Optimal capital structure in agricultural cooperatives and implications for equity retirement

Abstract

PurposeThis paper presents a model for determining the optimal capital structure for cooperatives and explores the relationship between financial leverage and the ability of cooperatives to retire member equity.Design/methodology/approachA model is developed to determine the optimal capital structure and explore the relationship between capital structure and the rate at which a cooperative can retire member equity. Using data from cooperative financial statements, ordinary least-squares regressions are conducted to test two hypotheses on capital structure and equity retirement.FindingsThe model shows that the optimal capital structure is determined by the ratio of the rate of return on capital employed to the interest rate on borrowed capital and the required level of interest coverage. The regressions suggest that cooperatives choose their capital structure largely according to the rate of return on capital employed and the interest rate in a manner consistent with maximizing the rate of return on equity and that the rate at which cooperatives can retire member equity is directly related to leverage.Research limitations/implicationsThe model does not consider unallocated earnings. Analysis of the relationship between leverage and equity retirement yields results contrary to the assumptions of earlier studies.Practical implicationsCooperatives can use the model because the necessary parameters are easily understood and readily available from financial statements, lenders and industry sources.Originality/valueThe model is developed specifically for determining the capital structure of cooperatives and differs substantially from the corporate model. A theoretical basis is provided for the relationship between leverage and equity retirement.

A comparative study of capital structure compositions in grain marketing and input supply cooperatives

“…Analogous to the cost of equity indicator, an increase in the interest rate is theoretically associated with a decrease in proportion of debt. Correspondingly, the interest rate is expected to relate positively to the proportions of allocated equity and unallocated equity (Royer and McKee, 2020). Diversification.…”

“…Using simulation, Royer (2019) also illustrated the relatively high cost of financing using member equity, as indicated by the cooperative firm-level return on equity (ROE). Subsequent empirical work confirmed the negative relationship of ROE to the proportion of equity on the balance sheet of USA input supply cooperatives and grain marketing cooperatives (Royer and McKee, 2020). Importantly, Royer (2019), Royer and McKee (2020), and other studies did not distinguish between allocated equity and unallocated equity.…”

“…Subsequent empirical work confirmed the negative relationship of ROE to the proportion of equity on the balance sheet of USA input supply cooperatives and grain marketing cooperatives (Royer and McKee, 2020). Importantly, Royer (2019), Royer and McKee (2020), and other studies did not distinguish between allocated equity and unallocated equity.…”

“…The profitability of the cooperative is indicated by its ROE, which is the ratio of net income to total equity. Following Royer and McKee (2020), ROE is also a proxy for the cost of equity, which is earmarked to be revolved or redeemed at some point in the future. Theoretically, an increase in the cost of equity is associated with a decrease in the use thereof.…”

“…In this article, we build on the work of Royer and McKee (2020) with an objective to explain variability in the capital structures of agricultural cooperatives. Specifically, we explore the relationships of various firm-level characteristics to the proportions of debt, allocated equity, and unallocated equity for a panel of U.S. input supply and grain marketing cooperatives for the 2010-2020 period.…”