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Leverage is a Concept and an Opportunity

Posted Dec. 1, 2002

Agriculture is a capital-intensive industry. Almost everyone realizes that a viable commercial farm or ranch requires a rather large investment in land, livestock and equipment. Smaller-scale firms in agriculture are mostly organized as sole proprietorships, partnerships and family corporations. Their main source of equity capital is retained earnings. The amount or availability of retained earnings is uncertain from year to year, and the rate of growth in retained earnings may not be fast enough to finance large investments. Therefore, many farm/ranch operations, especially if they are attempting to increase in size over time, employ borrowed funds and leasing as well as retained earnings and unrealized capital gains on farm assets to provide the capital required. The use of other people's money, called "leverage," is a tool that agricultural producers can and should use to harvest increased profits.

The optimal combination of debt and equity occurs at the minimum average cost of capital. This sounds simple enough, but in practice, it is often difficult to quantify. Because business interest is a deductible expense, the after-tax cost of borrowed money is 1 minus the tax rate times the interest rate. For example, if the interest rate is 10 percent and the marginal tax rate is 28 percent, then the after-tax interest rate or cost of borrowed funds is 7.2 percent. Determining the cost of equity capital is more difficult. The sole proprietor usually must give up a combination of family living, savings and other non-business uses of his equity in order to reinvest money in the business. The percentage of total capital that ultimately is obtained from borrowed funds often winds up being determined by the risk attitude of the decision maker rather than by the risk-return trade-off of financial leverage.

Farmers are traditionally a conservative lot, especially when it comes to borrowing money, but debt financing should not be feared. When the concept of leverage is used as effectively as any other piece of farm equipment or input, it can help increase profits and growth of the business.

And the opportunity? Interest rates are at 40-year lows. If there was ever a time to do your homework and determine the optimum combination of borrowed and equity funds for your agricultural operation, it is now! If you would like assistance in this area, contact one of the agricultural economists at the Noble Research Institute.

Thought for the month: "I like the dreams of the future better than the history of the past." Thomas Jefferson, letter to John Adams, 1816