Agricultural Finance
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Agricultural Finance

Charles Moss

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eBook - ePub

Agricultural Finance

Charles Moss

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About This Book

This textbook integrates financial economics and management in the area of agricultural finance. The presentation of financial economics discusses how the credit needs of farmer/borrowers are met by depositors through commercial banks. The financial management content presents methods used to make farm financial decisions including farm accounting, capital budgeting, and the analysis of risk.

The textbook begins by developing the farm financial market focusing primarily on the market for debt. Next, the textbook presents an overview of accounting concepts important for the credit market. The accounting section provides a detailed discussion of the Farm Financial Standards Council's suggestions for agricultural financial statements. Following the financial accounting, the book presents the use of ratio analysis applied to the farm firm. Next, the text describes capital budgeting followed by an introduction to risk analysis. Finally, the book presents the effect of debt decisions on the farm firm. In addition to the primary topics, the textbook includes a discussion of agricultural banking and monetary policy and an analysis of the choice of historical cost and market valued accounting methodologies on the farm debt decision.

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1    Introduction
A starting point for any class or study is to define the topic that will be covered. In this text we will study agricultural finance, which is usually taught in departments of agricultural economics and agribusiness. The fact that agricultural finance is typically taught in an agricultural economics department while in colleges of business, finance is typically taught by another department raises certain questions. Specifically, how are agricultural economics and finance different from one another; and, how are they different from courses offered in colleges of business? We follow Becker (2008) by defining economics as the study of the allocation of scarce resources to meet unlimited and competing human wants and desires. The abstraction of this definition is infamous, but to be fair, Becker has used economic theory to study such factors as marriage, fertility, and even suicide (Becker and Posner, 2004). Agricultural economists typically reduce the scope of their concern to questions of agriculture, natural resources, and the environment. Specifically, agricultural economists focus their efforts on crop production and the possible effects of this production on water quality, specie diversity, and more recently, on the ability of various crops to sequester carbon. Agricultural economics tends to be more applied, concerned less with the development of theory and more on the analysis of policy.
Given the definitions of economics and agricultural economics, what is the role of finance in general and agricultural finance in particular? In a significant way, neoclassical theory is sterile. In answering the general question of human action (von Mises, 2007) or choice, the description of economics abstracts away from the particulars. In addition, as described by Hicks (1939), economics is timeless. The production function which represents the transformation of inputs into outputs typically does not reference time. However, many production processes like agricultural crops require time because of their biological nature. In other industries, the complexity is due to the number of inputs required. The production of steel from iron and coke requires an inventory of each input. In its heyday, American steel represented an intricate web of mining, transportation, and smelting operations. Iron was mined in Minnesota’s Iron Range and shipped to smelting facilities in places such as Chicago to be joined with coke produced from coal in the Appalachian region. The product, steel, was then shipped to the automobile plants in Detroit. In each case, production requires some stock of past production carried over from a preceding period to produce a final product. The point of finance is the distribution of that prior period product required for the production of steel, automobiles, or even corn. A major source of previously produced inputs, even to production systems that appear instantaneous, is machinery or equipment. The point of finance is that ownership of these pre-produced inputs, whether operating capital (i.e., iron, coke, or steel) or the equipment used in the production process, matters. As will be discussed in this chapter, these processes require someone to forgo consumption in the short run to gain a larger return in subsequent periods. In addition, by investing in production in the short run, the investor also subjects his consumption to risk and uncertainty.
In the case of agricultural finance, the decision maker may own farmland and machinery, purchase inputs such as seed, fertilizer and fuel, and hire labor to plant a crop in one period to produce output such as corn in a subsequent period. In terms of the preceding discussion, this production process requires time, which implies that ownership is important. This producer had to own or control land and equipment, as well as a medium of exchange (i.e., cash) to purchase inputs and hire labor to carry out the production process. Financial decisions are then defined by the acquisition of these resources. Specifically, why does the producer choose to abstain from consumption to produce corn?
