Cost of Capital for Agricultural Cooperatives

The cost of capital is important in the financial management of agricultural cooperatives. A measure of the cost of capital is required when evaluating various aspects of strategic business plans, e.g., selecting a financial leverage position, calculating the profitability of alternative investment opportunities, measuring economic value-added, and comparing various merger and acquisition plans. The task of determining the appropriate cost of capital to use requires a careful analysis of the effect of alternative financing choices which are open to a cooperative. This report considers the close relationship between the cost of capital and capital structure. Ways are examined to determine the cost of capital by a cooperative. The report sequentially identifies: principles of capital structure and cost of capital, guidelines for capital structure choice, and applications of these guidelines through cooperative case examples. These applications are a starting point for cooperatives to develop capital positions and consider alternative assumptions about financing sources and their potential impacts on the overall cost of capital. To determine the overall cost of capital for a selected capital structure, a cooperative must first determine its cost of equity capital. The cost of equity capital cannot be derived directly from the market, as in the case of a publicly traded firm. Thus, there is no ideal method for determining the cost of capital for a cooperative. So an innovative approach is needed. The opportunity cost of funds approach relates the cost of capital to the rates of return from alternative uses of capital (i.e., the assets side of the balance sheet). The focus is on the expected (or required) rates of return from alternative investments which reflects the degree of risk involved. The discounted cash flow approach relates the cost of capital to the alternative sources of capital (i.e., the liabilities and equity capital side of the balance sheet). The component costs of equity and debt capital are combined into an overall cost of capital for the cooperative. Both approaches require making some assumptions to determine the cost of equity capital for a cooperative.