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Farm Management

Farm Management. Chapter 19 Capital and the Use of Credit. What is Capital?. Capital also includes money invested in assets. Agriculture has one of the highest ratios of capital to workers in U.S. industries. Many commercial farms have capital investments of over $1,000,000.

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Farm Management

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  1. Farm Management Chapter 19 Capital and the Use of Credit

  2. What is Capital? Capital also includes money invested in assets. Agriculture has one of the highest ratios of capital to workers in U.S. industries. Many commercial farms have capital investments of over $1,000,000.

  3. Figure 19-1Capital investment in U.S. agriculture Source: USDA

  4. Credit Credit is the ability to borrow money with a promise to repay the money in the future along with interest for its use.

  5. Economics of Capital Use • How much total capital should be used? • How should limited capital be allocated among its many potential uses?

  6. Total Capital Use When unlimited capital is available, the question is how much in total to use. In chapter 7, the concept of using an input until its marginal value product (MVP) equals its marginal input cost (MIC) was explained. The same concept applies to capital.

  7. MVP and MIC of Capital The MVP of capital is the additional net return, before interest payments, that results from an additional capital expenditure. The MIC of capital is 1 +i, where i is the interest rate on borrowed funds.

  8. Figure 19-2 Using marginal principles to determine optimal capital use

  9. Allocation of Limited Capital In chapter 7, the equal marginal principal was presented as the decision-making rule for allocating a limited resource. The use of this rule means limited capital should be allocated among competing uses so that the MVP of the last dollar used is the same in all uses.

  10. Sources of Capital • Owner equity • Outside equity • Leasing • Contracting • Credit

  11. Figure 19-3Total U.S. farm debt by type Source: USDA

  12. Types of Loans • Loans classified by length of repayment • Loans classified by use • Loans classified by type of security • Loans classified by repayment plan

  13. Length of Repayment • Short-term loans: loans used to purchase inputs needed to operate through the current production cycle, due at end of cycle • Intermediate-term loans: length of loan more than 1 year but less than 10 years, usually for purchase of intermediate assets • Long-term loans: A loan with a term of 10 years or longer, usually for the purchase of land

  14. Use • Real estate loans: loans for the purchase of real estate such as land and buildings, or loans that use real estate as security • Non-real estate loans: all business loans other than real estate loans • Personal loans: non-business loans used to purchase items for family

  15. Security • Secured loans: an asset is mortgaged to provide collateral for the loan • Unsecured loans: the loan is obtained with only a “promise to repay,” also called a “signature loan”

  16. Repayment Plans • Single payment • Line of credit • Amortized: equal total payments • Amortized: equal principal payments • Amortized with balloon Payment

  17. Table 19-1 Illustration of Line of Credit

  18. Table 19-2 $100,000 Loan at 8%

  19. Figure 19-4Loan repayment under two types of amortization

  20. Table 19-3 Amortization with Balloon Payment

  21. The Cost of Borrowing • True annual percentage rate (APR) should be stated in loan agreement • A way to compare loans is to find the discounted present value (chapter 17) of the series of payments • For a fixed rate loan, total interest payments over the life of the loan are known • In a variable rate loan the interest rate can change

  22. Sources of Loan Funds • Commercial banks • Farm credit system • Life insurance companies • Farm service agency • Individuals and suppliers • Commodity Credit Corporation • Small Business Administration

  23. Figure 19-5Market share of U.S. farm debt

  24. Establishing and Developing Credit • Personal character • Management ability • Financial position • Repayment capacity • Purpose of loan • Collateral

  25. Liquidity • Business growth • Non-business income and expenses • Debt characteristics • Debt structure Factors affecting liquidity:

  26. Financial Contingency Plan • Maintain savings or stored crops and livestock that can easily be turned to cash • Maintain credit reserve • Prepay debt when possible • Reduce non-farm expenditures or increase non-farm earnings when needed • Carry adequate insurance • Sell off less productive assets to raise $ • Get help from relatives or friends in emergency • Declare bankruptcy and work out repayments

  27. Solvency Most lenders use the debt/asset ratio to measure solvency. Maximum debt can be set to some level so that the debt/asset ratio remains below a given level, or a more complicated formula using return to capital and the lending interest rate can be found.

  28. Setting a Cap on Debt/Asset Total Liabilities + X Total Assets + X = 0.4 Use this formula to find the amount of borrowing (X) that will increase D/A ratio to 0.4 (or some other chosen level).

  29. An Alternative Return on Assets Interest Rate Maximum debt/asset = This maximum here is the level at which return on equity (%) is equal to zero. This formula assumes ROA < Interest Rate

  30. Table 19-4 Illustration of the Principle of Increasing Leverage

  31. Summary Capital includes cash and money invested in assets. Today’s farmers must be skilled in acquiring and using capital. Loans are available from many sources and there are many alternative repayment plans. Loans affect liquidity and solvency.

  32. 1. What economic principles are used to determine (a) how much capital to use, and (b) how to allocate a limited amount of capital? • (a) Additional capital should be employed as long as the marginal value product is greater than the marginal input cost (interest rate). • (b) Limited capital should be allocated according to the equal marginal principle, that is, among alternative uses in such a manner that the marginal return to the last dollar is approximately equal for all alternatives.

  33. 2. What is the single largest source of capital used in United States agriculture? What other sources are used? • Owner equity is the largest source of capital. • Other sources include outside investors, leased assets, contracted assets, and credit.

  34. 3. Define the following terms • a. Secured loan • b. Amortized loan - A loan which is repaid with a series of scheduled principal and interest payments. c. Real estate loan - A loan made for the purchase of land or other real property d. Collateral - Property that is pledged as security • e. Line of credit – • f. Balloon payment – A final principal payment for an amortized loan which is larger than the other principal payments

  35. 4. How are loans classified as short-term, intermediate-term, and long-term loans? List the types of assets that might serve as collateral for each. • Short-term loans are generally repayable in one year or less, and are secured by market livestock, feed, supplies, or crops. • Intermediate-term loans are usually repayable over one to ten years, and are secured by breeding livestock, machinery or equipment. • Long-term loans are repayable over periods longer than ten years, and are usually secured by buildings or land.

  36. 6. What are the advantages and disadvantages of a 10-year balloon loan versus a completely amortized loan of the same amount and interest rate? • A balloon payment loan requires smaller principal payments until the last payment. However, more total interest is paid, and it may be difficult for the borrower to make the last payment

  37. 7. Identify the different sources of agricultural loans in your home town or home county. Which types of loans does each lender specialize in? • Include state and federal government lenders, and dealers and suppliers as well as commercial banks and the Farm Credit System

  38. 9. What information and material would you need to provide a lender to improve your chances of getting a loan? What lenders might be willing to finance you? • You could provide a balance sheet showing your present assets, liabilities, and equity and a cash flow budget showing your capacity to repay a loan. Records summarizing your past performance and profitability with livestock would also be helpful. Potential lenders include commercial banks, Farm Credit System, and the Farm Service Agency.

  39. 10. List several reasons why a request for a loan by one farm operator might be denied while a similar request from another operator is approved. • It could be due to differences in the amount of collateral available, the degree to which each business is already leveraged, past loan repayment history, past profitability of the business, or personal character

  40. 11. Explain the difference between liquidity and profitability. Give three reasons why a profitable farm could experience liquidity problems. • Profitability refers to the margin between costs and income generated by the farm, while liquidity looks at the availability of cash when it is needed. A profitable farm could experience liquidity problems due to rapid expansion, high nonfarm expenditures, rapid repayment of debt, or large purchases of land or other capital assets.

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