A renewed interest in cooperative agri-businesses is sweeping across the Northern
Plains. These new cooperatives are structured differently than traditional farm supply and
elevator cooperatives.
The new venture cooperatives are focused on processing and marketing processed products
rather than supplying production inputs or marketing raw agricultural commodities. They
require producer members to supply raw commodities for processing through marketing
contracts, and tie the amount of commodity supplied to the purchase of equity stock in the
cooperative. The new cooperatives are selling enough equity stock shares, and related
delivery rights, to meet the cooperatives' financial needs and ensure peak use of
processing facilities.
A combination of factors make the decision about becoming a member in a new venture
cooperative unique and complex. This publication is designed to identify the key aspects
of that decision by asking five questions. They are:
Questions 1 and 2 focus on the new venture cooperative and the industry it will be
involved in. These questions are asked to determine if the expected returns from
cooperative membership are great enough to justify the risks surrounding the cooperative's
operations and your equity stock investment. These questions are often difficult for
farm/ranch managers to answer because they go beyond the more familiar market factors
which affect raw agricultural commodities.
Questions 3 and 4 are intended to identify the short-term and long-term impacts the
cooperative's marketing contract and equity stock investment have on your farm/ranch
operation and finances.
Question 5 deals with your unique personal and business goals and how those goals may
influence a decision about cooperative membership.
What are the Potential Returns from Membership in the Cooperative
Accurately estimating the financial returns of cooperative membership is not as easy as
it may seem, because returns appear in several forms and are received at different times.
Cooperatives can return financial benefits to members in the form of favorable prices, net
returns from operations (both cash and retained), and appreciation in equity stock. Most
new venture cooperatives choose to offer competitive, rather than favorable, prices to
members and pass on benefits in the form of operating net returns and equity stock
appreciation. Therefore, we will focus on these two forms of benefit.
Cooperatives distribute net returns to members based on patronage, or use. A portion of
the net returns are distributed in cash, while the remainder is retained by the
cooperative to be used in continuing business operations. This retained portion is
returned to the member, but at some time in the future. Also, because there is a limited
supply, equity stock typically appreciates in value if the cooperative is successful.
However, equity stock appreciation is not realized until it is sold at a future date.
The time between the purchase of equity stock and when all financial benefits are
received in the future is typically overlooked when analyzing potential returns. This
oversight can have considerable impact on a cooperative investment evaluation and final
membership decision.
A process called net present value is used to compare the outflow of money today with
the inflow of money in the future. The basic concept is that income received today is
worth more than income received in the future. This is because the income received today
could be invested now, earn interest, and be worth more in the future. So, to compare the
flow of money that occurs at different times on an equal basis, you MUST adjust the future
cash flows downward to correct for the fact they are not available for use today.
A brief example should demonstrate this important concept. Several references which
provide a more detailed explanation and discussion of the net present value process are
listed in the back of this publication.
An Example
A new venture processing cooperative is requesting a $200 common stock, or membership,
fee plus a minimum purchase of 500 shares of preferred stock at $20 per share. This
results in a minimum total investment of $10,200. Each share of preferred stock requires
the member to deliver one unit of commodity to the cooperative for processing. In this
example, the member plans to sell the equity stock in 20 years for an estimated value of
$32,500. A 30% marginal income tax rate was also used.
Table 1 shows the annual after-tax net cash flow without considering the influence of
time on the inflow and outflow of money. The false impression is that cooperative
membership will result in a net benefit of $34,414.00 (Column E, Table 1) after 20 years.
However, this is not the number which should be used to make a membership decision.
Table 1. Net after-tax cash flow for a cooperative
investment, without time value.
