Using Net Present Value Analysis in Cooperatives
By
J. Frederick Johnson, CPA
Manager of Accounting and Finance
Farmers Telephone Cooperative, Inc.
Rainsville, Alabama
And
Thomas I. Smythe, Jr.*
Assistant Professor of Finance
The University of Tennessee at Chattanooga
College of Business Administration
615 McCallie Ave.
Chattanooga, Tennessee 37403
(423) 755-5252
Tom-Smythe@utc.edu
And
John G. Fulmer, Jr.
Vieth Professor and Head
Department of Accounting and Finance
The University of Tennessee at Chattanooga
Chattanooga, Tennessee
*Corresponding author.
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Using Net Present Value Analysis in Cooperatives
Introduction
Historically, industry insiders and outsiders have viewed America’s rural electric and
telephone cooperatives as being fundamentally different from traditional for-profit shareholderowned companies. This view is based in part on the fact that the cooperative’s owners are also
its customers. While cooperative membership represents an ownership claim, it is also true that
the primary relationship is one of service provider and customer. In the past, cooperative
management has at times used this unique relationship as a rationalization for not using common
business principles when making critical business decisions. This article provides a framework
for using the principle of shareholder wealth maximization in the cooperative decision making
process. Specifically, the application of Net Present Value analysis is recommended to enhance
cooperative decision making. By following the example illustrated below, cooperative managers
can implement this widely used business tool thereby directly benefiting cooperative members.
Background
The general field of business evolved a great deal during the twentieth century. Of the
developments in the field of Finance, Net Present Value (NPV) or Discounted Cash Flow (DCF)
analysis is arguably one of the most important. For example, a 1999 survey of Fortune 500
firms, published in the Financial Practice and Education journal, indicates that over 80% of
respondents use NPV analysis to make financial decisions.1 In effect, NPV analysis provides the
framework necessary to evaluate capital projects in the context of shareholder wealth
maximization. The fundamental principle behind NPV analysis is that people who invest and
expose capital to risk should be adequately compensated for taking that risk. On the surface, the
goal of wealth maximization may sound somewhat brutal and may appear to ignore other valued
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corporate traits such as social responsibility. However, in its simplest form, wealth
maximization means to do what is best for owners, which encompasses all aspects of a firm’s
operations. It is in this context that wealth maximization in general, and NPV analysis in
particular is applied to the domain of rural cooperatives.
Most cooperatives, beginning with the Rochdale Pioneers, serve rural areas that would
otherwise go without electric or telephone service. Operationally, cooperatives have historically
emphasized providing services at or below cost. While cooperatives certainly play a unique role
in the provision of these services, the goal of wealth maximization is likewise very applicable in
the cooperative domain. Two of the fundamental issues to reconcile are “who a cooperative’s
shareholders are” and “how does the shareholder receive his or her return on invested capital.”
Initially and even today, one primary way of returning invested capital is by providing the
service at a price below that offered by comparable for profit firms. Another method is to return
patronage capital credits to owners at year-end or at regular disbursement periods over time,
which is effectively a dividend.
More recently, customers are demanding more than basic telephone or electric service.
Specifically, customers want more reliable and thereby more value enhancing service from
cooperatives. In other words, the cheapest telephone or electric service may no longer be
enough; customers are demanding greater value in the form of service reliability. Since
cooperative members are the “owners” of the cooperative, then all financial decisions should be
made in a way that provides them with the maximum benefit, whether that be lower prices or
more reliable service at a comparable price. Stated differently, cooperative management’s
decisions should be guided by the principle of shareholder wealth maximization. While creating
additional value at a comparable price is an increasingly important business objective for
1
See Exhibit 2, p. 50, Ryan and Trahan (1999), FPE, Spring/Summer 1999.
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cooperatives, the remainder of this article emphasizes low cost production because cash flow
savings are more readily identifiable. To the extent improved service value can be quantified
with cash flows, the following methodology is equally applicable.
