issue equity.

‘A firm may prefer to finance with debt until expected earnings materialize.

A firm will determine if its reserve of future borrowing capacity will be impaired by the use of

debt financing today.

Source: Brigham and Houston (1998), p. 521-522

In addition, the choice of a capital structure may

be linked to funding decisions underlying the actual

implementation of investment projects. Thus, it is

often necessary to incorporate practical experience and

knowledge of firm and industry conditions into a more

realistic determination of capital structure. This

approach explores the methods which potentially can

be used by cooperatives to determine the cost of capital given any of several alternative capital structures,

not only optimal ones.

Agricultural Cooperatives

In comparison with corporate capital structure,

the literature on agricultural cooperative capital structure is relatively underdeveloped, and yet no less controversial. In general, the existing cooperative finance

literature has stressed the unique characteristics of

agricultural cooperatives. These characteristics tend to

obstruct the straightforward application of several

approaches which have been taken in the general corporate finance literature. We review each of the four

primary approaches, plus the potential role of cooperative objectives, as determinants of cooperative capital

structure choice.

Economic Trade-offs. One of the central ideas of the

trade-off approach is that the firm balances the benefits of tax savings (from deducting interest expense)

with the cost of financial distress due to bankruptcy

when too much debt is used. The trade-off approach

suggests that firm size may be a factor in cooperative

financial leverage, even though its exact role is indeterminate. It appears that a significant positive relationship exists between financial leverage and cooperative

size. However, there does not appear to be a consensus

on what role cooperative size plays as a determinant of

financial leverage position. Thus, the trade-off

approach is mostly useful as a conceptualization of the

issues involved in capital structure choice.

Asymmetric Information. The asymmetric information approach shows managers can manipulate the

firm’s value via the signaling of information about the

firm and the influence of their actions on stock prices

(Meyers and Majluf, 1984). Two factors make it difficult for agricultural cooperative managers to signal

information to investors. First, managers don’t often

own the equity of the cooperatives they operate.lO

Second, even if they were owners, the equity is not a

‘0 Cooperatives increasingly are providing stock ownership

incentives to their management personnel.

10
traded asset.” It is more likely that cooperatives follow

a “pecking order” strategy, because they would potentially improve the performance of the cooperative by

selecting the lowest cost financing alternatives first.

Tangible assets may also play a role in cooperative capital structure choice under the asymmetric

information approach. Pederson and Manda (1994)

find that cooperatives with higher fixed assets generally also carry higher levels of debt. The reasoning for

this result appears to be that tangible assets provide

good collateral for lenders, which may reduce the costs

of asymmetric information by lowering the costs of

financial distress for the lender and the borrower.

However, if the assets are firm-specific, the cooperative would likely have a comparatively lower debt

level because of the implied reduction in asset liquidation value, if bankruptcy were to occur. Thus, the proportions of tangible and firm-specific assets in a cooperative may contribute to opposing effects on capital

structure.

Agency Costs. The agency costs of equity capital

are less applicable because agricultural cooperatives

are substantially still owned by their members. It is

less likely that cooperative managers will attempt to

appropriate perquisites, or that they will change their

attitudes and become less oriented toward searching

for profitable projects, even though they are not substantial owners. However, the agency costs of debt

might apply to cooperatives.12 The scenario is the

same as in the corporate financing situation, although

cooperatives may not be as sensitive as corporations to

these costs.13 The type of agency cost of debt which

remains for both cooperatives and corporations is the

cost of bankruptcy.

Cooperatives confront another potential agency

cost of financing. Cobia (1989) and Fischer (1983) suggest that cooperatives may be trapped in a “free cash

11 These factors imply that cooperative value may be less sensitive to

information. In economic terms, the gain to a cooperative

manager is less than the associated cost of signaling false

information, because one possible consequence is bankruptcy.

However, this does not mean that managers of cooperatives will

not signal false information. Given an incentive to do so,

managers might do so to reduce the cost of debt. Therefore, the

asymmetric information result can happen even in agricultural

cooperatives, but only if managers are motivated by an

achievement incentive.

I* Jensen (1986) provides an interesting theoretical discussion of the

role of debt in monitoring managers and their organizations to

increase efficiency.

I3 Use of debt only weakly induces cooperative members

(stockholders) to prefer risky projects, since cooperative stocks are

not readily marketable. The weak incentive to take on risky

projects lowers monitoring costs as well.

flow problem.” That is, cooperative management may

decide to extend or maintain a longer revolving fund

period or increase the percentage of retained patronage refunds to finance the cooperative’s growth, even

though this might not significantly benefit current

members. This is an “agency cost of patronage

refunds,” which would theoretically be reflected in the

cooperative’s capital structure and cost of capital.

Market Interaction. The influence of product characteristics is less likely to be a significant factor in agricultural cooperatives where the customers are also the

owners. Moreover, agricultural cooperatives do not

generally produce (or supply) durables to their customers. When durable goods are involved, a cooperative usually plays the role of an agent, who bargains

for its members with the firm producing the durable

good. Although product characteristics are not likely

to influence cooperative capital structure decisions,

input characteristics may be important (e.g., due to

lumpiness in input acquisition)

Cooperative Objectives

Potential differences exist between cooperative

capital structure decisions and those of corporations

for various reasons. Van Sickle and Ladd (1983) state

that the disparities include: a cooperative’s customers

are its owners, the price of a cooperative’s common

stock is fixed, deferred patronage refunds are a source

of capital financing, cooperatives may operate with a

single tax, and a cooperative’s objective is to benefit its

member-customers.

The fact that cooperative customers are also its

owners raises the prospect for a more complicated

objective. If owners and customers are separated, the

objective could be either to maximize owner profits or

to minimize customer costs. Farmer-customers of an

agricultural cooperative want to sell products at high

prices and buy inputs (and services) at low prices. As

owners, farmers would prefer the reverse situation.

Thus, to specify the objective of the cooperative

requires careful consideration of these characteristics.

The optimal prices paid to cooperative users should be

determined by the patronage refund policy. A lower

proportion of cash refunds and a longer deferred

patronage refunds revolvement period should induce

farmers to act more like customers of the cooperative

and less like owners.

