FIGURE 1. COST OF EQUITY (Ke), COST OF
DEBT (Kd), AND COST OF CAPITAL
(Ko) CURVES ILLUSTRATING ZERO
LEVERAGE IN AN OPTIMAL CAPI-
TAL STRUCTURE
towards the firm which is expressed in a given Kd
function, Ke will increase faster with leverage the
greater the degree of risk aversion of the farmer. For
any given level of the Ke function, Kd will be more
responsive to leverage, the more risky the lender
perceives the debt or, in more conventional terms, the
borrower’s credit worthiness.
In summary, the cost of capital concept provides
a convenient framework for identification of situations
in which a farmer would be expected to have no debt in
his financial structure. If cost of equity is less than
that of debt, a clear case for no financial leverage
exists. If cost of equity is not much larger than cost of
debt, zero financial leverage can also be optimal if the
owner’s risk premium for debt increases faster than
that for lenders. Thus, analysis of the use of debt
among farm firms can concentrate on the relative
level of Ke to Kd and of factors affecting the risk
preferences of farmers and agricultural lenders.
AN EMPIRICAL MODEL
In the previous section, two factors were
deduced as being important in identifying situations
in which zero financial leverage would be optimal in
the cost of capital framework. In this section, an
empirical model is developed which includes variables
to test the influence of these two factors. In
development of this model, empirical propositions
from the literature on agricultural finance are inte-
grated with the theoretical results of the previous
section.
Identification of variables to analyze the relative
levels of Ke and Kd requires particular attention to
Kd . As indicated in equation (3), Ke depends largely
on factors which are observable in operation of a
farm business. Estimation of Kd is more difficult. As
shown in equation (2), an estimate of Kd requires the
effective interest rate, which is difficult to estimate
for farmers with no debt. The approach taken in this
study is to utilize estimates of Ke as a variable to
reflect differences between K,. and Kr,. Since interest
rates are relatively uniform among farmers [3, pp.
558-559], the main variation in Kd among farm
firms results from variation in the income tax rate.
The depressing effect of the tax rate on Kd would
also be positively related to Ke since a higher Ke
reflects a higher net income with a given investment.
Thus, the level of Ke measures both the relationship
between Ke and a standard interest rate and the
effect of taxes on Kd .
In the theoretical area of risk preferences of
farmers and lenders, operator’s age and enterprise
portfolio effects were included to represent impor-
tant differences. Inclusion of age is in recognition of
the inverse relationship between debt and age which
is often noted in literature [3, pp. 549-550; 5, pp.
138-141; 1, pp. 23-24]. This literature indicates that
farmers begin to stress stability of income during the
middle of the life cycle more than in their younger
years. In the framework of the cost of capital model,
farmers would be expected to require a higher level of
Ke for positive levels of leverage as they get older.
Thus, increasing age would be expected to be
associated with lower likelihood of using debt in the
capital structure.
Enterprise portfolio effects are a result of the
well-known reduction in risk from diversification in
farm organization. For farmers with a specialized
farm organization, the risk of any particular level of
financial leverage is higher. If farmers’ risk patterns
follow the typical pattern of decreasing rate of
personal substitution of risk for returns, it could be
expected that the rate of increase in Ke with respect
to leverage would be greater on specialized than on
diversified farms. Ideally, portfolio effects would be
measured as a percentage of net income derived from
the major enterprise. The problems of allocating costs
to particular enterprises makes this a difficult proce-
dure even if complete farm record data are available.
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