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Improving the Ability of Agricultural Decision Makers to Compare Financing Alternatives

Jayson Harper

Summary

Agricultural businesses rely on borrowed capital for inputs, machinery, equipment, and land. Debt capital, relative to equity capital, is typically less expensive and can accelerate equity capital growth. However, use of debt capital increases the risk of equity loss and its management is a critical farm business management function. Managing debt capital for a farm is choosing from among multiple financing sources offering differing interest rates, rebates, points, and other non-interest costs. Educational efforts that teach producers how to evaluate financing alternatives are important so the true cost of borrowing is known. Knowing the true cost of debt capital can lead to better decision making because financing sources can be ranked based on cost. In addition, knowing the true cost of debt capital aids in risk management because equity loss only occurs when the farm’s rate of return of farm assets drops below the cost of debt capital.

Three Excel-based decision aids were developed that allow producers to calculate the cost of debt capital. The first model uses the economic concept of opportunity cost and the financial concept of time value of money to determine the cost of capital from supplier financing. The second decision aid uses of time value of money concepts for machinery and equipment purchases. The third decision aid evaluates the cost of capital for real estate purchases. Each of the decision aids elicit the appropriate financial information for each financing alternative so the costs of capital can be compared.

Details

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