Ladd (1974) assumes that the cooperative’s objective is to maximize members’ supply price or the

quantity of raw material to outside processors. Fischer

(1983) assumes that the objective function is composed

of the sum of total members’ net revenue from produc11
tion and the cooperative’s net revenue. To make that

specification compatible with real problems, Fischer

assumes that the cooperative restricts itself to do business with members and that they are not concerned

with the patronage refund policy of the cooperative

(i.e., separability applies). Although both approaches

consider members’ double role, they ignore the patronage refund policy. A better way to state this objective

function has been shown by Van Sickle and Ladd

(1983). Their objective includes the sum of members’

total net revenue, the present value of patronage

refunds paid to members, and the net dividends paid

to members. This specification captures the interests of

cooperative members, the patronage refund policy,

and the cost of capital.

While cooperative stock is not marketable, the

value of the underlying equity capital is not fixed

either. Thus, the value of equity depends on the cooperative’s dividend, equity redemption policies, and

operational risk. While there is no ideal way to value

cooperative equity capital, the value of equity can be

expressed by the sum of discounted dividend stream

and redemption value of the stock adjusted for the

cooperative’s operational risk (i.e., the risk-adjusted

cost of capital). Therefore, if operational risk varies, we

cannot argue that a fixed dividend and known length

of equity retirement will lead to a fixed price for a

cooperative’s stock, even though the book value per

share may be fixed. Accordingly, the cost of capital of

the cooperative is also not fixed. These and related

issues are considered later in this report when it is

illustrated how a cooperative might estimate its annual

cost of capital using a discounted cash flow approach.

In corporate operations the level of retained earnings is an important financing source. In cooperatives

it is largely reflected by retained patronage refunds.

Corporate financing is “investor-oriented,” but is

“user-oriented” in cooperatives. The implication is that

the value and cost of retained patronage refunds are

more important when valuing a cooperative. Instead

of just two parties to the capital structure (stockholders

and debtholders), a cooperative contains a potential

third party, the owners of the patronage refunds. Thus,

where a corporation’s primary value is in the value of

its stock, the corresponding value of a cooperative is

the sum of member patronage accounts and its stock.

Cooperative Taxation. While corporate earnings

are taxed at the corporate level and at the personal

level when distributed as dividends, this double-taxation can be eliminated by qualifying as a cooperative

for tax purposes. The Internal Revenue Code requirements are in Subchapter T and Section 521. Subchapter

T requires that refunds be allocated in proportion to

patronage, based on the net income of the cooperative

from business done with its patrons. A cooperative

which meets the requirements of Subchapter T can

deduct its patronage refunds from taxable earnings. If

cooperatives meet the requirements of Section 521 of

the Internal Revenue Code, they can also deduct the

earnings from nonpatronage sources which are allocated to patrons in proportion to patronage and the dividends paid on capital stock. This implies that the tax

advantage of debt might not apply to the capital structure decision of a cooperative. Thus, the tax advantage

of debt financing, when compared to other financing

sources, would appear to be relatively lower than in

the case of a corporation.

IV-Developing Approaches

to the Cost of Capital

Different methods have been developed in the

finance literature to estimate the equity investor’s

required rate of return, or opportunity cost of common

equity capital. Patterson suggests a classification of

those methods which differentiates between accounting-based and market-based approaches (Figure 1).

Accounting-based methods rely on information

which is routinely assembled through a firm’s accounting system. They generally require the same kind of

data as reflected in the financial statements of a company. Indicators such as the rate of return on equity of

the company (or those of companies in the same

industry or risk classification) may be used.14 The

comparable earnings approach has been used primarily in the field of public utility regulation, where the

rates of return earned on alternative investments is a

key factor in determining the rate of return a utility

can achieve through adjusting the prices it charges.

This approach reflects the opportunity cost of capital.

Market-based approaches may be either implicit

or explicit in their derivation of the cost of equity capital. Explicit models attempt to derive the cost of equity

capital directly from capital market data through the

use of a theory of market equilibrium prices. The

Capital Asset Pricing Model (CAPM) is the most frequently used, although the Arbitrage Pricing Theory

(APT) approach is more general in terms of the market

I4 The option-pricing model (OPM) is a subcategory of the “own

firm” model. The OPM uses data from the balance sheets and

income statements of the company and some key assumptions on

interest rates and the volatility of the historical rates of return of

the company.

12
Figure I-Classification of Cost of Capital Models (Adapted from Patterson)

/

1 Accounfing B;d 1

Opportunity Cost of Equity Capital

OwnFrm

I

I

,

Option-Pricing

r

Comparable Earnings

1

:

Market Based

I

I

Historical Risk Premium

Discounted Cash Flows

Explicit Estimate

I

13
factors which it incorporates. In contrast, implicit

models derive the investors’ required rates of return

without consideration of the factors which are causing

those returns to change. For example, the discounted

cash flow (DCF) approach uses observed current dividend and market price data and estimates of what

investors expect as the future rate of dividend growth

to approximate the total expected rate of return. The

historical risk premium model looks at average market

returns over long periods of time and compares them

with the average of rates of return on risk-free securities to determine the risk premium.15 The estimated

risk premium is added to the current risk-free rate to

determine the required rate of return on equity capital.

When considering the application of accountingbased and market-based models at the firm level, the

alternatives are more limited than the classification

scheme suggests. This is because of the lack of available data and the resulting set of necessary assumptions. The OPM is the only one which uses both information on firm capital structure and market information to derive a cost of capital estimate.i6 The DCF

model makes different assumptions about the expected growth of earnings and dividends, and can be modified to account for different growth indicators and

varying growth in the future. In this way, variations of

the model may yield a wide range of cost-of-capital

estimates. Thus, there appears to be no ideal model

which can be readily applied to determining the cost

of capital at the firm level. With these limitations in

mind, we use the DCF approach and a hurdle rate

approach (a variation of the implicit model) to illustrate how to estimate the cost of capital.

Discounted Cash Flow

In the DCF method, the cost of equity capital is

defined as the sum of the dividend yield and the

growth rate of share price. l7 The approach provides a

simple method for calculating the cost of capital of a

traded company, yet it requires relatively strong

assumptions about dividends per share and their rate of

growth. In this way, the cost of equity capital calculation

incorporates the opportunity cost of funds concept.

