Capital and the Use of Credit Chapter 19

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Capital andthe Use of Credit(Chapter 19)
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Objectives

• Discuss the importance of capital.
• Illustrate the optimal use and allocation of
  capital.
• Compare different sources of capital and credit.
• Describe different types of loans.
• Show how to set up different loan repayment
  plans.
• Explain how to establish and develop credit
  worthiness.
• Examine the factors that affect the liquidity and
  solvency of a farm business.

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What is capital?

• Cash.
• Balances in checking and savings accounts.
• Money invested in
• Livestock.
• Machinery.
• Buildings.
• Land.
• Other assets that are bought and sold.

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Capital in Agriculture

• Agriculture has one of the largest capital
  investments per worker of any major U.S. industry
  (capital intensive)
• Makes farm operators very productive.
• Farm numbers have been declining.
• More capital in land, buildings, livestock,
  machinery.

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Credit

• The ability to borrow money with a promise to
  repay the money in the future and pay a rate of
  interest for its use
• Critically important to capital acquisition and
  use.
• Lets you acquire productive assets and pay for
  them later with the income they generate.

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Economics of Capital Use

• Capital The money invested in the physical
  inputs used in agricultural production
• Purchase or rent productive assets
• Land, livestock, equipment
• Pay for chemicals, seed, feed, labor and other
  inputs.
• Finance family living and other personal
  expenditures.

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Economics of Capital Use

• Basic questions to be answered
• How much total capital should be used?
• How should limited capital be allocated among its
  many potential uses?

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Economics of Capital Use

• How much total capital should be used?
• Capital is an input.
• Decision rule to find the optimal amount of an
  input to use MVP MIC
• MVP The additional net return, before interest
  payments, that result from an additional dollar
  of capital investment.
• MIC The additional dollar of capital plus the
  interest that must be paid to use it.

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Optimal Capital Use
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Economics of Capital Use

• How should limited capital be allocated among its
  many potential uses?
• What if capital is limited to something less than
  the amount that will maximize total profit?
• Decision rule to allocate a limited input to its
  optimal uses Equal Marginal Principle
• The marginal value of the last dollar is equal in
  all uses.

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Sources of Capital

• Owner Equity
• Outside Equity
• Leasing
• Contracting
• Credit

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Sources of Capital

• Owner Equity
• The farmers own capital.
• Total assets minus total liabilities.
• Most farmers begin with a contribution of
  original capital
• Savings
• Gifts
• Inheritances
• Retained earnings from the farm business can be
  reinvested.
• Increases in asset value.
• Nonfarm or investment income.

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Sources of Capital

• Outside Equity
• Investors willing to contribute capital to a farm
  or ranch without being the operator.
• Share lease agreements
• Landowner may contribute operating capital.
• Landowner may provide equipment and breeding
  livestock.
• Limited partners.
• Corporations may sell stock.

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Sources of Capital

• Leasing
• Advantages
• Cheaper than owning.
• Easier to change the amount or kind of assets.
• Disadvantages
• Uncertainty about the availability of land.
• Discourages long-term improvements.

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Sources of Capital

• Contracting
• Contracting services to other agribusiness firms
• Restricted access to capital or credit.
• Want to limit financial risk.
• Examples included custom feeding, custom crop
  farming, contracted broiler production.
• Operator provides
• Labor, management, equipment, buildings.
• Contractor (agribusiness firm) pays for other
  inputs.
• Operator receives a fixed payment per unit of
  production.

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Sources of Capital

• Credit
• Capital obtained from lenders.
• Can help the business
• Grow more rapidly.
• Improve efficiency.
• Spread purchases over time.
• Withstand temporary periods of negative cash
  flow.
• Second largest source of capital in agriculture
  after owner equity.

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Types of Loans

• Classified by
• Length of repayment.
• Use of funds.
• Type of security.