The Methodology
Given that cooperative members are its owners, standard net present value analysis can
be readily applied to decisions ranging from new equipment purchases or major capital
investment decisions to simple projects undertaken to reduce costs. The fundamental question to
be answered is whether the project in question adds wealth to members or more concretely,
generates enough risk adjusted cash flow to warrant the project’s cost to members. The NPV
calculation itself is very straightforward and is simply the process of discounting all after-tax
cash flows back to the present. There are three types of cash flows to be considered in the
analysis: initial investment outlays, normal (after-tax) net operating cash flows, and terminal year
cash flows. Initial investment outlays are those made to get the project started and generally
include the installed cost of equipment and/or increases in working capital. The terminal year
cash flows reflect not only those generated by normal operations, but also any after-tax cash flow
from estimated equipment salvage value and the return of working capital.
NPV is determined by summing the future benefits of the project (in present value terms),
and subtracting the initial investment outlay. If the resulting calculation is greater than zero, the
project in question should be undertaken. If there are two mutually exclusive projects, then the
project with the highest NPV should be undertaken. While the calculation itself is relatively
simple, there are two issues that must be addressed and are unique for cooperatives. The first is
the unique tax environment that cooperatives face, and the second is how to develop the
cooperative’s Weighted Average Cost of Capital (WACC). The Weighted Average Cost of
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Capital is the discount rate used to determine the present value of the project’s future benefits.
The WACC is calculated as the “weighted average” cost of debt and equity. More specifically,
the after-tax cost of debt is multiplied by the proportion of the balance sheet supported by debt,
and the cost of equity is multiplied by the proportion of the balance sheet supported by equity.
In the example below, we assume the firm finances itself with long-term debt and equity.
Tax Issues
The complicated nature of cooperative tax structure presents a challenge when using
NPV analysis. A cooperative’s tax status is important because all cash flows in the NPV
analysis must be on an after-tax basis and the debt component of the WACC is adjusted to reflect
any tax savings from using debt. The latter issue is extremely important because the effective
cost of debt is higher when the cooperative is fully tax exempt. So, inaccurately projecting the
firm’s tax status could unknowingly bias the cooperative’s WACC higher or lower, ultimately
leading to poor decisions. In the event that the cooperative is fully tax-exempt this is not an
issue. A brief review of cooperative taxation is helpful.
Some cooperatives are completely exempt from income taxation under § 501c(12) of the
Internal Revenue Code of 1986. However, even for those that are not exempt, the determination
of taxable income, and the related tax, is not as straightforward as for a regular taxable
corporation. A primary reason for the difficulty is that taxable cooperatives can exclude (not
deduct) net income derived from patronage sources from the cooperative’s taxable income. The
exclusion is only allowed if the patronage net income is distributed to members under terms
outlined in the Internal Revenue Code. For an example of such a calculation see Table 1.
Table 1 demonstrates that any projected income or expense related strictly to patronagesource activities has no tax effect, assuming the cooperative assigns all net income from
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patronage-source activities to members as capital credits. As such, a critical question is whether
cash flows are related to patronage or non-patronage activity. If all items are strictly patronage
related there is no tax effect. When all cash flows result from non-patronage activities, cash
flows must be adjusted for tax effects as in traditional NPV analysis. The most complicated case
arises when the cash flows are comprised of both patronage and non-patronage related activities.
In this case, an estimate must be made as to the proportion of cash flow allocable to each class of
activity and the effects of taxation computed accordingly for the non-patronage source cash
flows.2 Since NPV analysis examines marginal cash flows, management must simply estimate
whether there will be non-patronage sources of income in future years. If so, the appropriate
marginal tax rate should be applied to the non-patronage cash flows. Table 2 provides examples
of each of these scenarios given certain assumptions and variables.
Estimating the Weighted Average Cost of Capital (WACC)
The second problem for cooperatives to address is the estimation of the appropriate
WACC. The WACC is comprised of the proportional cost of debt and equity for the cooperative
in question. Of the two components, the debt cost is the easier to determine, although not as
straightforward as it might appear due to the cooperative’s tax status. The debt component of the
WACC is represented by the after-tax cost of the debt (debt cost times one minus the firm’s
marginal tax rate). In the event the cooperative is fully tax exempt, the debt component of the
WACC is simply the cooperative’s cost to raise an additional dollar of debt.
