Barry and Ellinger
Loan Pricing and Farm Performance 51
Conversely, a growth-oriented firm starting in
a relatively high leverage and low liquidity po-
sition will have a less favorable credit rating
and higher borrowing costs. Growth will tend
to be delayed and diminished until the vari-
ables determining the credit rating change suf-
ficiently to yield an improved credit score and
lower borrowing costs.
These anticipated performance patterns are
consistent with the insight provided by finance
theory. If the rate of return on assets exceeds
the cost of borrowing, then higher financial
leverage increases the expected rate of return
to equity capital, although total risk increases
as well. Under constant values for borrowing
costs and asset returns, only nonprice credit
responses by lenders would limit financial le-
verage and thus growth potential. Including
the price response of the lender in the analysis
through adjustments in interest rates as credit
worthiness changes will provide an internal
control mechanism that dampens the incen-
tive for growth as credit worthiness diminishes
and stimulates growth as credit conditions
strengthen. In this fashion, the lender response
serves as an equalizing factor for growth-ori-
ented farms starting in different credit posi-
tions and Should yield near equality among the
ending capital structures, credit classifications,
and the return on assets and borrowing costs,
after accounting for the discrete price intervals
and under the deterministic conditions as-
sumed here.
Similar response patterns are anticipated
under alternative economic conditions. Real
growth in earnings and asset values will im-
prove credit, reduce borrowing costs, and
stimulate growth and financing until the in-
terest rate response to diminished credit wor-
thiness occurs. Conversely, real negative
growth in earnings and asset values will di-
minish credit, raise borrowing costs, and thus
dampen the incentive for growth.
Empirical Results
The results of the simulation analysis, con-
ducted over a 10-year horizon, are consistent
with the anticipated patterns of response de-
scribed above. In table 2 selected model results
are shown for each of the 10 years for alter-
native values of the initial debt-to-asset ratio,
growth rates, and the presence and absence of
credit-scored loan pricing. Section I of table 2
shows that, in the absence of credit-scored
pricing and with a beginning debt-to-asset ra-
tio of 30%, net worth grows by 123.33% by
the end of the horizon, 160 acres are purchased
beginning with a 40-acre purchase in year 4,
and the credit classification and scores show a
strengthening from class 2 to class 1 in years
2 and 3 and then a return to class 2 as land
investments and financing occur.
The introduction of credit-scored pricing, as
shown in section II of table 2, allows the firm
to begin with interest rates of 10% in year 1
which then decline to 8% in years 2 through
6. These relatively low rates in turn contribute
to improved financial performance and a lon-
ger tenure in credit class 1, even with an ac-
celeration in land investments. Following the
initial 40-acre land investment in year 4, sub-
sequent land purchases occur one year earlier
than in the absence of credit-scored pricing and
include an additional 80-acre purchase in year
10, bringing total purchases to 240 acres. The
added investments and financing increase the
interest rates to 10% for years 7 through 10.
Net worth grows by 139.22% over the 10-year
period, and while the ending debt-to-asset ra-
tio of 34.5% is higher than that of the section
I case, the ending credit score still yields a class
2 credit classification.
Section III of table 2 reflects a more favor-
able economic environment in which farm in-
come and land values grow at a 5% annual rate
compared to annual growth rates of 3% for
operating and other costs. As expected, net-
worth growth increases to 251.84%, and land
purchases increase to 360 acres. The credit
scores, classifications, and interest rates follow
the same patterns as in section II of the table.
That is, credit worthiness improves to class 1
in the early periods and then returns to class
2, reflecting the financial consequences of the
additional land investments.
The model specifications in section IV of
table 2 are the same as those of section III
except for an increase in the initial debt-to-
asset ratio from 30% to 60%. (Since total assets
are the same in both cases, the increase in le-
verage implies a lower level of beginning net
worth.) The high initial leverage along with less
favorable values for the other credit variables
pushes the year 1 credit score into class 4 with
a high interest rate of 14%. As debts are repaid,
leverage is reduced, and other credit variables
strengthen in response to the growth in farm
income and land values, the credit score im-
proves and the credit classification improves
as well, to class 3 in year 3, class 2 in year 6,