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Length of Repayment

• Short-Term Loans
• Intermediate-Term Loans
• Long-Term Loans

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Length of Repayment

• Short-Term Loans
• Less than 1 year (current liability).
• Production or operating loans
• Fertilizer, seed, feeder livestock, feed
  (variable inputs).
• Repayment is due when the crops or marketable
  livestock are sold.

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Length of Repayment

• Intermediate-Term Loans
• More than 1 year but less than 10 years
  (noncurrent liability).
• One or more payment due each year
• Machinery.
• Breeding and dairy livestock.
• Some buildings.

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Length of Repayment

• Long-Term Loans
• More than 10 years (noncurrent).
• Annual or semiannual payments
• Land and other real estate.

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Use of Funds

• Real Estate Loans
• Non-Real Estate Loans
• Personal Loans

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Use of Funds

• Real Estate Loans
• Loans for the purchase of real estate
• Land.
• Buildings.
• Real estate assets serve as security.
• Typically long term
• 20 to 40 years.

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Use of Funds

• Non-Real Estate Loans
• All business loans other than real estate loans.
• Short-term or intermediate-term.
• Security
• Crops, livestock, machinery, and other non-real
  estate assets.

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Use of Funds

• Personal Loans
• Non-business loans used to purchase personal
  assets.
• Homes, vehicles, appliances.

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Security

• Assets pledged to the lender to ensure loan
  repayment
• Often called collateral.
• If the borrower cant make the principal and
  interest payments
• Lender can take possession of secured assets.
• Assets can be sold by lender.
• Proceeds are used to pay off loan.

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Security

• Secured Loans
• Some asset is mortgaged to provide collateral for
  the loan.
• Preferred by lenders.
• Intermediate and long-term loans
• Equipment or parcel of land as collateral.
• Some include a blanket security statement.
• Can include assets acquired or produced after the
  loan is obtained.
• Growing crops, for example.

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Security

• Unsecured Loans
• A promise to repay.
• No specific collateral is pledged.
• Signature loan
• Borrowers signature is the only security.
• Lenders are discouraged from making unsecured
  loans.

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Repayment Plans

• Single Payment Loan
• Line of Credit
• Amortized Loan
• Balloon Payment Loan

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Repayment Plans

• Single Payment Loan
• Principal and interest are payable in one lump
  sum.
• Short-term operating loans.
• Requires good cash flow planning for repayment.
• Simple interest
• Repay principal interest P X i X T (in
  years).
• 10,000 borrowed for 6 months at 6
• Repay 10,000 10,000 X 0.06 X (6/12 or 0.5)
  or 10,300.

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Repayment Plans

• Line of Credit
• Loan funds are transferred into a business
  account as needed, up to an approved maximum
  amount.
• Borrower
• Pays the accumulated interest on the loan first.
• Then applies the rest of the funds to the
  principal.
• No fixed repayment schedule or amount.
• Reduces borrowers interest costs.
• Less time spent in loan approval process.

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Line of Credit(40,000)

•  

Sep 1. Interest due (20,000 X 0.12 X 7/12)
(10,000 X 0.12 X 5/12)
1,400
500 1,900 Dec 1.
Interest due (14,400 X 0.12 X 1/12) (14,400
X 0.11 X 2/12)
144
264 408
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Repayment Plans

• Amortized Loan
• Periodic interest and principal payments.
• Installment loan
• As the principal is repaid and the loan balance
  declines, the interest payments also decline.
• Interest is paid
• Only on the unpaid loan balance.
• Only for the length of time that amount was
  borrowed.

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Repayment Plans

• Amortized Loan
• Two types of amortization plans
• Equal principal payment
• Same amount of principal each payment.
• Plus interest on the unpaid balance.
• 2. Equal total payment
• All payments are the same amount.
• Easier for new or expanding businesses.

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Equal Principal versus Equal Payment Amortization
(100,000)
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Equal Principal versus Equal Payment Amortization
Note table value from Table 1 (10 years at 8)
0.14903
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Repayment Plans

• Balloon Payment Loan
• Payments balloon in size
• Small periodic payments (interest only?).
• Large final payment.
• More total interest cost.
• May require refinancing to make the balloon
  payment(s).