However, if cooperative management believes that at least some future revenues are
likely to be of the non-patronage variety, then the debt cost must be adjusted to reflect the tax
savings from using debt. The difficulty arises in estimating the tax savings. Unlike a publicly
2
While traditional NPV analysis often groups all operating cash flows together, cooperatives may find it useful to
estimate cash flows by type, i.e. patronage and non-patronage, and then combine them prior to discounting.
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traded corporation which has all revenues taxed in the same way, the cooperative likely has a
large portion of revenue (patronage) that is tax exempt. At issue is that the interest cost (and
therefore tax savings) must be allocated between patronage and non-patronage operations. As a
result, the tax savings only apply to the non-patronage portion of revenues. A review of Panel A
in Table 3 provides an example. In this case, we assume that 80% of the debt finances patronage
operations and the remaining 20% non-patronage. As a result, the cooperative is only able to
deduct $40,000 in interest expense. So, the after-tax cost of debt is not equal to:
After Tax Cost of Debt = kd x (1-T)
where ‘kd’ is the before tax cost of debt and ‘T’ is the firm’s marginal tax rate. Instead the after
tax cost of debt is:
After Tax Cost of Debt = kd – [kd x %NP x T]
where ‘kd’ and ‘T’ are defined as above and ‘%NP’ is the estimate of the proportion of NonPatronage operations to be financed by debt.
The next task for the cooperative financial manager is to estimate its cost of equity or the
return required by shareholders (or members). However, it must be remembered that
cooperatives are not publicly traded companies. Additionally, a cooperative’s risk is lower than
that of a for-profit firm since competition is limited. While cooperative risk may be lower than
that for publicly traded firms, there is risk associated with a member’s “equity”. As such, an
estimate of the cooperative’s required return to shareholders is necessary. A cooperative’s
proportion of equity is represented by the proportional amount of patronage capital on the
cooperative’s balance sheet.
For publicly traded utilities, the required return to shareholders is generally estimated
using either a dividend growth model or the capital asset pricing model, where most of the model
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inputs are estimated based on existing market data for the firm. It is the lack of market data that
makes estimating the required return to shareholders (members) different for cooperatives. One
alternative currently being applied links the cost of cooperative equity to the capital credit
rotation cycle or the member’s opportunity cost for not having use of the money. However, we
believe that these methods do not adequately capture the relationship between risk and return.
As such, four alternatives are presented below that more directly equate risk and return. The
fourth approach is simply a composite of the other three.
The Modified Capital Asset Pricing Model (CAPM) Approach
The CAPM is commonly used to estimate the required returns to shareholders. The
following formula, which effectively states that shareholders (members) require the market riskfree rate plus a risk premium, is used:
Ri = Rf + (Rm-Rf).
‘Ri’ is the expected return for the firm in question and is the required return for the firm’s
shareholders. ‘Rf’ and ‘Rm’ are the expected return on a risk-free asset and the “market”
respectively. Cooperatives can use the one-year Treasury bill to approximate the risk-free rate,
and they can use a market index such as the S&P 500 to approximate the “market” return. Of the
variables to be used, beta (), which captures the relative risk of the cooperative with the market,
is the one that proves difficult for cooperatives to estimate. If cooperatives had publicly traded
stock, the beta would be estimated by using a statistical technique (ordinary least squares) to
determine the correlation between the cooperative’s historical returns and the market. Knowing
beta and estimates for ‘Rf’ and ‘Rm’, one could estimate the required return.
In the absence of traded stock, cooperatives can create a proxy beta by using the average
beta for the electric (telephone) industry. One criticism of this approach is that the firms that
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make up the average are exposed to more market risk than a cooperative, thereby overestimating
the required return to cooperative members. While true, this approach represents an upper bound
in the cooperative’s analysis. (See Panel B in Table 3 for an example.) With this beta, the
calculation of the WACC can proceed.
The Accounting Beta Approach
The accounting beta approach is a variant of the CAPM. It is more likely to accurately
account for a cooperative’s lower cash flow variability relative to a publicly traded counterpart.
With this approach, an analyst can use ordinary least squares to estimate the correlation between
the return on assets (ROA) for the cooperative and the average ROA for the S&P 500 or a group
of publicly traded electric (telephone) companies. This approach has the advantage of focusing
on variations in cash flow and therefore will likely produce an estimate for beta that is lower than
the average market return beta discussed above. After estimating the accounting beta, it is then
used in the CAPM equation above to develop an estimate of required return.
