SOUTHERN JOURNAL OF AGRICULTURAL ECONOMICS
JULY, 1977
AN ANALYSIS OF OPTIMAL FARM CAPITAL STRUCTURE
Wesley N. Musser, Fred C. White, and John C. McKissick
Use of debt in financing agricultural firms is an
issue of perennial interest. Much of this interest
reflects farmers’ disastrous experience with debt
during the Great Depression. The foreclosed mort-
gages and bankruptcies of that era reaffirmed an
historical feeling that achieving a level of zero debt or
financial leverage was a high priority goal. E. G.
Johnson, who was Chief of the Economic and Credit
Research Division of the Farm Credit Administration,
articulated the position in the 1940 Yearbook of
Agriculture that this goal is even more important than
increasing profits: “It may be well to emphasize again
that while credit properly used may help farmers to
increase their income and raise their standard of
living, the fact must not be overlooked that more
credit will not cure all the ills of agriculture. The
greatest need is to assist the farmers in getting out of
debt, not deeper into it,” [6, p. 754]. As memories
of the Great Depression faded, agricultural econo-
mists tended to emphasize the effect of debt on farm
size and therefore net income. Heady emphasized
increased income from obtaining more resources
through use of debt [3, pp. 535-561], and Hopkin,
Barry and Baker stressed that leverage could increase
rate of growth of farm firms [5, pp. 143-163].
Increased use and acceptability of leverage in agricul-
ture has stimulated some empirical research on
factors affecting the level of farm debt. The earliest
research attempts in this area used time series data [4,
7, 9]. Lins and Donaldson [8] provided a recent
cross-sectional analysis of level of farm debt in 1970.
One limiting factor in empirical analysis of
agricultural use of financial leverage has been the
weak theoretical framework. Many earlier writings
have been conceptualized in a marginal returns and
marginal costs framework. Conceptual and empirical
difficulties in including risk in this standard frame-
work limit its usefulness in analyzing situations where
risk is important. In corporate finance theory, the
concept of cost of capital is utilized to analyze
optimum level of financial leverage [1, 11]. While
Hopkin, Barry and Baker present a theoretical dis-
cussion of this concept in their textbook [5, pp.
251-256], it has not been integrated into empirical
analysis in agricultural finance. The purpose of this
paper is to explore applicability of the concept of
cost of capital in analyzing farmers’ decisions to
utilize financial leverage. Specific objectives include:
(1) a brief discussion of the concept of cost of
capital, (2) derivation of an empirical model from the
cost of capital concept to analyze the decision to
employ financial leverage and (3) presentation of a
discriminant analysis which tests the model for a
sample of Georgia farmers.
THE COST OF CAPITAL CONCEPT1
In general terms, cost of capital is the weighted
sum of the component cost of each capital source
weighted according to its long-run level of use in the
firm’s capital structure. If a farm firm is financed
with two categories of debt and proprietor equity,
the cost of capital is calculated as follows:
Ko = (°) Kd+ (1-°) Ke (1)
Wesley N. Musser is Assistant Professor, Fred C. White is Associate Professor and John C. McKissick is Former Graduate Research
Assistant, Department of Agricultural Economics, University of Georgia, Athens, Georgia. Mr. McKissick is currently an
Extension Economist, Marketing Extension Department, University of Georgia.
1This section synthesizes the traditional theory of cost of capital. The seminal work in this area is Solomon [10]. This
subject matter is also considered in corporate finance textbooks such as Weston and Brigham [11, pp. 594-622].
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