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Repayment Plans

• Balloon Payment Loan
• Principal has not been consistently repaid during
  the loan period
• Half of the principal may be paid with the
  periodic payments, with the other half due at the
  end of the loan period.
• Periodic payments may be interest only, with all
  the principal due at the end of the loan period.
• Small principal payments throughout, and then a
  large principal payment at the end.
• etc., since several different possible
  combinations.

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The Cost of Borrowing

• Interest Rates
• (APR) Annual Percentage Rate.
• Other fees
• Loan closing fees or points.
• Appraisal fees.
• Other fees.

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The Cost of Borrowing

• Comparing the cost of different plans
• Calculate the dollar amount to be repaid in each
  time period
• Principal, interest, other fees.
• Find the discounted present value of the series
  of payments
• Use the same discount rate for each alternative.
• Find the NPV, or true cost, of the loan
• IRR to the lender if want in percentage terms.

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The Cost of Borrowing

• FixedRate Loans
• Interest rate remains the same
• Lenders may dislike because the rate they must
  pay to obtain funds may change.
• Borrowers dislike if they think interest rates
  may decrease.
• Typically have higher interest rates than
  variable-rate loans.

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The Cost of Borrowing

• VariableRate Loans
• Allow for adjustment of the interest rate
  periodically
• Usually annually.
• Typically have lower initial interest rates than
  fixed-rate loans.
• Can you evaluate cost of fixed versus variable?
• How to choose?

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Sources of Loan Funds

• Commercial Banks
• Farm Credit System
• Life Insurance Companies
• Farm Service Agency
• Individuals and Suppliers
• Other sources

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Sources of Loan Funds

• Commercial Banks
• Largest source of nonreal estate loans for
  agriculture.
• Proximity to customers.
• Also provide checking\savings accounts and other
  financial services.
• Small banks may arrange for credit to be supplied
  through a correspondent bank.

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Sources of Loan Funds

• Farm Credit System
• Established by Congress in 1916
• Government funds were used initially.
• Now a private cooperative owned by its
  members/borrowers.
• Supervised, audited, and regulated by the Farm
  Credit Administration.

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Sources of Loan Funds

• Farm Credit System
• Obtain loan funds by selling bonds
• Proceeds are made available to seven district
  Farm Credit Banks across the country.
• Provide funds to local associations.
• Loans may be used to purchase
• Livestock, machinery, buildings, and land.
• Short-term operating credit.

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Sources of Loan Funds

• Life Insurance Companies
• Acquire funds from the premiums paid on life
  insurance policies and from other earnings and
  reserve funds.
• Funds are placed in various investments
• Long-term agricultural real estate loans.
• Prefer large farm real estate loans.
• Usually over 500,000.

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Sources of Loan Funds

• Farm Service Agency (FSA)
• Part of US Department of Agriculture.
• Farm ownership and operating loans
• Some necessary qualifications.
• Emergency loans to qualified farmers and ranchers
  in officially declared disaster areas
• Flood and drought.

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Sources of Loan Funds

• Farm Service Agency (FSA)
• Moved from direct loans toward more guaranteed
  loans
• A lender provides the loan funds.
• FSA guarantees up to 95 repayment in case of
  default by the borrower.
• Most are granted to beginning farmers.

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Sources of Loan Funds

• Individuals and Suppliers
• Real estate and nonreal estate loans
• Relatives or friends.
• Accounts payable at farm supply stores, or input
  manufacturing firms.
• Many suppliers allow 30, 60, or 90 days to pay
  before interest is charged.

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Sources of Loan Funds

• Individuals and Suppliers
• Seller financed land sales
• Seller transfers possession of the land.
• Buyer makes periodic payments.
• Tax benefits for the seller.
• Buyer can negotiate
• Lower down payment.
• Lower interest rate.
• More flexible repayment terms.