I5 The closest thing to a true “risk-free” security is the short-term

U.S. Treasury bill, because of the implied low probability of

default.

I6 A drawback of the OPM is the relatively strong assumptions

made about the distribution of rates of return. Consequently, the

OPM estimates of the cost of equity capital may be quite sensitive

to these assumptions.

I7 Myers and Borucki (1994) use the discounted cash flow approach

to determine the cost of equity capital for utility firms.

Constant Growth Model. The formula for the cost

of equity (k r) is,

k E = (Div, / PO) + g n

where Div, is the dividend one year later, I’, is the

price per share today, and g D is the expected annual

rate of growth of dividends.‘* Another way to look at

the calculation of k is based on the idea that the return

to equity holders comes as dividends and capital gains

(or losses). The expected rate of return is,

k E = (Div, / PO) + g P

where g p is the expected rate of stock price appreciation (or decline). However, this may not give a reliable

estimate of the cost of equity unless it is possible to tie

the change in stock price to the company’s performance. The constant-growth DCF model attempts to

solve this problem by assuming that the expected rate

of return from capital gains equals the expected

growth rate of dividends (i.e., the expected long-run,

sustainable growth rate).

Sustainable Growth Rate. The long-run growth rate

for earnings and dividends can be derived from the

forecasted profitability and growth of assets. One such

estimate of the sustainable growth rate (g J is the rate

of return on equity (ROE) multiplied by the retention

rate, i.e., the fraction of annual earnings retained by

the company,

g s = ROE x retention rate.

Thus, the constant-growth DCF method can be

used with an observed stock price and an approximate

forecast of dividends per share to derive an estimate of

the cost of equity capital,

k E = (Div, / PO) + g s = (Div, / PO) + (ROE x retention rate).

For example, assume that a company is expected

to pay out $0.40/share 1 year from today and the book

value is currently $5/share. If the company expects a

15 percent rate of return on book value equity and follows a constant policy of 40 percent payout, the estimated cost of equity capital becomes 17 percent.19

I8 Myers and Borucki say that this derivation can be dangerous if

the assumption of a constant dividend growth rate cannot be

satisfied.

I9 This example uses the book value of equity, but the equity value

can also be based on the market value measure of equity.

14
That is,

k E = ($.40/ $5) + (.15 *.60) = .17.

Alternatively, if the company expects to earn a

higher ROE (20 percent) and retain a higher percentage

of earnings (70 percent), the cost of equity capital rises

significantly to 22 percent. Thus, the cost of equity capital rises as an indication that the opportunity cost of

capital has risen, even though the dividend payout (and

yield) has not increased. Thus, this cost of capital

reflects the cost of retained equity capital, which may be

different than the rate of return required by new equity

investors in the company. A key to this method is the

selection of an appropriate growth rate. The selection of

a growth rate to use is likely to have more problems

when a company bases its forecast on relatively shortterm estimates (e.g., under 5 years of financial data).

Overall Cost of Capital. The average cost of capital

(WACC) is the weighted-average of the after-tax costs

of debt and equity capital, where the weights are the

percentages of the debt and equity capital components

in the capital structure of the company. That is, WACC

= k D (D/V) + k E (E/V) where k ,, is the after-tax cost

of debt, D/V is the debt capital/total capitalization

ratio, k E is the cost of equity capital, and E/V is the

equity capital/total capitalization ratio. For illustration, assume that debt capital comprises 30 percent of

total capitalization and the after-tax cost of debt is 8

percent. If the cost of equity capital is 17 percent (as

calculated above), the WACC is 14.3 percent (.08*.30 +

.17*.70 =0.143).

V-Applying Cost of Capital Concepts

to Agricultural Cooperatives

Preceding sections suggested that a cooperative

has two basic approaches from which to choose when

determining its cost of capital-the discounted cash

flow (DCF) approach and the opportunity cost of

funds (OCF) approach.

Opportunity Cost of Funds Approach

Patterson (1995) suggests that the DCF approach

focuses on the right side of the balance sheet and the

assumption of a financing mix (of debt and equity capital) may be misleading in solving the cost-of-capital

problem. He says the focus should be placed on the

investment alternatives of the investor (as implied by

the asset side of the balance sheet). Thus, the cost of

capital would be related to the alternative uses of capital, not to its alternative sources.

Because of the problems which have been cited

with determining the cost of equity capital, agricultural cooperatives appear to have followed the OCF

approach in various ways. One such method is to

determine an acceptable rate of return on cooperative

investments. That is, cooperative management identifies what is believed to be an acceptable rate of return

for the risk class of investment project(s) under consideration (i.e., an opportunity cost of capital). The procedure for implementing this approach is quite straightforward once the acceptable rate of return (the hurdle

rate) has been established. This rate is compared with

the calculated internal rates of return of the investments and the acceptable projects are identified. The

advantage of this approach is that it is relatively easy

to implement and it allows for other criteria to enter

the final decision concerning which projects are preferred. The hurdle rate need not bear any relationship

to the cost of funds to the cooperative.

Application of the OCF Approach

The United Farmers Cooperative (UFC) is a pooling cooperative located in the Midwest which processes and markets a specialty agricultural crop. UFC

operates several processing plants in the region. It

acquires the raw commodity from farmers in the fall at

various collection points, processes the raw product,

and sells the final products in a national market under

its own label.

The UFC has also been gradually upgrading its

facilities under a capital improvement plan. As a

result, UFC must periodically evaluate new capital

investment projects. The company uses several criteria

for funding and selecting capital projects: base capital

plan projects (for routine asset replacement projects),

strategic investment plan projects (typically, projects

which exceed a minimum threshold size and have

quite long lives), and all other projects (which are of

smaller size). Base capital investments are made to

cover 50-75 percent of the annual depreciation of

assets. Strategic investments are approved by the

board of directors of the cooperative. All projects are

evaluated on their estimated economic returns (the

internal rate of return after-tax) and total project costs.

The estimated internal rate of return of each project is

compared with the hurdle rate of the company to

determine its acceptability. In recent years that hurdle

rate has been set at 15 percent (after-tax). Strategic projects with rates of return under the 15 percent benchmark may also be accepted based on other nonfinancial criteria and objectives of the cooperative.