The Bond-Yield-Plus Risk Premium Approach
Another alternative for the cooperative financial manager to use as the estimate for
member required returns is the bond-yield-plus risk premium approach. It is the simplest to
implement (but probably the least rigorous theoretically). With this approach, the primary input
is the cooperative’s yield on long-term debt. A “risk premium” is added to the long-term debt
yield that reflects the increased risk of equity (relative to debt). The size of the risk premium is
based on the financial manager’s perception of the cooperative’s level of risk. The subjective
nature of determining the risk premium is both a plus and a minus. On the negative side, there is
little theoretical rationale for choosing one premium or another; i.e. it is subjective. On the
positive side, management can reflect the lower level of equity risk inherent in the cooperative
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environment. There is evidence to suggest that the premium usually ranges from three to five
percent above the cost of debt. As a practical matter, the cooperative financial manager should
feel relatively comfortable taking the cost of debt and adding three to five percent to obtain an
estimate for the cooperative’s cost of equity.
The Pooling Approach
The pooling approach simply takes the average of the three approaches discussed thus
far. By doing so, the weaknesses of any one approach are unlikely to unduly influence the
estimation of the required return to shareholders. Regardless of the approach taken, cooperative
financial managers should consider at least two of the alternatives in their analysis.
Once the after-tax cost of debt and the cost of equity have been estimated, the
cooperative’s WACC is calculated using one of two weighting approaches. First, management
could use the existing proportional weighting of long-term debt and member’s equity on the
balance sheet as weights. Alternatively, management could set the weights based on a target
capital structure that management wants to move toward over time. See Panel C of Table 3 for
an example WACC calculation.
An Example
An example of how a cooperative financial manager would use NPV analysis is
presented in Table 4. The cooperative is considering one of two possible new pieces of
equipment, Project A and Project B. The assumption is that the projects are mutually exclusive.
The projects have an expected economic life of 15 years and straight-line depreciation is used.
The before-tax cash flows are net cash flows that already account for expenses and depreciation.
It is assumed that twenty percent of cash flows will come from non-patronage sources. We also
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assume that investment in the project will occur one year from today and all other cash flows are
at the end of each subsequent year.
The assumptions are recapped in Panel A. The calculation of net cash flows appears in
Panel B, and two points in this section are worth noting. First, the positive tax effects, i.e. adding
back the non-cash depreciation expenditure, only apply to the taxable non-patronage activity.
Additionally, taxes are only applied to the portion of the terminal year salvage value allocated to
non-patronage activity (the $8,000 and $9,600 respectively). Panel C summarizes the cash flows
and shows the results of discounting the cash flows using the WACC of 8.19% calculated in
Table 3. As is evident, both projects have a positive NPV, but Project B’s NPV is larger and
should be accepted since it is assumed that the projects are mutually exclusive.
Conclusion
The cooperative industry has at times looked upon itself as being so different from forprofit firms that financial managers have at times ignored using valuable financial principles
when making decisions. This article broadly outlines how the principle of wealth maximization
should be applied to the cooperative industry. More specifically, a methodology for
implementing NPV analysis in the cooperative setting is provided. In doing so, two of the
unique issues facing cooperatives in their attempt to use NPV analysis have been addressed and
solved. These two issues are the special tax environment cooperatives are faced with and how to
estimate the weighted-average cost of capital and the cost of equity. Following the example
outlined in Table 4 will allow cooperatives to implement a most useful financial tool (NPV
analysis) in their efforts to make better decisions for their members.
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References
Brigham, Eugene F. and Joel F. Houston, 1999, Fundamentals of Financial Management, The
Dryden Press – Harcourt Brace Publishers.
Ryan, Harely E. and Emery A. Trahan, Spring/Summer 1999, Financial Practice and Education
Vol. 9, pp. 46-58.
