Agriculture Reference
In-Depth Information
The marginal income tax rate mentioned is the rate of income tax paid on the last
increment of taxable income. Proprietorships and partnerships (see
Chapter 4
) must also be
aware of this cost as they decide between investing their own funds and borrowing capital
funds for their businesses.
The leverage principle
Leverage
is the concept of fi nancing through long-term debt instead of equity capital.
Many managers like to use debt as a lever against equity as much as possible so that they
can maximize the amount of assets or capital at their disposal. Several factors affect the
leverage principle. First, it must be remembered that as the proportion of debt to equity
increases, lenders are likely to increase the cost of supplying borrowed funds because of
the deterioration in the solvency measures and the resulting increase in risk. It must be
understood that risks for equity holders also increase as debt increases, because they hold a
last-place claim on the fi rm's assets in the event that the assets of the fi rm must be liquidated
to satisfy the fi rm's debt obligations. In general, equity capital is risk capital—in the event
of fi nancial problems, all other creditors are paid before equity owners are paid. Leverage,
or increasing the proportion of debt to equity, can be either a profi table or an unprofi table
decision.
As a rule of thumb, the after-tax rate of return on the capital of the agribusiness
must exceed the after-tax cost of the debt undertaken to increase profi ts. For example, if
the fi rm's overall ability is to return 10 percent on the borrowed capital and the after-tax cost
of borrowing that capital, or money, is 6 percent, borrowing more money should increase
profi ts.
Determining how much agribusinesses should borrow
The question of how much an agribusiness should borrow is one that agribusiness managers
frequently ask. Some answer by saying, “All I can get,” while others say, “Let's pay off the
mortgage and eliminate our long-term debt.” These philosophical generalizations are not
adequate for determining how much an agribusiness should borrow. The good manager
always establishes criteria and a frame of reference for such decisions. This section will deal
primarily with intermediate- and long-term debt, since it is assumed that short-term debt will
be paid off from conversion of current assets to cash. The amount of debt that is most desir-
able depends on several factors, some of which have already been discussed. Many of these
factors are easy to measure, but others are more diffi cult.
The fi rst factor to consider is the amount that the agribusiness will be able to generate for
debt servicing (repayment of the loan). While available funds can be calculated from all
sources of cash fl ow, generally two factors are considered the primary inputs for debt servic-
ing: (1) net operating income for the year and (2) depreciation. Net operating income must
be further reduced by any interest that is due, income tax to be paid, dividends owed on
owner equity, or patronage refunds in the case of a cooperative (see
Chapter 4
).
For example, if Doug Davies has a net operating income of $50,000 and depreciation of
$25,000, he has a preliminary total of $75,000 in cash. Depreciation is added to net operating
income, because it is a noncash operating expense that is subtracted from gross margin
(profi t) to calculate net operating income. However, the depreciation expense is not paid to
an entity outside the fi rm, so those dollars are available to pay debt obligations. For debt
servicing purposes, he would have to deduct $8,000 in interest expense, $25,000 in taxes,