15
Determining the Hurdle Rate. This rate at UFC has

remained at 15 percent for the past couple of years.

Several factors have been used to determine the ratethe level of long-term desired economic returns, alternative rates of return on noncooperative investments,

interest rates, and the average cost of debt and equity

capital. The desired level of economic returns is determined informally by the directors through a review of

past cooperative projects. Information about the rates

of return on past projects is typically derived from

post-completion audit reports.

Table r&S&P 500 Total Return Index and compound

annual rate of return.

Mid-year S&P Total

Return Index

Percentage annual

compound rate of return

(through mid-1997)

1977 132.75 15.9% (20 yr.)

1987 647.35 14.7% (10 yr.)

1992 1,030.88 19.8% (5 yr.)

1997 2,571.47 -

The UFC has determined that the noncooperative

rates of return should include: the anticipated rate of

return on a stock market index (e.g., the S&P 5001, the

average return on sales of the Fortune 500 companies in

its industry group, and the rates of return that farmers

can expect on investments in their own cropping operations. These are clearly quite diverse rates of return

concepts, and UFC uses them to bracket the long-run

rate of return that is acceptable to farmers as investors.

For example, the total rate of return to the S&P 500

Index during the past several years has varied around

15 percent. The S&P 500 Total Return Index and the

corresponding compound annual rate of return on the

Index are reported in Table 10.

before-tax rate of return experienced by farmers on

their overall cropping operations has been below the

hurdle rate of 15 percent, but the average net rate of

return per acre on their specialty crops has been above

that level. Thus, the 15 percent hurdle rate of UFC

compares reasonably well to the opportunity cost

which farmer members face in their on-farm investment alternatives.

Similarly, the median rate of return on sales of

the Fortune 500 group of “food” companies was 16.5

percent in 1996. Comparable measures of the median

total returns of the food group of 500 companies are

also useful indicators.20 The l-year median total return

for 1996 was about 18.1 percent and the lo-year median total return (1987 through 1997) was about 15.4 percent. Thus, the UFC hurdle rate falls quite close to the

long-term industry benchmarks.

The rates of return on farmer investments in their

operations vary considerably by farm, by crop and by

year. Thus, the expected rate of return on farm cropping operations has been a difficult number to approximate. The average rate of return on assets of crop

farmers in the region was about 7 percent during 1990-

1995. For comparison, the average rate of return on

assets among the top 20 percent of farmers in the

region varied from 10 percent to 14.4 percent (depending on how farm assets were valued). Alternatively,

selected specialty crops grown in the region produced

average, before-tax net rates of return (net

returns/ total variable and overhead expenses including rent) per acre which were slightly higher than 15

percent during 1990-95. This suggests that the average

The interest rate paid by UFC varies by lender

and maturity of the debt. UFC pays about 1 to 1.5 percent above the Treasury rate on funds borrowed

through the Bank for Cooperatives. In 1996, the longterm Treasury rate (e.g., 5-10 year) was about 6.2 percent to 6.5 percent. Thus, a term loan to UFC through

the Bank for Cooperatives would have been priced at

about 7.2 percent to 8 percent, depending on the maturity of the loan. Variable-rate term loans available to

UFC through commercial banks in the region have carried interest rates of 9.0 - 9.5 percent in recent years.

Because the average commercial bank rate has been

higher than that available through the Bank for

Cooperatives, the UFC has primarily used the Bank for

Cooperatives for its term borrowing requirements.

To reflect the opportunity cost of funds to the

cooperative members, the UFC also considers the rate

of interest paid on loans by its farmer-members. The

rates paid by members vary considerably depending

on the source, maturity, security offered, pricing

option, and other features of the loan. During 1995-

1996, the average rate paid on long-term farm loans to

commercial banks was about 9.7 percent. The corresponding average long-term rate paid to the Farm

Credit System was about 8.5 percent. Related to the

opportunity cost of funds to its members, UFC evaluates how the cost of capital is affected by changes in

the per unit retains of its members.

*O The Fortune 500 total return to investors series includes capital In the final analysis, the hurdle rate is detergains and losses plus reinvested dividends. mined based on a consensus. To formulate a consensus

16
the UFC goes through a sequential review process.

Initially, the finance committee prepares a comparative

chart which lists the above alternative opportunity

costs of capital. The committee formulates a consensus

of what rate is an appropriate cost of capital from that

data and forwards that recommendation, along with

the other comparative cost of capital information, to

the senior management group at UFC. The senior management group formulates a consensus on the appropriate hurdle rate and forwards that and the other cost

of capital information to the board of directors. The

final step in building a consensus at UFC is for the

board to review the hurdle rate recommendation of the

senior management group (and the related information on the opportunity cost of funds) and develop a

consensus hurdle rate. Through this process additional

information from post-completion audits of prior

investment projects and other nonfinancial considerations are brought into the decision. This makes the

hurdle rate at UFC a cost of capital which reflects the

overall financial and strategic objectives of the cooperative.

Assessing Risk. To evaluate an investment project,

other factors related to project- specific risks are considered. The UFC includes risk factors such as: market,

construction, acquisition, operation, project duration,

and technology. These factors could be used to adjust

the hurdle rate requirement to reflect the level of

uncertainty about investment projects with higher levels of risk. UFC does not explicitly adjust the hurdle

rate for risk. Rather, the risk factors are evaluated and

their joint influence is considered implicitly when

selecting projects.

Each of these risk factors varies in importance

according to the specific project under consideration.

A description of the process is provided from a recent

UFC strategic plant expansion project (see Box 1).

The process of assessing the risks of a project of

this size is often time-consuming. The cooperative has

developed a strategic plan, and to execute that strategic plan capital needs and availability are generally

projected for 5 to 10 years. Major projects (such as the

one described) may be considered as a part of the

cooperative’s long-term capital plan for several years

before actual construction begins. During this time, the

priority of a project may change as the evaluation of

risk factors changes.

Discounted Cash Flow Approach

The DCF approach provides a practical alternative to determining the cost of equity capital, because

it relies on information that can be obtained from the

cooperative’s financial accounting system. The DCF

approach for an agricultural cooperative deviates from

the standard discounting of dividends formula found

in the finance literature. This application derives a

proxy for the discount rate from the relationship

between the level of dividend payout and the book

value of equity. Thus, the approach does not use a

market-value-of-equity measure of the dividend yield

when deriving the cost of capital.

