Do Differing Attitudes Towards Risk Contribute to Cooperative Agency Costs of Debt?

1. Do Differing Attitudes Towards Risk Contribute to Cooperative Agency Costs of Debt? Getu Hailu Scott Jeffrey Ellen Goddard Symposium 2004 Cooperative Program in Agricultural Marketing and Business June 2nd, 2004

2. Distribution of Non-financial Co-operatives in Canada, 2000 Canada 5824 64 0 23 13 420 65 295 2032 598 177 991 963 FED = 25

3. Outline • Background • Part I: Agency Costs of Debt • Part II: Decision Makers Risk Attitudes

4. Do co-operatives have a significant economic impact in Canada ? • > 1,000 agriculture based co-operatives in Canada (2001) • In 2001 the Top 50 Co-ops employed about 2.5 million people (~8%). Current situation • Increased capital investment needs to be financed Co-operative agribusinesses and Capital Constraints • Equity capital (members’ equity, unallocated equity) • Debt capital (borrowing)

5. What Happened? 1. Excessive borrowing (D/E>>1) 2. Demutualization 3. Sales to/Alliance with IOFs

6. Long term Debt-Equity Ratio (CO-OP vs. IFO) Maple Leaf Foods Lilydale Foods

7. Maple Leaf Foods Lilydale Foods ROE – (COOP vs. IOF)

8. Brief Summary of the 1990’s Evolution • 1992 – UGG Demutualization • 1996 – SWP partial demutualization • 1998 – MWE & AWP merger • 2001 – Agrifood International was sold • 2001 – Agricore United became part of a private company • 2003/4 –Ponoka Co-op

9. So What? • Some co-operative agribusiness firms are going out of business or changing their business model due partially to pressure to make investments to produce economies of scale. Who Cares? • In some cases this is leading to increased concentration in the agribusiness sector. • Traditional co-operative members may lose their equity.

10. Is there a Problem with Debt Financing? Does Capital Structure Matter? • No, if the capital market is perfect, capital structure doesn’t matter (M-M) • Yes, asymmetry of information • The costs related to differing incentives are often referred to as agency costs. • Yes, corporate income tax • The benefits related to corporate income tax (tax subsidy)

11. Principal-Agent Problem • Do the firms manager(s) and the owner of the firm have the same objectives? • Usually not! • The firms owners want to make profits. • Manager(s) usually want to maximize their benefit from working (i.e. their wage less the time and effort required to get that wage). • The difference between the firm managers goals and those of the owners creates what is called a principal-agent problem • Assumption: risk-averse manager and risk-neutral member!!

12. What are Agency Costs? The concept of agency costs are meant to include: • the costs of mitigation of the problems (e.g., monitoring costs). • the welfare loss due to inefficient resource allocation. In short, agency costs are the difference between the first best solution under symmetric information and the second best under asymmetric information. • It is possible to minimize agency costs, but it is not possible to eliminate them altogether.

13. What are Agency Costs of Debt? • It can be established that managers behave differently given different capital structures. • Arises as the leverage of the firm increases: • Incentive to over-invest by managers (Jensen and Mackeling, 1976) leading to inefficiency of resource use. • Under co-op situation, these problems may be more important as the manager’s compensation may not be tied to equity-based incentive mechanism.

14. Debt Leverage and Efficiency • BUT increase in debt leverage may increase efficiency of resource uses Jensen (1986). • debt servicing obligations help to discourage overinvestment of free cash flow • Open empirical question for co-op agribusiness firms?

15. Similar Studies in the U.S. Impacts of a 10% increase in debt: • In all previous studies, the agency costs of debt are investigated for aggregated data. • This study examines the agency costs of debt case by case to take into account the differences across firms.

16. Intractability and Testing for Agency Costs of Debt • The agency costs of debt are not easily tractable and testable. • In an attempt to deal with an intractable problem the agency costs of debt are defined as follows: • agency costs of debt represent a shift in the production function through the impact on managerial efforts. • Thus, there exists a stable relationship between output, inputs and pre-existing debt.

17. Duality From the economic theory Financial theory (Brander and Spencer, 1989) The dual cost function is

18. Agency Cost Measurement Agency problem Marginal cost • Measure and test the agency cost related to debt capital: Altered Incentive • If ACi> 0, and statistically significant, then • there is agency cost of debt, and hence excessive debt leads to cost inefficiency. • If ACi< 0, and statistically significant, then • debt improves efficiency of resource use.

19. Does Supply Management Matter? A policy of limiting total production and imports through the allocation of marketing rights, or quotas. Invoking Envelope Theorem: Then, agency costs of debt are lower if there is regulatory constraint on raw material supply.