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Table 1 – Calculation of Patronage Exclusion and Taxable Income
Operating Income
Patronage
Sourced
$8,000,000
Operating Expense
($6,000,000)
Non-Patronage
Sourced
$2,000,000
($500,000)
Total
$10,000,000
$6,500,000
Non-operating Income and Expense
Investment Income
Interest Expense
Net Income Before Taxes
$100,000
($400,000)
$500,000
($100,000)
$600,000
($500,000)
$1,700,000
$1,900,000
$3,600,000
Patronage Exclusion*
$1,700,000
Taxable Income
$1,900,000
Income Taxes (40%)
($760,000)
Net Income
$1,140,000
* The patronage exclusion is generally limited to the lessor of the actual amount assigned to the
members patronage capital accounts or the net income from activities that are patronage sourced.
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Table 2 – Determination of Tax Effects on Cash Flows
Project Cash Flows
Applicable only to patronage
activity
Before Tax
Tax Effects*
After Tax
$100,000
NA
$100,000
Applicable only to non-patronage
activity
$100,000
($40,000)
$60,000
Applicable to both activities**
$100,000
($8,000)
$92,000
* Assuming a marginal tax rate of 40%.
**This assumes that for this example that cash flows are related to and split between patronage
and non-patronage activities in the proportion of 80% and 20% respectively. As a result, the tax
is calculated as ($100,000) (0.2) (0.4) = $8,000.
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Table 3 – Calculation of Weighted Average Cost of Capital (WACC)
Panel A: Calculation of after-tax cost of long-term debt
Assume that 80% of $10 million of long-term debt is allocated to patronage activity and 20% to
non-patronage. Additionally, the marginal tax rate is 40% and the long-term debt rate is 5%.
Annual Interest Cost
Patronage
Source
($400,000)
Non-Patronage
Source
($100,000)
NA
$40,000
$40,000
($400,000)
($60,000)
($460,000)
Tax Effects
After-tax cost
After-tax cost as percent
Total
($500,000)
4.6%
Equivalently: kd – [kd x %NP x T] = 0.05 – (0.05x0.2x0.4) = 0.05–0.004 = 0.046 = 4.6%
Panel B: Calculation of required return to shareholders using the CAPM
Assume:
1. The average ‘’ from estimating the returns of electric utilities on the S&P500 is 0.75.
2. The expected return on the one-year T-bill (Rf) is 5.5%.
3. The expected return on the S&P 500 is 11%.
Ri = Rf + (Rm-Rf)  0.055 + (0.75)(0.11-0.055) = 0.0963 = 9.63%
Panel C: Calculation of WACC
Assume the cooperative’s capital is in the form of $10 million of long-term debt and member’s
equity amounts to $25 million. Then the WACC is:
WACC = (wd)(ATCD) + (we)(Ri) = (10/35)(0.046) + (25/35)(0.0963) = 0.0819 = 8.19%
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Table 4 – Project NPV Analysis Example
Panel A: Assumptions
Initial Investment
Annual Depreciation
Expected Project Life
Before-tax operating cash flows, excluding
Depreciation for years 2-15
Salvage value in year 15
Marginal tax rate
Percent of cash flows from non-patronage
Activity
Project A
$1,000,000
($66,667)
15 yrs
Project B
$800,000
($53,333)
15 yrs
$200,000
$100,000
40%
$180,000
$120,000
40%
20%
20%
Panel B: Calculation of after-tax cash flows (outflows in parentheses)
Year
1
Cash Flow Type
Initial investment
Total Year 1
2-14
Before-tax operating cash flows
Taxes
Operational cash flows
($1,000,000)
($1,000,000)
$200,000
($16,000)
Net cash flow from operations
Salvage Value
Taxes**
Net salvage values
Total for Year 15
$180,000
($14,400)
$184,000
Depreciation
($66,667)
Cash flow from tax effects*
Total net cash flows for 2-14
15
($800,000)
($800,000)
$165,600
($53,333)
$5,333
$189,333
$4,267
$169,867
$189,333
$100,000
($8,000)
$169,867
$120,000
($9,600)
$92,000
$281,333
$110,400
$280,267
Year
1
2-14
15
($1,000,000)
$189,333
$281,333
($800,000)
$169,867
$280,267
NPV using WACC of 8.19%
$530,906
$574,705
Panel C: Recap of cash flows and NPV calculations
* Calculated as (Depreciation x NP% x Tax Rate).
** Calculated as (Salvage Value x NP% x Tax Rate).
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