Application of the DCF Approach

Midwest Cooperative primarily merchandises

grain, the major crops grown in the Midwest. It also

sells feed and other farm supplies, and offers other services. The cooperative is also involved in the processing and refining of grain. During 1990-96, the average

sales revenues were composed of grain merchandising

(83 percent), processed grain (13 percent) and feed

sales and farm supply services (4 percent).

According to the constant growth equation, the

cost of equity capital for Midwest Cooperative is the

sum of the expected dividend rate of return (or yield)

and the sustainable growth rate,

k r = @iv, / I’,,) + g,

where g s (the sustainable growth rate) is the product

of the rate of return on equity and the retention rate.

Thus, the constant-growth DCF method requires an

observed price and an approximate forecast of dividends per share in order to derive the cost of equity

capital.

Since Midwest Cooperative pays no dividends

per se, it must estimate the dividend yield. Therefore, a

modification is made to the constant growth model.

The annual dividend yield is calculated during 1990-95

as: the sum of the annual amount of cash patronage

paid plus the annual redemptions of capital equity certificates (both paid in the following year), all divided

by the average annual equity capital of the cooperative. The required accounting data for Midwest

Cooperative’s cash patronage, redemptions of equity

certificates, and equity capital balances were taken

from the annual consolidated statements of capital.

The book value of equity capital used in calculating the dividend yield may be either the total or allocated equity capital of the cooperative. However, as

applied to investment decisions, the total equity capital of the cooperative is a more appropriate measure.

The cash patronage part of the dividend (Div,) is paid

based on the level of patron business, so there is no

explicit connection between the level of cash paid out

17
Box 1. Determining the Hurdle Rate

A processing plant is to be expanded to increase daily production capacity by 30 percent at that plant, and by 6

percent overall, at a cost of $60 million. The expansion will require upgrading equipment in most areas of the

plant. In addition, members must increase their production of the cooperative’s raw product by 6 percent. This

will result in a corresponding 6-percent increase in the production of all UFC products.

The project involves a variety of risks, but they are generally related to matters with which the cooperative has a

great deal of experience. Therefore, the risk factor is considered low. The investment does not involve new products, new technology or the purchase of another business. However, the project does include risk elements in the

market, construction and operation, and raw product production.

The expansion is projected to increase production of the cooperative’s primary product by 6 percent, while consumption of the cooperative’s primary products is only growing at a rate of 2 percent. The sales department is

requested to thoroughly review market conditions, consumption by current customers, projected pricing levels,

logistical arrangements and expected reaction from competitors. The market evaluation also includes analysis of

the market conditions for the byproducts produced. This review is quite extensive and the final report is presented to the board of directors. The report indicates that there would be no direct adverse consequences and the

indirect consequences are manageable. Thus, market risk is not considered to be a factor which would warrant a

higher than normal hurdle rate.

Construction and operation risk arise due to the project’s significant size and the duration of the construction

period. The operations department has completed preliminary engineering on the major components of the plant

expansion and has had preliminary discussions with equipment vendors and construction companies on the timing and cost. Operations risk is considered to be relatively low. The final report is presented to the board of

directors. Based on the company’s experience with expanding other plants and the findings in the final report,

construction risk is not considered to be a factor that would warrant a higher than normal hurdle rate.

Production risk derives from the ability and desire of the members to supply the raw product to the cooperative

at levels which exceed current levels. There is no risk of a shortage of raw products to supply the expanded plant

capacity.

After the board of directors considered the consistency of the project with the cooperative’s long-term strategy

and the various risk factors, the financial projections were presented and considered. There was no risk premium

adjustment to the hurdle rate in this case, so the projected internal rate of return of the project was compared

with the general hurdle rate of 15 percent.

and the level of equity investment of a particular

investor in the cooperative. However, at the cooperative level there is no requirement to associate cash paid

out with the amount of individual investor equity, so

total book value of equity capital can be used to estimate the dividend yield.21

The resulting annual estimates of the cost of equity capital are reported in Table 11. To illustrate the use

21 In the case of Midwest Cooperative, about 72 percent of all equity

capital is held as patronage certificates.

18

of the cost-of-equity-capital equation, the cost of equity capital ( k r) was calculated for 1996. The dividend

yield in 1996 is 6.31 percent. This is calculated as: the

sum of the cash patronage ($13,194,000) and redemptions ($6,900,000) in 1996 all divided by average total

equity capital for 1996 (about $318,370,000). The second component of the cost of equity capital is the sustainable rate of growth for 1996, or 11.87 percent. The

sustainable growth rate is calculated in two steps.

First, the retention rate on equity in 1996 t.2587) is calculated as: 1 .O minus the ratio of cash patronage divided by net earnings ($13,194,000 / $51,000,000). Then,
Table I l-Cost of equity capital estimates for Midwest Cooperative, 1990-l 996.

Item 1996 1995 1994 1993 1992 1991 1990

Dividend Yield 0.0631 0.0615 0.0606 0.0525 0.0528 0.0474 0.0538

Retention Rate 0.7413 0.7555 0.7170 0.7890 0.8012 0.7612 0.7845

Rate of Return on Equity 0.1602 10.577 0.1358 0.1381 0.1469 0.1038 0.1389

Sustainable Growth Rate 0.1187 0.1191 0.0974 0.1090 0.1177 0.0790 0.1089

Estimated Cost of Equity 0.1819 0.1807 0.1579 0.1615 0.1705 0.1264 0.1628

the retention rate is multiplied times the ROE for 1996.

The ROE in 1996 (16.02 percent) is calculated as: net

earnings (about $51,000,000) divided by average total

equity ($318,370,000) for 1996. Thus, the cost of equity

capital in 1996 is,

k, = (Div, / PO> + g,

= [ (cash patronage + redemptions) /

average equity capital] + [ 1.0 - (cash

patronage / net earnings) I x (net

earnings / average equity capital)

k (1996) = .0631 + (1.0 - .2587) x .1602

= .1819

The cost-of-equity estimates in Table 11 vary

between 12.64 percent in 1991 and 18.19 percent in

1996, when using total equity capital to calculate the

dividend yield. The corresponding average of these

rates for 1990-1996 indicates that the average cost of

equity capital for Midwest Cooperative is about 16.3

percent.

