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Understanding the cost of capital

Understanding the cost of capital. Agricultural businesses rely on borrowed capital for inputs, machinery, equipment, and land Managing debt capital requires a farmer to choose from among multiple financing sources offering differing interest rates, rebates, points, and other non-interest costs.

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Understanding the cost of capital

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  1. Understanding the cost of capital • Agricultural businesses rely on borrowed capital for inputs, machinery, equipment, and land • Managing debt capital requires a farmer to choose from among multiple financing sources offering differing interest rates, rebates, points, and other non-interest costs. • Debt can increase the rate of growth in equity capital • Debt will increase risk of equity loss

  2. Financing decision aids • Short-term financing alternatives • Trade credit • Credit cards/Lines of credit • Intermediate-term financing alternatives • Machinery and equipment loans • Long-term financing alternatives - Real estate loans

  3. Design Considerations • Developed to be easy to use and flexible to encourage producers to compare financing alternatives • Uses Microsoft Excel and Visual Basic for Applications (VBA) so that is readily available to a wide range of users • Macros are used to prevent accidental corruption of code by user

  4. Short-term Financing Module • Uses the economic concept of opportunity cost and the financial concept of time value of money to determine the cost of capital from supplier financing. • Many agricultural input suppliers offer terms of sale that offer cash discounts for early payment. Such terms of sale typically have a very high implicit cost of capital.

  5. Example of short-term financing alternative

  6. Intermediate-term Financing Module • Uses time value of money concepts for machinery and equipment purchases. • Alternative sources of financing have different interest rates and non-interest costs. • Dealers often offer a choice between rebate dollars or lower interest rates.

  7. Example of intermediate-term financing alternative

  8. Long-term Financing Module • Different lenders often have different terms, interest rates, and non-interest costs. • Many lenders also allow borrowers to pay points to lower their interest rate. • Also important are any stock requirements such as that required by the Farm Credit System (still working on impact of patronage dividends on cost of capital).

  9. Example of long-term financing alternative

  10. Potential farm decision analysis tools: • Leasing options calculator • Will help farmers understand the risks inherent in leasing farm assets including options to buy in leveraged leases • Contracting options calculator • Designed to analyze the risks associated with typical production contracts including those common in poultry and swine production • On-farm methane digester capital budgeting model • Will assist producers considering the implementation of an on-farm methane digester and would help them evaluate the risk associated with bearing a large and irreversible investment

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