In theory, the producer could rent his land to another farmer and simply consume the cash that would have been used to plant a crop. Clearly the producer has expectations that the additional return from corn will exceed the short run cost of production (i.e., the seed, fertilizer, and labor) and the wear and tear on the machinery. In addition, we expect that this profit will exceed the rent that the producer would have received from renting the land to another farmer. Thus, we have assumed that the profit was sufficient to meet all the input costs including the opportunity cost of land. The question is then whether the producer perceives that an additional return is necessary to undertake the production process. Back to the concept of abstinence; if the revenue simply covered the cost of production, why did the producer forgo consumption?
Building on this example, next we assume that the farmer owns the farmland and equipment but does not have cash to purchase the seed, fertilizer, or fuel or to hire the labor. In this case, we typically say that the farmer lacks operating capital. In today’s economy, the farmer could acquire the funds to purchase these operating inputs from another individual or institution in three ways. The first method common in agriculture is operating credit obtained by short-term debt – an operating loan. In this transaction, a bank provides the cash (or more typically a claim on deposits) to the farmer for a fixed period of time (e.g., 6 months) for a fixed payment (typically principal plus interest). This fixed payment is guaranteed by pledging collateral which would be forfeited upon non-payment. The fixed nature of the repayment classifies this transaction as a debt instrument as opposed to an equity instrument (discussed below). From one point of view, the upper bound on the return on the debt instrument is fixed by the terms of the contract. The lender may earn a smaller return if the borrower fails to pay the loan, but the return can never exceed the stated interest rate.
A second possibility would be an equity transaction (i.e., a partnership) such that an individual with excess cash could participate in the investment by purchasing the operating inputs with his cash. In this transaction, the outside investor typically shares proportionately in the return according to some pre-arranged agreement (or formula). Unlike the debt relationship, the equity investment has no upside limitation. However, the partner also has less protection against loss. Looking forward, the debt contract is discharged (paid) first by the bankruptcy courts. Participation through equity also implies an elevated level of trust or monitoring. Specifically, an equity contract might stipulate that the partner receives 25 percent of the net returns from the crop. The question is who determines what 25 percent of the net returns actually was? The partner could build in a monitoring cost such as an audit of the farmer’s books at the end of the year. In the most common form of an equity arrangement (common stock), firms are typically required to publish audited financial statements with the stock exchange where their shares are traded and/or the Securities and Exchange Commission (a government entity). In either case these reporting requirements are referred to as costly monitoring (someone has to pay for the cost of the audit).
A third way of obtaining inputs is by trade credit. Many merchants will advance the inputs on credit to long-time customers. In the farm sector, grain elevators, cotton gins, and other agribusinesses where farmers typically sell their crops often also sell the associated inputs. Thus, the cotton gins may sell cotton seed, fertilizer, and agricultural chemicals. Given that the farmer will typically sell his output to this entity, the gin advances the inputs against the crop. This contract is somewhat different from the standard debt contract because it represents an input (i.e., a combination of a productive input and a debt instrument).
In this simple construction we anticipate a positive return on the capital used to purchase the inputs. However, this conjecture has been the subject of historical debates. As described by Bawerk (2007), interest on capital was viewed as a return “born to barren money.” In other words, the money was not in and of itself productive, but the input purchased with the money was the factor that generated the return. Given this background, interest on money was viewed as immoral by the Greeks and sinful by the Christian church through the Renaissance. Pope Clement V at the council at Vienna in 1311 threatened to excommunicate any secular authority who permitted the charging of interest. However, while the church and the civil authorities maintained laws against interest, lending and interest continued as practical institutions, sometimes using circuitous methods (such as limited liability partnerships). Chapter 2 will examine the questions raised by Bawerk by developing an overview of the financial market for agriculture.
Extending the time horizon beyond the single year, we assume that the farmer has enough short run capital to purchase operating inputs but insufficient capital to purchase equipment. For example, the farmer could either purchase the seed, fuel, and fertilizer or acquire those inputs using trade credit, but lacks the funds to buy a tractor. Again, the funds for the purchase of this piece of machinery could be acquired either by debt, equity, or a form of trade credit. However, in this scenario the amount of credit required typically implies an extended period (i.e., more than one crop year) to pay off the purchase of the tractor. Typically, machinery loans (either made by a lender or by an equipment manufacturer) will be repaid over 3 to 5 years. Likewise, the extension of a partnership over more than one year involves a more formal (and complicated) agreement.