The average cost of capital (WACC) for Midwest

Cooperative is the weighted-average of the after-tax

component costs of debt and equity capital, where the

weights are the proportions of term debt and equity

capital in the capital structure from the annual end-ofyear (May 31) balance sheets. Algebraically, the average cost of capital is

WACC = k ,, (D/V) + k E (E/V),

where D/V is the term debt/total capitalization ratio

and E/V is the equity/total capitalization ratio.** For

22 Total capitalization is the sum of long-term debt capital and total

equity capital of the cooperative.

example, in 1996 Midwest Cooperative had a 7.6 percent before-tax cost of term debt and an estimated

18.19 percent cost of equity capital (Table 12). Based on

the 1996 proportions of term debt and equity capital in

the total capitalization of the cooperative, the average

cost of capital is calculated to be 15.2 percent. Because

of the increase in the cost of equity capital component,

the average cost of capital in 1995 and 1996 are higher

than any of the previous years. Based on the annual

cost of capital estimates in Table 12, the 7-year average

Midwest Cooperative cost of capital for 1990-1996 is

estimated to be about 14.6 percent.

Determining Divisional Costs of Capital. The DCF

approach can be adapted for use at the divisional level

of a company. This method illustrates how to determine the cost of equity capital and the average cost of

capital for each division in the Midwest Cooperative.

As with DCF, the divisional cost of capital calculation

is based on historical financial accounting data. The

methodology is relatively similar to the cooperativelevel cost-of-equity-capital calculation, yet there are

some additional assumptions which are made to

implement it.

One key assumption is that the divisional cost of

equity capital and the cooperative cost of equity capital differ in their implied sustainable growth rates

(which in turn is due to differences in the rates of

return on equity capital). The reasoning is that, while

the sustainable growth rate of the cooperative is

derived from its divisions, the growth rate of a division may be higher or lower than the overall growth

rate of the cooperative due to differences in profitability and the corresponding rates of return of the various

divisions. So this differential in profitability should be

reflected in the cost-of-equity estimates of the various

divisions of the cooperative.

Alternative assumptions could be made about the

divisional cost of debt capital. One assumption could

be that it is equal to the average cost of debt of the

cooperative. This appears to be a reasonable assump19
Table +-Weighted-average cost of capital estimates for Midwest Cooperative, 1990-l 996.

Item 1996 1995 1994 1993 1992 1991 1990

Proportion of term debt capital 0.26 0.21 0.11 0.13 0.16 0.20 0.21

Cost of term debt 0.076 0.076 0.073 0.077 0.073 0.095 0.0975

Proportion of equity capital 0.74 0.79 0.89 0.87 0.84 0.8 0.79

Estimated cost of equity capital 0.1819 0.1807 0.1579 0.1615 0.1705 0.1264 0.1628

Effective tax rate* 0.119 0.102 0.135 0.103 0.139 0.0545 0.163

Average cost of capital 0.1520 0.1570 0.1475 0.1495 0.1533 0.1191 0.1457

* The effective tax rate is equal to the income taxes paid divided by the net earnings before tax. The rate is equal to the combined federal and

state marginal tax rate of the cooperative after adjusting the amount of tax liability downward to account for the distribution of patronage

earnings. The marginal federal income tax rates were 35% (1994-96) and 34% (1990-93).

tion because a cooperative is expected to borrow as a

single entity. Thus, if the cooperative were requesting a

loan or issuing debt to finance an investment in any

one of its divisions, it would be quoted a single rate of

interest on that funding request, regardless of which

division uses it. The alternative is to allocate the total

interest charges to the divisions and allow the cost of

debt to vary by division. The latter approach is used

here.

The procedure begins by determining the implied

amount of equity financing in each division of the

cooperative. This is done by calculating the annual

average assets, the annual amount of debt financing,

and the residual amount of annual equity capital

financing in each division. The sustainable growth rate

in each division is calculated based on the annual rate

of return on equity capital and the dividend rate and

retention rate of the cooperative. Finally, the average

cost of capital is calculated based on the derived proportions of equity and term debt financing in each

division, and the effective tax rate of the cooperative.

This procedure is schematically illustrated in Figure 2.

This approach is applied to data from the 1996

annual report of Midwest Cooperative. Midwest has

two divisions: grain merchandising and grain manufacturing/milling and feeds.23 In Table 13, the two

divisions and the consolidated cost-of-capital calculations are summarized for 1996. The average assets of

the grain marketing division and the manufacturing/milling and feeds divisions account for about 60

percent and 40 percent, respectively, of total cooperative assets.

23 For purposes of illustration, the feed and farm supply activities of

Midwest Cooperative are incorporated into the grain

manufacturing/milling division estimates.

20

Annual interest expenses are allocated to the

divisions based on accounting data. The average borrowing rates of the divisions are calculated based on

the weighted averages of the outstanding seasonal and

term debt obligations of the divisions. The grain merchandising division has a lower average borrowing

rate (6.31 percent) than the manufacturing and feeds

division (7.06 percent) because the grain marketing

activities of the cooperative rely relatively more on

seasonal credit lines which carry somewhat lower

interest rates than term loans. Based on the estimated

average interest rates and interest expenses of the divisions, the total interest-bearing debt of each division

can be determined. The total interest-bearing debt of

the grain marketing division is about $304 million, and

about $181 million for the manufacturing and feeds

division. Midwest Cooperative estimates that more of

its total long-term debt is used by the manufacturing

and feeds division. So, that information is used to

break total debt down into the term and seasonal debt

components.

