February 12, 2016

Leverage and Interest Rate Risk

Financial risk is incurred when a farm borrows money to purchase assets or operate the farm. Financial risk is caused by uncertainty pertaining to interest rates, lending relationships, changes in market value of assets used as collateral, and cash flow used to repay debt. Financial risk is often inter-related with other sources of risk, particularly production and technical, and price and market risk. For instance, when production and/or prices are relatively low, a farm is going to have more difficulty repaying loans and the market value of assets is likely going to soften and perhaps even decline in value.

Managing financial risk is an extremely broad topic. Sub-topics would include managing capital structure (i.e., mix of debt and equity capital), examining the relationship between financial leverage and risk, using credit reserves, liquidation costs or converting risky assets to cash, using self-liquidating loans, and managing changes in interest rates. The discussion below focuses on the relationship between leverage and interest rate risk. A previous article (February 2016) discussed a related topic, the relationship between leverage and financial risk.

Changes in interest rates impact the expected rate of growth of equity. Two case farms (Farmer A and Farmer B) are used to illustrate the sensitivity of the growth rate of equity to changes in net returns and interest rates. Both farms have total assets of $2,000,000; family living expenses of $75,000; and face a 25 percent tax rate on farm income (income tax and social security tax). The farms differ by their debt structure. Farmer A has a debt to asset ratio of 25 percent while Farmer B has a debt to asset ratio of 50 percent.

Before examining the sensitivity of the growth rate of equity to changes in net returns and interest rates, we first need to illustrate how the growth rate of equity is computed. Table 1 illustrates the computation of the growth rate of equity for Farmer A under a scenario in which the net income on assets (net income divided by total assets) is 10 percent and the interest rate is 5 percent. Under these conditions, net income on assets is $200,000; after-tax income is $131,250; addition to retained earnings (i.e., the growth in equity measured in dollars) is $56,250; and the growth rate of equity is 3.75 percent.

Table 1. Rate of Growth of Equity for Farmer A

Table 1. Rate of Growth of Equity for Farmer A

Table 2 illustrates the sensitivity of the growth rate of equity to changes in net income on assets and interest rates. In this table, r is net income divided by total assets and i is the interest rate. A relatively large increase in interest rates is used for illustrative purposes. Three levels of net income on assets are presented. The highest rate (r = 0.15) represents rates earned by farms in the top quartile in terms of financial performance. The median rate (r = 0.10) represents an average long-term rate of return. The lowest rate (r = 0.05) represents a below average long-term rate of return. The lowest rate was typical of rates of return from 2000 to 2006, while the median rate is typical of the period from 2007 to 2013. The lowest rate also conveys typical rates of return from 2014 on. The conceptual framework in table 1 was used to compute the growth rate of equity. It is important to note that the debt to asset ratio varied between the two farms. Asset levels, tax rates, and family living expenses were assumed to be the same for each farm.

Table 2. Rate of Growth of Equity for Farmer A and Farmer B under Various Scenarios

Table 2. Rate of Growth of Equity for Farmer A and Farmer B under Various Scenarios

The increase in interest rates caused the growth rate of equity to drop 1.25 percent for Farmer A, and 3.75 percent for Farmer B under each scenario for r. The larger drop in the growth rate for Farmer B is directly related to its higher degree of leverage. As was illustrated in a previous article (February 2016), leverage has a positive impact on additions to equity when rates of return are larger than the interest rate, and a negative impact when rates of return are smaller than the interest rate. For instance, under the r = 0.15 and i = 0.05 scenario, Farmer B had a larger growth rate of equity. Conversely, under the r = 0.05 and i = 0.05 scenario, Farmer A had a smaller decline in the growth rate of equity. Note that the growth rate of equity was negative for all of the r = 0.05 scenarios indicating that equity declined under these scenarios. Obviously, if returns were lower than 0.05, equity would decline even more than that depicted for the r = 0.05 scenario.

This article described financial risk and illustrated the impact of a change in interest rates on the growth rate of equity. An increase in the interest rate has a large adverse impact on the growth rate of equity. The impact is particularly harmful for farms with more leverage and under a scenario where rates of return are relatively low, which has been the case in the last couple of years. Obviously, it is very important to carefully monitor capital structure (i.e., solvency), particularly in the current economic environment.

 


References

Langemeier, M. “Leverage and Financial Risk.” Center for Commercial Agriculture, Purdue University, February 2016.

TAGS:

TEAM LINKS:

RELATED RESOURCES

Managing Strategic Risks on Your Farm

May 24, 2024

Purdue University’s Center for Commercial Agriculture recorded a series of short podcasts and accompanying videos to help agricultural producers improve their strategic risk management skills. Farms are exposed to strategic risks that are caused by a wide variety of unanticipated shocks to the operating environment ranging from government policy shifts to disease outbreaks.

READ MORE

Key Resources

May 24, 2024

Advancements in production agriculture continue to accelerate making the business environment more complex and creating a significant need for a forward-thinking mindset. Develop an integrated risk management approach and build a strategic plan now.

READ MORE

Farm Resilience, Management Practices, and Producer Sentiment: Segmenting U.S. Farms Using Machine Learning Algorithms

April 4, 2024

Margaret Lippsmeyer, Michael Langemeier, James Mintert, and Nathan Thompson segment U.S. farms by farm resilience, management practices, and producer sentiment. This paper was presented at the Southern Agricultural Economics Meeting in Atlanta, Georgia in February. 

READ MORE

UPCOMING EVENTS

We are taking a short break, but please plan to join us at one of our future programs that is a little farther in the future.

2024 Crop Cost and Return Guide

November 22, 2023

The Purdue Crop Cost and Return Guide offers farmers a resource to project financials for the coming cropping year. These are the March 2024 crop budget estimations for 2024.

READ MORE

(Part 2) Indiana Farmland Cash Rental Rates 2023 Update

August 7, 2023

Purdue ag economists Todd Kuethe, James Mintert and Michael Langemeier discuss cash rental rates for Indiana farmland in this, the second of two AgCast episodes discussing the 2023 Purdue Farmland Values and Cash Rents Survey results.

READ MORE

(Part 1) Indiana Farmland Values 2023 Update

August 6, 2023

Purdue ag economists Todd Kuethe, James Mintert and Michael Langemeier discuss Indiana farmland values on this, the first of two AgCast episodes discussing the 2023 Purdue Farmland Values and Cash Rents Survey results. Each June, the department of agricultural economics surveys knowledgeable professionals regarding Indiana’s farmland and cash rental market.

READ MORE