Farm Management
Chapter 19
Capital and the Use of Credit
Chapter Outline
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•
•
•
•
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 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
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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.
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Figure 19-1
Capital 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 money
in the future along with interest for
its 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 an
input until its marginal value product (MVP)
equals its marginal input cost (MIC) was
explained. The same concept applies
to capital.
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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.
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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 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.
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Sources of Capital
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Owner equity
Outside equity
Leasing
Contracting
Credit
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Figure 19-3
Total U.S. farm debt by type
Source: USDA
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Types of Loans
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•
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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
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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
Date
Amount Interest Amount
borrowed rate
repaid
Feb 1
April 1
Sept 1
Oct 1
Dec 1
$40,000
20,000
0
0
0
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9%
9%
9%
8%
8%
$0
0
32,850
0
24,000
Interest
paid
$0
0
2,850
0
625
Principal Outstanding
paid
balance
$0
0
30,000
0
23,375
$40,000
60,000
30,000
30,000
6,625
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Table 19-2
$100,000 Loan at 8%
Equal Principal Payments
Year
1
2
3
4
5
5
7
8
9
10
Equal Total Payments
Principal
paid
Interest
paid
Total
payments
Principal
remaining
Total
payment
Interest
paid
Principal
paid
Principal
remaining
$10,000
10,000
10,000
10,000
10,000
10,000
10,000
10,000
10,000
10,000
$100,000
$8,000
7,200
6,400
5,600
4,800
4,000
3,200
2,400
1,600
800
$44,000
$18,000
17,200
16,400
15,600
14,800
14,000
13,200
12,400
11,600
10,800
$144,000
$90,000
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
0
$14,903
14,903
14,903
14,903
14,903
14,903
14,903
14,903
14,903
14,903
$149,030
$8,000
7,448
6,851
6,207
5,512
4,760
3,949
3,073
2,126
1,104
$49,030
$6,903
7,455
8,052
8,696
9,391
10,143
10,954
11,830
12,777
13,799
$100,000
$93,097
85,642
77,590
68,895
59,503
49,360
38,406
26,576
13,799
0
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Figure 19-4
Loan repayment under
two types of amortization
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Table 19-3
Amortization with Balloon Payment
$100,000 at 8% with a Balloon Payment
Year
1
2
3
4
5
5
7
8
9
10
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Principal
paid
Interest
paid
Total
payments
Principal
remaining
$5,177
5,591
6,039
6,522
7,044
7,607
8,215
8,873
9,583
35,349
$100,000
$8,000
7,586
7,138
6,655
6,134
5,570
4,962
4,304
3,595
2,828
$56,772
$13,177
13,177
13,177
13,177
13,177
13,177
13,177
13,177
13,177
38,177
$156,770
$94,823
89,232
83,193
76,671
69,627
62,020
53,805
44,932
35,349
0
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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
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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 19-5
Market share of U.S. farm debt
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Establishing and Developing Credit
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Personal character
Management ability
Financial position
Repayment capacity
Purpose of loan
Collateral
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Liquidity
Factors affecting liquidity:
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Business growth
Non-business income and expenses
Debt characteristics
Debt structure
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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 nonfarm 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 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.
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Setting a Cap on Debt/Asset
Total Liabilities + X
= 0.4
Total Assets + X
Use this formula to find the amount of
borrowing (X) that will increase D/A ratio
to 0.4 (or some other chosen level).
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An Alternative
Return on Assets
Maximum debt/asset =
Interest Rate
This maximum here is the level at which
return on equity (%) is equal to zero. This
formula assumes ROA < Interest Rate
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Table 19-4
Illustration of the Principle
of Increasing Leverage
0.00
Equity Capital ($)
Borowed Capital ($)
Total Assets ($)
100,000
0
100,000
Debt/asset ratio
0.33
0.50
100,000
50,000
150,000
100,000
100,000
200,000
0.67
100,000
200,000
300,000
Good Year
Return on assets (15%)
Interest paid (10%)
Return on equity ($)
Return on equity (%)
15,000
0
15,000
15.0
22,500
5,000
17,500
17.5
30,000
10,000
20,000
20.0
45,000
20,000
25,000
25.0
10,000
10,000
0
0
15,000
20,000
-5,000
-5
Poor Year
Return on assets (5%)
Interest paid (10%)
Return on equity ($)
Return on equity (%)
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5,000
0
5,000
5
7,500
5,000
2,500
2.5
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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.
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