Farm Management Chapter 19 Capital and the Use of Credit.

Farm Management

Chapter 19

Capital and the Use of Credit

farm management chapter 19

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Chapter Outline

• Economics of Capital Use• Sources of Capital• Types of Loans• The Cost of Borrowing• Sources of Loan Funds• Establishing and Developing Credit• Liquidity• Solvency


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Chapter Objectives

1. To point out the importance of capital in agriculture

2. To illustrate the optimal use and allocation of capital

3. To compare different sources of capital and credit

4. To describe different types of loans5. To show how to set up repayment plans6. To explain how to develop credit worthiness7. To examine factors affecting liquidity and

solvency


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What is Capital?

People think of capital as cash, balancesin savings and checking accounts, andother liquid funds. Capital also includesmoney invested in assets. Agriculturehas one of the highest ratios of capitalto workers in U.S. industries. Many commercial farms have capital investmentsof over $1,000,000.


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Figure 19-1Capital investment in U.S. agriculture

Source: USDA


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Credit

Credit is the ability to borrow money with a promise to repay the moneyin the future along with interest forits use.


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Economics of Capital Use

• How much total capital should be used?

• How should limited capital be allocated among its many potential uses?


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Total Capital Use

When unlimited capital is available,the question is how much in total to use.In chapter 7, the concept of using aninput until its marginal value product (MVP)equals its marginal input cost (MIC) wasexplained. The same concept appliesto capital.


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MVP and MIC of Capital

The MVP of capital is the additionalnet return, before interest payments,that results from an additional capitalexpenditure.

The MIC of capital is 1 + i, where i is the interest rate on borrowed funds.


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


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Allocation of Limited Capital

In chapter 7, the equal marginal principalwas presented as the decision-makingrule for allocating a limited resource. The use of this rule means limited capital should be allocated among competinguses so that the MVP of the last dollarused is the same in all uses.


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Sources of Capital

• Owner equity

• Outside equity

• Leasing

• Contracting

• Credit


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Figure 19-3Total U.S. farm debt by type

Source: USDA


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Types of Loans

• Loans classified by length of repayment

• Loans classified by use

• Loans classified by type of security

• Loans classified by repayment plan


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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


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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


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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”


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Repayment Plans

• Single payment

• Line of credit

• Amortized: equal total payments

• Amortized: equal principal payments

• Amortized with balloon Payment


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Table 19-1 Illustration of Line of Credit

Amount Interest Amount Interest Principal OutstandingDate borrowed rate repaid paid paid balance

Feb 1 $40,000 9% $0 $0 $0 $40,000April 1 20,000 9% 0 0 0 60,000Sept 1 0 9% 32,850 2,850 30,000 30,000Oct 1 0 8% 0 0 0 30,000Dec 1 0 8% 24,000 625 23,375 6,625


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

Principal Interest Total Principal Total Interest Principal PrincipalYear paid paid payments remaining payment paid paid remaining

1 $10,000 $8,000 $18,000 $90,000 $14,903 $8,000 $6,903 $93,0972 10,000 7,200 17,200 80,000 14,903 7,448 7,455 85,6423 10,000 6,400 16,400 70,000 14,903 6,851 8,052 77,5904 10,000 5,600 15,600 60,000 14,903 6,207 8,696 68,8955 10,000 4,800 14,800 50,000 14,903 5,512 9,391 59,5035 10,000 4,000 14,000 40,000 14,903 4,760 10,143 49,3607 10,000 3,200 13,200 30,000 14,903 3,949 10,954 38,4068 10,000 2,400 12,400 20,000 14,903 3,073 11,830 26,5769 10,000 1,600 11,600 10,000 14,903 2,126 12,777 13,799

10 10,000 800 10,800 0 14,903 1,104 13,799 0$100,000 $44,000 $144,000 $149,030 $49,030 $100,000

Equal Principal Payments Equal Total Payments


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Figure 19-4Loan repayment under

two types of amortization


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Table 19-3 Amortization with Balloon Payment

Principal Interest Total PrincipalYear paid paid payments remaining

1 $5,177 $8,000 $13,177 $94,8232 5,591 7,586 13,177 89,2323 6,039 7,138 13,177 83,1934 6,522 6,655 13,177 76,6715 7,044 6,134 13,177 69,6275 7,607 5,570 13,177 62,0207 8,215 4,962 13,177 53,8058 8,873 4,304 13,177 44,9329 9,583 3,595 13,177 35,34910 35,349 2,828 38,177 0

$100,000 $56,772 $156,770

$100,000 at 8% with a Balloon Payment


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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


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Sources of Loan Funds

• Commercial banks

• Farm credit system

• Life insurance companies

• Farm service agency

• Individuals and suppliers

• Commodity Credit Corporation

• Small Business Administration


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


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Establishing and Developing Credit

• Personal character

• Management ability

• Financial position

• Repayment capacity

• Purpose of loan

• Collateral


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Liquidity

• Business growth

• Non-business income and expenses

• Debt characteristics

• Debt structure

Factors affecting liquidity:


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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


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Solvency

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


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Setting a Cap on Debt/Asset

Total Liabilities + X

Total Assets + X

= 0.4

Use this formula to find the amount ofborrowing (X) that will increase D/A ratioto 0.4 (or some other chosen level).


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An Alternative

Maximum debt/asset = Return on Assets

Interest Rate

This maximum here is the level at whichreturn on equity (%) is equal to zero. Thisformula assumes ROA < Interest Rate


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Table 19-4 Illustration of the Principle

of Increasing Leverage

0.00 0.33 0.50 0.67

Equity Capital ($) 100,000 100,000 100,000 100,000Borowed Capital ($) 0 50,000 100,000 200,000Total Assets ($) 100,000 150,000 200,000 300,000

Return on assets (15%) 15,000 22,500 30,000 45,000Interest paid (10%) 0 5,000 10,000 20,000Return on equity ($) 15,000 17,500 20,000 25,000Return on equity (%) 15.0 17.5 20.0 25.0

Return on assets (5%) 5,000 7,500 10,000 15,000Interest paid (10%) 0 5,000 10,000 20,000Return on equity ($) 5,000 2,500 0 -5,000Return on equity (%) 5 2.5 0 -5

Debt/asset ratio

Good Year

Poor Year


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Summary

Capital includes cash and money invested in assets. Today’s farmersmust be skilled in acquiring and usingcapital. Loans are available from manysources and there are many alternativerepayment plans. Loans affect liquidityand solvency.

Date post:	21-Dec-2015
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Farm Management Chapter 19 Capital and the Use of Credit.

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