--------------------------------------------------------------
Total Cash Redeemed
Patronage Patronage Estimated Retained Net
Refund Refund Tax (30%) Refund Cash Flow
Year (A) (B) (C) (D) (E)
--------------------------------------------------------------
Present $-10,200.00
1 $0.00 $0.00
2 $0.00 $0.00
3 $500.00 $100.00 $-150.00 $-50.00
4 $1,000.00 $400.00 $-300.00 $100.00
5 $1,625.00 $975.00 $-487.50 $487.50
6 $1,625.00 $975.00 $-487.50 $487.50
7 $1,625.00 $975.00 $-487.50 $487.50
8 $1,625.00 $975.00 $-487.50 $487.50
9 $1,625.00 $975.00 $-487.50 $487.50
10 $1,625.00 $975.00 $-487.50 $487.50
11 $1,625.00 $975.00 $-487.50 $0.00 $487.50
12 $1,625.00 $975.00 $-487.50 $0.00 $487.50
13 $1,625.00 $975.00 $-487.50 $400.00 $887.50
14 $1,625.00 $975.00 $-487.50 $600.00 $1,087.50
15 $1,625.00 $975.00 $-487.50 $650.00 $1,137.50
16 $1,625.00 $975.00 $-487.50 $650.00 $1,137.50
17 $1,625.00 $975.00 $-487.50 $650.00 $1,137.50
18 $1,625.00 $975.00 $-487.50 $650.00 $1,137.50
19 $1,625.00 $975.00 $-487.50 $650.00 $1,137.50
20 $1,625.00 $975.00 $-487.50 $650.00 $1,137.50
--------------------------------------------------------------
Stock Sale $32,500.00 $-7,136.00* $6,500.00 $31,864.00
--------------------------------------------------------------
Net After-Tax Cash Flow $34,414.00
--------------------------------------------------------------
*Capital Gains taxed at 28%
The annual after-tax net cash flow including the influence of time is shown in Table 2.
This example uses an 8% discount factor, which will be discussed in more detail shortly.
The correct analysis shows a positive $1,214.67 net present value. This means that the
money invested in the cooperative will generate at least an 8% after-tax return.
If the net present value had been negative, the cooperative would provide something
less than an 8% after-tax return, and your money may generate a higher return within your
current farm/ranch operation or in other ways. A negative net present value does not mean
that you should not become a member in the cooperative, only that the cooperative will not
generate the selected rate of return. Your personal and business goals, as well as the
potential impacts on the farm/ranch, should also be considered.
As you can see, the impact of time on the outflow and inflow of money can be dramatic.
It is critical that the influence of time be included in your analysis, and that a net
present value process be used.
Appendix A provides a more complete explanation of this example and the calculations
involved in Table 2. It includes a detailed discussion of the assumptions, an explanation
of the calculation of each column, and how to calculate the marginal income tax rate.
Table 2. After-tax net present value calculation for
new venture cooperative investment.
-----------------------------------------------------------
Per-Unit Total Percent Cash
Patronage Patronage Cash Patronage Estimated
Refund Refund Refund Refund Tax (30%)
Year (A) (B) (C) (D) (E)
-----------------------------------------------------------
Present Initial Investment
1 $0.00 $0.00
2 $0.00 $0.00
3 $1.00 $500.00 20 $100.00 $-150.00
4 $2.00 $1,000.00 40 $400.00 $-300.00
5 $3.25 $1,625.00 60 $975.00 $-487.50
6 $3.25 $1,625.00 60 $975.00 $-487.50
7 $3.25 $1,625.00 60 $975.00 $-487.50
8 $3.25 $1,625.00 60 $975.00 $-487.50
9 $3.25 $1,625.00 60 $975.00 $-487.50
10 $3.25 $1,625.00 60 $975.00 $-487.50
11 $3.25 $1,625.00 60 $975.00 $-487.50
12 $3.25 $1,625.00 60 $975.00 $-487.50
13 $3.25 $1,625.00 60 $975.00 $-487.50
14 $3.25 $1,625.00 60 $975.00 $-487.50
15 $3.25 $1,625.00 60 $975.00 $-487.50
16 $3.25 $1,625.00 60 $975.00 $-487.50
17 $3.25 $1,625.00 60 $975.00 $-487.50
18 $3.25 $1,625.00 60 $975.00 $-487.50
19 $3.25 $1,625.00 60 $975.00 $-487.50
20 $3.25 $1,625.00 60 $975.00 $-487.50
20 Stock Sale $32,500.00 $-7,136.00*
-----------------------------------------------------------
-----------------------------------------------------------
Redeemed Net Discount
Retained Cash Factor Present
Refunds Flow (8%) Value
Year (F) (G) (H) (I)
-----------------------------------------------------------
Present Initial
Investment $-10,200.00 1.0000 $-10,200.00
1 $0.00 0.9259 $0.00
2 $0.00 0.8573 $0.00
3 $-50.00 0.7938 $-39.69
4 $100.00 0.7350 $73.50
5 $487.50 0.6806 $331.79
6 $487.50 0.6302 $307.22
7 $487.50 0.5835 $284.46
8 $487.50 0.5403 $263.40
9 $487.50 0.5002 $243.85
10 $487.50 0.4632 $225.81
11 $0.00 $487.50 0.4289 $209.09
12 $0.00 $487.50 0.3971 $193.59
13 $400.00 $887.50 0.3677 $326.33
14 $600.00 $1,087.50 0.3405 $370.29