Equity capital of each division is calculated as a

residual and defined as: total assets minus the calculated interest-bearing debt and the noninterest-bearing

debt allocated to each division.24 The resulting estimates of equity financing of the divisions are: $191

million for grain marketing and $127 million for manufacturing and feeds. The net earnings of each division

is determined from accounting records and the rates of

return on equity (ROE) of the divisions are calculated

using the standard net income/average total equity

24 Noninterest-bearing debt of the cooperative includes: patron

credit balances, advances received on grain sales, drafts

outstanding, accounts payable, accrued expenses. and patronage

dividends payable.
Figure e-Schematic of the Divisional Cost of Capital

Working Captial

and Net Fixed

Assets in Division

Net Earnings

in Division

Other Assets in Interest Expense in

Division

Estimated Equity

Financing in Division

Average Borrowing

Rate of Cooperative

-I--

Estimated Debt

Financing in Division

Rate of Return on Dividend Rate

Equity in Division of Cooperative

-7

Retention Rate of

Cooperative

f v

) Cost of Equity

Capital in Division

-

Tax Rate of

Cooperative

Proportions of Debt

and Equity Financing

in Division

Weighted Cost of

Capital in Division

Cost of Debt Capital

I/

in Cooperative

21
Table 1%Divisional cost of capital calculations for Midwest Cooperative, 1996.*

Item

Grain Merchandising

Division

Manufacturing and

Feeds Division

Midwest

Cooperative

Total assets

Interest expense

Ave. borrowing rate

Interest-bearing liab.

Term debt financing

Equity financing

Net earnings

Rate of return on equity

Sustain. growth rate

Cost of equity capital

Cost of debt capital**

% Equity financing

% Debt financing

Average cost of capital

$646,000 $431,000 $1,076,000

$19,153 $12,769 $31,922

0.0631 0.0706 0.0667

$304,000 $181,000 $485,000

$20,000 $78,400 $98,400 -’

$191,000 $127,000 $318,000

$30,000 $21,009 $51,009

0.157 0.165 0.160

0.116 0.122 0.119

0.179 0.185 0.182

0.076 0.076 0.076

90.5 61.9 74.0

9.5 38.1 26.0

0.169 0.140 0.152

* Dollar amounts are rounded to the nearest $000.

** The before-tax, average cost of long-term debt.

ratio. The ROE of the grain marketing division is about cost-of-capital estimate to approximate the risk-adjust15.7 percent and 16.5 percent for the manufacturing ed rate.25 An alternative is to subjectively adjust the

and feeds division. Because ROE estimates of the two cost of capital for individual projects based on the

divisions are quite similar, the sustainable rates of board of directors’ consensus view of the risk involved

growth and the costs of equity capital of the two divi- in each investment project. The result is a project risk

sions are also similar. The cost of equity of the grain classification scheme. Because the overall cost of capimarketing division is about 17.9 percent, while that of tal of the cooperative implies an average risk premium

the manufacturing and feeds division is about 18.5 for the cooperative, the subjective adjustment could be

percent. The overall rate for Midwest Cooperative is either an upward or downward adjustment of the cost

18.2 percent. of capital depending on project risk characteristics.

The average costs of capital of the two divisions

reported in Table 13 differ more significantly due to

the variation in proportions of debt and equity financing used, and differences between the component costs

of equity and debt. The average cost of capital for the

grain marketing division is about 16.9 percent due to

the higher proportion of equity financing used. The

average cost of capital in the manufacturing and feeds

division is about 14 percent, compared with 15.2 percent for the cooperative.

Economic Value Added

The economic value added (EVA) is a measure of

the true profitability of the firm. More specifically, EVA

is equal to the value added by the company above the

minimum return acceptable to investors in a similar

investment alternative.

Adjusting the Cost of Capital for Risk. Although the

Midwest Cooperative has no specific approach to

adjusting the cost of capital for risk, two relatively

straightforward methods could be suggested. Based on

a comparison of the company to other companies in

the same line of business, where the degree of systematic risk is known, the cooperative could adjust its

The EVA may be computed in either of two ways:

use total (debt and equity) capital (called EVA1 here)

or use equity capital only (called EVA2 here). For consistency, the after-tax earnings must be adjusted to

reflect the deduction of interest expense when just

x This is referred to as the “pure play method” in the finance

literature (Brigham and Houston, 1998). The primary problem with

this approach is in finding good comparatives.

22
equity capital is used. The calculation of the EVA is

based on accounting data and calculations of the percentage cost of capital.

EVA1 = after-tax operating profit - after-tax

cost of capital

= earnings before interest but

after-tax - (total capital x % average

cost of capital)

The alternative calculation of the EVA is based on the

return to equity. That is,

EVA2 = Net profit (after-tax) - (Equity capital

x % cost of equity capital)

The cost of capital plays a key role in determining the

EVA of a cooperative in both methods of calculation.

An increase in the cost of capital will result in a

decrease in the EVA. For example, cost of equity capital is equal to the Midwest Cooperative estimated cost

of equity capital in 1996 t.1819). The assumption is that

this cost of equity capital reflects the appropriate risk

premium for the business, based on the Midwest

Cooperative’s 1996 average equity capital (about $318

million) and earnings after-tax (about $51 million),

EVA2 = $51,000,000 - ($318,000,000 x .1819) =

- $6,844,200.

That is, the cooperative lost value relative to its cost of

equity capital. However, if Midwest Cooperative had

arbitrarily set its overall cost of capital at the average

borrowing rate (6.67 percent) plus 4 percent, the EVA

estimate would have been positive,

EVA2 = $51,000,000 - ($318,000,000 x .1067) =

$17,069,400.26

This example can also be expressed in terms of percentages (EVA%). For example,

EVA% = EVA / average equity capital

Investment

= (net profit / average equity capital)

- % cost of equity capital

= ($51,000,000 / $318,000,000) - .1819

= - .022 or -2.2%

when the estimated cost of equity capital is used.

When the arbitrary .1067 rate is used for the cost of

equity capital, the EVA% is equal to about 5.3 percent .

These numerical results illustrate that the cost of capital plays an important role in evaluating the economic

contribution of the cooperative to its members. The

EVA is sensitive to the cost-of-capital calculation, but

more importantly it communicates an important message to the management and the members of the cooperative about the financial performance of the cooperative.

Cooperative management may use any of four

strategies to increase the EVA percentage-increase

earnings while using the same amount of total assets,

maintain earnings at the same level while using less

assets, increase earnings through an expansion project

which utilizes assets more efficiently, and/or redeem

equity capital if its current rate of return is less than

the current EVA percentage.