Similarly extending the capital market to an extremely long-lived asset such as land involves still more formal lending and partnership contracts. Trade credit in the land market is replaced by owner sales of land where retiring farmers will transfer title to farmland to another farmer over time. In essence, the retiring farmer becomes the lender.
These scenarios allow for a more formal discussion of the terms finance, financial management, and financial economics. Financial management typically involves the decision made by the individual or the firm regarding how to fund operating requirements such as whether to purchase equipment or farmland, and how to fund those purchases (i.e., the choice of lender and credit terms). Financial economics focuses primarily on the market transactions; specifically, what conditions lead to the choice of equity capital over debt capital, the choice of investment alternatives, and the effect of monetary and fiscal policy. Both fields taken together define the overall field of finance.
Practically, the study of agricultural finance tends to differ from the finance courses offered in the college of business administration in that the focus of agricultural finance is on the sole proprietorship versus the corporate form. Several aspects of the farm firm make this sector less attractive to the detached ownership of the corporate form. However, this difference does not affect a large portion of the field which serves both business forms. Much of this material represents financial management questions.
1.1  Chapter summary
  • Production is time dependent in all but the simplest processes. It may be dependent due to the biological process (such as the case of growing crops), or the time dependence may be due to the use of other inputs or transportation.
  • Since production processes require time, ownership and ownership costs of factors of production affect economic efficiency.
    –  Financial decisions are defined by the acquisition and control of these factors of production.
  • The emergence of both financial markets and markets for factors of production (including both variable factors of production and equipment) implies that sufficient profit is expected to meet these costs and the opportunity cost of any other fixed factors of production (i.e., land and labor).
  • Funds can be acquired to purchase factors of production from retained earnings (the individual’s forgone consumption), the issue of debt (funds acquired under a contract to pay a fixed return [interest rate] after a specified period of time), or the sale of equity (basically a share in the enterprise which does not bear a fixed interest rate [at risk capital]).
    –  Equity investment implies either an elevated level of trust or additional monitoring expenditures (auditing expenses).
    –  Trade credit could be construed as lending or price discounts (zero or low interest loans for equipment implies a discounted price).
  • Comparing financial management with financial economics:
    –  Financial management develops the individual’s decisions on how to fund a business’s operating requirements in the short run, or purchase equipment or farmland.
    –  Financial economics is primarily interested in market transactions between businesses and sources of capital in the form of either debt or equity capital, and the effect of exogenous factors such as monetary and fiscal policy on these equilibria.
1.2  Review questions
1-1R.  Choose a crop or livestock enterprise. What imputs must be purchased before the production process begins? What (if any) inputs must be purchased after the production process begins?
1-2R.  Compare the sources of capital used in a farming enterprise (owner equity, debt, lease, etc.). Which of these sources of capital are considered “at risk” and why?
1-3R.  Compare the inputs financed by the supplier (i.e., trade credit) with the use of third-party credit (i.e., obtaining an operating loan from the bank to purchase inputs). Which mechanism is likely to yield the lowest input price? Which is likely to yield the lowest interest rate?
1-4R.  What is meant by “barren money”?
1-5R.  How do the legal instruments for agricultural credit change with the length of the debt repayment period?
Part I
Financial institutions
2 Financial institutions and markets
As described in Chapter 1, the use of purchasing power to buy factors of production is an important dimension to all business today. In fact, the emergence of financial intermediation (institutional arrangements linking the demand for this purchasing power with sources of purchasing power) has been critical in economic development.
Perhaps the best way to appreciate the importance of financial intermediators is to consider what the world would look like without them. In their absence, firms seeking finance and savers looking for investment opportunities would have to find each other and negotiate detailed contracts. Will funds be loaned or will they purchase a share of the enterprise? If loaned, for how long, at what interest rate, and against what collateral? If the funds purchase an ownership share, to what fraction of profits and seats on the board of directors will investors be entitled and, if the enterprise fails, how much liability will they bear? A system without financial intermediators would be, to put it mildly, inefficient. The transaction costs involved in seeking out investors and reaching agreements would be prohibitive, and firm managers, in all likelihood, would be forced to rely on retained earnings (i.e., funds generated by the firm but not distributed to owners) and the fortunes of friends and family to finance expansion. Economic growth, as typified by the modern industrialized – or industrializing – economy would seem impossible.
(Grossman, 2010, p. 1)
For the most part, farmers tend to borrow capital for the purchase of operating in...

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