20. Federated Co-op Does Governance Structure Matter? • Good co-operative governance • lower probability of information asymmetry • altered incentive effect will be negligible

21. Case Co-operative Agribusiness Firms For the results of the analysis to be meaningful firms with different situations should be examined. • Alberta Honey Producers Co-op - Unregulated raw material • processes and packages pure natural honey and honey related products • Lilydale Poultry Co-op - Regulated raw material • Primary processing, Further processing, Hatchery operation • Federated Co-operative - Wholesaling Co-operative • petroleum retailing, family fashions, feed, food, forest products, and hardware and building products

22. How Big are the Case Co-ops? Source: Agriculture and Agri-Food Canada: http://www.agr.gc.ca/cb/news/2002/n21213ae.html

23. Data • Individual co-op annual financial reports • Output, variable cost, long-term debt, capital stock, variable input expenditures, • CANSIM (Statistics Canada Database) • CPI, raw honey price, container price index, interest rate • The Annual Survey of Manufacturers (ASM: Statistics Canada) • Wage rates, poultry raw material prices • Agriculture and Agri-Food Canada • Poultry raw material price, poultry wholesale price

24. CAPINV and Debt/Equity-Alberta Honey Producer Co-operative Capital Investment Debt-to-Equity =0.096

25. CAPINV and Debt/Equity-Lilydale Poultry Co-operative Capital Investment Debt-to-Equity =0.38

26. CAPINV and Debt/Equity- Federated Co-op Capital Investment Debt-to-Equity  = -0.437

27. Elasticities – Alberta Honey Producer Co-operative

28. Elasticities – Lilydale Poultry Co-operative

29. Elasticities – Federated Co-operative

30. Agency Costs – Elasticity (1975/85/2001/mean)

31. What Does the Alberta H.P.C. Board Say? “… It is evident that we are not yet totally efficient in ourmanagement and organization... “ -Chairman of the Board (Alberta Honey Producers Co-operative Limited, Annual Report 2002: 3)

32. Does Supply Management Really Help Overcome the Incentive Incompatibility Problem? • “...within the industry, supply of product to processing plants is governed by national and provincial boards that directly impact quantities and live prices. As a result, the Co-operative only has control over the efficiency of itsoperations, which is a much smaller component of the total cost of merchandise sold[i.e., total variable costs] “ (LILYDALE, Annual Report 2002: 28).

33. Does co-op Structure Have Implications for Agency Costs of Debt? “… Federated Co-operatives Ltd. conscientiously breathes life into the co-operative principles in its governance…. Member co-ops are supported by courses in human resources, financial services, member relations, etc.” (CCA. Autumn 2002. Those Things We Stand For: http://www.coopscanada.coop/NewsLetter/Governance/.) • Management has control over much smaller component of the total cost of goods sold to members.

34. Concluding Remarks • Capital structure may matter in firm’s decision making. • The degree of agency costs of debt may depend on the regulatory environment. • Good corporate governance may mitigate the agency problem related to debt. • When agency costs of debt are present, agency cost adjusted discount rate may be appropriate for capital investment decision making. • If the agency costs of debt exist BUT are not included in decision making, it may lead to an overestimation of the NET BENEFITS of capital investment.

35. Part IIDo Decision Makers Debt Risk Attitude Affect the Agency Costs of Debt?

36. Agency Costs and Risk Attitudes • Agency costs empirical results are based on the theoretical assumptions that managers are risk-averse and members are risk-neutral. • Risk-averse managers are expected to borrow less as compared to risk-taking managers. • Managers’ /directors’ degree of risk-aversion has important implication on the level of debt financing risk exposure • Different attitudes will affect negotiations between directors and managers and potentially lead to conflict.

37. Debt and Risk Attitudes • Mathematically,

38. Theory of Planned Behaviour Human behaviour/intentions are guided by: • Attitude towards the behaviour (debt) • Subjective norm (perceived social pressure) • Perceived behavioural control (ability to affect company decisions)

39. Theory of Planned Behaviour (Debt) (Debt)

40. Empirical Model

41. Demographic Characteristics • N =24

42. Age Categories of Respondents

43. When making investment decisions, I am willing to accept more risk to achieve higher returns and reach member goals.

44. In your opinion, could excessive debt financing lead to serious financial risk in your company?

45. During the next two years I will approve additional borrowing to finance new investments in the company.

46. During the next two years additional investments should be financed solely through equity.

47. I intend to approve additional borrowing to finance new investments in the company over the next two years.

48. Attitude towards Debt

49. Subjective Norm

50. Perceived Behavioural Control