The EVA concept can also be used to evaluate

strategies for achieving specific performance objectives. For example, if Midwest Cooperative were to

earn $51 million again next year, the next year’s earnings must increase by $5,820,800 to be equal to the current EVA percentage (see Box 2).

Box 2. Calculation of the Required EVA

Net earnings $51,000,000

(less) Cash Patronage $12,000,000

(less) Equity Redemptions $ 7,000,000

= increase in Equity Capital

(times) cost of equity capital

$32,000,000

.1819

= Required EVA $5,820,800

26 The adding of a rate premium to the average cost of debt is

referred to as the “bond yield plus risk premium approach” in the

finance literature (Brigham and Houston, 1998).

23
VI-Conclusions

Cooperative capital structure and cost of capital

are co-determined. Once a capital structure has been

selected, the cost is also determined. The interdependence is due to the fact that each component of the

capital structure has a cost. Therefore, the cost of capital to the cooperative must reflect the combined costs

of the various sources of funds, including the capital

investment of the cooperative’s members. It is this

close relationship between capital structure and the

cost of capital which creates a “cost of capital problem” for a cooperative. A cooperative’s equity capital

comes from its members and is not a security that is

publicly traded in the financial market. Moreover, the

major source of long-term capital in a cooperative may

be retained earnings and allocated patronage dividends. This makes the value of cooperative equity capital more difficult to determine.

Historically, equity capital may have been treated

as a relatively fixed component of the overall capital

structure, and the selection of an appropriate capital

structure viewed as the concern of the cooperative

financial officer. Yet, the selection of an equity capital

position and capital structure influences the overall

financial strategy and the performance of the cooperative. Therefore, capital structure must be the concern of

all decision makers in a cooperative. In addition, a

wider range of financing choices (including equity capital substitutes) is available today and should be considered along with the importance of financial flexibility and manueverability in selecting a capital structure.

The cost-of-capital problem may have been

avoided by cooperatives through a couple of different

ways. First, a cooperative may have relied on the experience and intuition of a manager in situations where

the cost of capital is a factor in the decision. Second,

some cooperatives may have (incorrectly) just put a

zero financial cost on revolving fund capital, thinking

that it carries no explicit cost to the cooperative. Third,

the cooperative board of directors may have set an

arbitrary “hurdle rate” for all of its investment projects

based on external factors, and used that rate to evaluate the profitability and acceptability of investment

projects. Yet, these methods could easily lead to an

under-estimation of the cost of capital and a corresponding over-investment in facilities.

To determine the overall cost of capital for a

selected capital structure, a cooperative must determine its cost of equity capital. Yet, a cooperative’s cost

of equity capital cannot be derived directly from the

market, as in the case of a publicly traded firm. Thus,

there is no ideal method for determining the cost of

equity capital for a cooperative, so it becomes necessary to use an innovative approach. The opportunity

cost of funds approach relates the cost of capital to the

rates of return from alternative uses of capital (i.e., the

assets side of the balance sheet). That is, the focus is on

the expected (or required) rates of return from alternative investments which reflects the degree of risk

involved. The discounted cash flow approach relates

the cost of capital to the alternative sources of capital

(i.e., the liabilities and equity capital side of the balance sheet). The component costs of equity and debt

capital financing are combined into an overall cost of

capital for the cooperative. Both approaches require

making some assumptions to determine the cost of

equity capital.

Our analysis of data suggests that the capital

structure of cooperatives varies by size and type, and

that it has changed in recent years. Larger cooperatives

have typically carried higher proportions of term debt

and lower proportions of equity capital than smaller

cooperatives. Larger cooperatives have reduced their

dependence on debt capital. Several factors may be

contributing to this trend in financial leverage, among

them changes in the strategic objectives of cooperative

management.

Case applications illustrate how agricultural

cooperatives can use the opportunity cost-of- capital

approach and the discounted-cash-flow approach to

determine the cost of equity capital. These cases serve

as a starting point for cooperatives to model their capital positions and consider alternative assumptions

about financing sources, and their potential impacts on

the overall cost of capital.

The discounted-cash-flow approach requires

some key assumptions about profitability of the cooperative, sustainable rates of growth of earnings, and

payout rates. Yet, it provides additional flexibility to

consider both the overall average cost of capital and

the divisional costs of capital for a cooperative. The

resulting cost of capital is useful in estimating the economic value added of the cooperative. In contrast, the

opportunity cost of funds approach requires some key

assumptions about the range of available investments

and the expected rates of return the cooperative and its

members would realize. Both approaches require a risk

adjustment. Although the opportunity cost of funds

approach may be more frequently used by cooperatives, the discounted-cash-flow approach is also valid

and can be derived from cooperative accounting information.

24
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25
U.S. Department of Agriculture

Rural Business-Cooperative Service

Stop 3250

Washington, D.C. 20250-3250

Rural Business-Cooperative Service (RBS) provides research,

management, and educational assistance to cooperatives to

strengthen the economic position of farmers and other rural

residents. It works directly with cooperative leaders and

Federal and State agencies to improve organization,

leadership, and operation of cooperatives and to give guidance

to further development.

The cooperative segment of RBS (1) helps farmers and other

rural residents develop cooperatives to obtain supplies and

services at lower cost and to get better prices for products they

sell; (2) advises rural residents on developing existing

resources through cooperative action to enhance rural living;

(3) helps cooperatives improve services and operating

efficiency; (4) informs members, directors, employees, and the

public on how cooperatives work and benefit their members

and their communities; and (5) encourages international

cooperative programs. RBS also publishes research and

educational materials and issues Rural Cooperatives magazine.

The U.S. Department of Agriculture (USDA) prohibits

discrimination in all its programs and activities on the basis of

race, color, national origin, gender, religion, age, disability,

political beliefs, sexual orientation, and marital or familial

status. (Not all prohibited bases apply to all programs.)

Persons with disabilities who require alternative means for

communication of program information (braille, large print,

audiotape, etc.) should contact USDA’s TARGET Center at

(202) 720-2600 (voice and TDD).

To file a complaint, write USDA, Director, Office of Civil

Rights, Room 326-W, Whitten Building, 14th and

Independence Avenue, SW, Washington, D.C. 20250-9410 or

call (202) 720-5964 (voice or TDD). USDA is an equal

opportunity provider and employer.