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

2. farm management chapter 19 2 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

3. farm management chapter 19 3 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 loans 5.To show how to set up repayment plans 6.To explain how to develop credit worthiness 7.To examine factors affecting liquidity and solvency

4. farm management chapter 19 4 What is Capital? People think of capital as cash, balances in savings and checking accounts, and other liquid funds. 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.

5. farm management chapter 19 5 Figure 19-1 Capital investment in U.S. agriculture Source: USDA

6. farm management chapter 19 6 Credit Credit is the ability to borrow money with a promise to repay the money in the future along with interest for its use.

7. farm management chapter 19 7 Economics of Capital Use How much total capital should be used? How should limited capital be allocated among its many potential uses?

8. farm management chapter 19 8 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.

9. farm management chapter 19 9 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.

10. farm management chapter 19 10 Figure 19-2 Using marginal principles to determine optimal capital use

11. farm management chapter 19 11 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.

12. farm management chapter 19 12 Sources of Capital Owner equity Outside equity Leasing Contracting Credit

13. farm management chapter 19 13 Figure 19-3 Total U.S. farm debt by type Source: USDA

14. farm management chapter 19 14 Types of Loans Loans classified by length of repayment Loans classified by use Loans classified by type of security Loans classified by repayment plan

15. farm management chapter 19 15 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

16. farm management chapter 19 16 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

17. farm management chapter 19 17 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”

18. farm management chapter 19 18 Repayment Plans Single payment Line of credit Amortized: equal total payments Amortized: equal principal payments Amortized with balloon Payment

19. farm management chapter 19 19 Table 19-1 Illustration of Line of Credit

20. farm management chapter 19 20 Table 19-2 $100,000 Loan at 8%

21. farm management chapter 19 21 Figure 19-4 Loan repayment under two types of amortization

22. farm management chapter 19 22 Table 19-3 Amortization with Balloon Payment

23. farm management chapter 19 23 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

24. farm management chapter 19 24 Sources of Loan Funds Commercial banks Farm credit system Life insurance companies Farm service agency Individuals and suppliers Commodity Credit Corporation Small Business Administration

25. farm management chapter 19 25 Figure 19-5 Market share of U.S. farm debt

26. farm management chapter 19 26 Establishing and Developing Credit Personal character Management ability Financial position Repayment capacity Purpose of loan Collateral

27. farm management chapter 19 27 Liquidity Business growth Non-business income and expenses Debt characteristics Debt structure Factors affecting liquidity:

28. farm management chapter 19 28 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

29. farm management chapter 19 29 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.

30. farm management chapter 19 30 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).

31. farm management chapter 19 31 An Alternative Maximum debt/asset = Return on Assets Interest Rate This maximum here is the level at which return on equity (%) is equal to zero. This formula assumes ROA < Interest Rate

32. farm management chapter 19 32 Table 19-4 Illustration of the Principle of Increasing Leverage

33. farm management chapter 19 33 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.