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Sources of Loan Funds

• Other sources
• Commodity Credit Corporation (CCC)
• Federal government entity.
• Short-term loans using stored crops as
  collateral.
• Made at a fixed rate per bushel or pound.
• Small Business Administration (SBA)
• Make some agricultural loans.
• Emergency loan program for farmers in disaster
  areas.

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Establishing and Developing Credit

• Personal Character
• Management Ability
• Financial Position
• Repayment Capacity
• Purpose of the Loan
• Collateral

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Establishing and Developing Credit

• Personal Character
• Characteristics considered by lenders
• Honesty, Integrity, Judgment, Reputation.
• To maintain a good credit record
• Promptly inform lenders changes in the financial
  condition of the farming operation that may
  affect repayment.
• Be honest and open with lenders.

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Establishing and Developing Credit

• Management Ability
• Lenders often rate poor management ability as the
  number one reason for borrowers getting into
  financial difficulty
• Past records
• Background
• Education
• Training

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Establishing and Developing Credit

• Financial Position
• Accurate, well-prepared
• Balance sheets.
• Income statements.
• Cash flow budget
• A record of good financial progress over time can
  be just as important as the current financial
  position.

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Establishing and Developing Credit

• Repayment Capacity
• Measured by the cash flow of the business
• Cash flow budget for one or more years.
• Money is often borrowed for a profitable business
  only to find that cash flow in the early years is
  not sufficient
• Longer-loan terms.
• More flexible repayment schedule.

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Establishing and Developing Credit

• Purpose of the Loan
• Self-liquidating loans
• Fertilizer, seed, feeder livestock.
• Can be repaid from the sale of crops or
  livestock.
• Easier to obtain.
• Capital asset loans
• Land, machinery.
• Must generate additional revenue without being
  sold themselves.
• May require extra collateral.

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Establishing and Developing Credit

• Collateral
• Loans shouldnt be made or requested unless
  repayment can be projected from farm income.
• If unexpected happens, they want collateral
• Land
• Buildings
• Livestock
• Machinery
• Stored grain
• Growing crops

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Factors Affecting Liquidity

• Business Growth
• Non-business Income/Expenditures
• Debt Characteristics
• Debt Structure

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Factors Affecting Liquidity

• Business Growth
• Holding back inventories of young breeding
  livestock or feed.
• Construction of new buildings.
• Purchases of land or machinery.
• Investing in new technology.

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Factors Affecting Liquidity

• Non-business Income Expenditures
• Basic family living expenses must be met.
• A dependable source of outside income
• Stabilize resources for family living expenses.
• Support farm during periods of negative cash
  flow.
• More and more off-farm income.

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Factors Affecting Liquidity

• Debt Characteristics
• The rates and terms of credit may affect cash
  flow as much as the amount of debt incurred
• Find the lowest available interest rate.
• When necessary, use longer-term debt or balloon
  payment loans.

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Factors Affecting Liquidity

• Debt Structure
• The distribution of debt among
• Current
• Intermediate
• Long-term liabilities
• Loan payment terms should correspond to the class
  of assets that they were used to acquire.

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Summary

• Capital includes money invested in machinery,
  livestock, buildings, cash, and bank account
  balances.
• Sources of capital that are available to farmers
  include the operators own equity, equity from
  outside investors, leased or contracted assets,
  and borrowed funds.

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Summary

• Interest rates, loan terms, and repayment
  schedules vary from lender to lender and by loan
  type.
• Borrowers should compare the annual percentage
  rate of interest, loan fees, variable rate
  provisions, and other loan terms when shopping
  for credit.
• Ag. loans are available from commercial banks,
  the Farm Credit System, life insurance companies,
  government agencies, individuals, and other
  sources.

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Summary

• Borrowers should work at improving their credit
  by maintaining good personal character, improving
  management skills, demonstrating adequate
  financial progress and repayment capacity, and
  providing sufficient collateral.
• Liquidity is affected by business growth,
  nonbusiness income and expenses, and the
  characteristics and structure of the debt held.