15 $650.00 $1,137.50 0.3152 $358.54
16 $650.00 $1,137.50 0.2919 $332.04
17 $650.00 $1,137.50 0.2703 $307.47
18 $650.00 $1,137.50 0.2502 $284.60
19 $650.00 $1,137.50 0.2317 $263.56
20 $650.00 $1,137.50 0.2145 $243.99
20 $6,500.00 $31,864.00 0.2145 $6,834.83
----------------------------------------------------------
Net Present Value $1,214.67
-----------------------------------------------------------
*Capital gains taxed at 28%
The Sources of Information
The cooperative's business plan is the source of information we will use to evaluate
both its risks and returns. A business plan is a group of documents which help define how
a business is organized, operated, managed, and financed. For a new venture cooperative,
the business plan typically includes an economic feasibility study, articles of
incorporation, proposed by-laws, a marketing plan and/or marketing agreement, and
projected (pro forma) financial statements.
This information is summarized and published in a prospectus, or offering circular,
which is provided to potential members during equity drive meetings. The prospectus is
usually the only document available to make a membership decision, unless more information
is obtained from the interim board of directors or steering committee.
The cooperative's prospectus will provide most of the information needed for a net
present value calculation. It will include the amount of the initial membership fee, the
value of each share of stock, and any minimum stock requirements. The economic feasibility
study should include projected per-unit net return for several years of operation into the
future. And, the cooperative's by-laws should explain how the net returns will be
distributed and how retained patronage earnings will be refunded.
The decision about the division of net returns between cash refunds and retained
refunds is left to the cooperative's board of directors. The percentage of cash versus
retained refunds normally changes from year to year depending on the cooperative's net
returns and strategic business plan. This makes the net present value analysis more
difficult because estimates of this division need to be made for each year of membership.
Typically, cooperatives return net income to members based on patronage. These
cooperatives must distribute at least 20% of their net income in cash, unless the
cooperative is paying the income tax. Many new venture processing cooperatives attempt to
distribute larger cash patronage refunds because of the initial membership investment.
Therefore, a 20% cash patronage refundshould be considered a minimum, and a larger
percentage is reasonable to expect.
Other cooperatives distribute net income on a per-unit basis. Net income is distributed
periodically in cash with a portion, called a per-unit capital retain, being withheld for
use by the cooperative. The amount of cash payments and capital retains will change from
one year to the next depending on the cooperative's operations and long-term business
goals.
Another important fact to include is that the cooperative's allocated net returns are
considered taxable income to the member. This includes both the cash and retained
portions. This element can have significant impacts on short-term cash flow, as well as
the final net present value. In some cases, cooperatives have not returned a large enough
cash refund to cover all of the member's current income tax liability.
Selecting a Discount Factor
Selecting an appropriate discount factor is important because it has considerable
impact on the results of the analysis. For instance, if the discount rate in our example
was increased from 8% to 9%, the net present value would decrease from $1,214.67 to
-$429.93.
There are two common approaches to selecting an appropriate discount rate. One approach
is to choose a discount rate which is equal to the highest interest rate paid on debt
capital. This approach emphasizes the fact that there are alternative uses of money. It
assumes that the cooperative membership investment funds would be used to pay farm/ranch
debt if it were not used within the cooperative. Therefore, the cooperative should
generate at least the same rate of return as the next best use of the funds.
An alternative approach is to choose a discount rate which reflects your desired rate
of return on investment. This allows you to incorporate all of the risk factors
surrounding the cooperative business into the analysis; the higher the risk, the larger
the discount factor. This approach is more subjective but allows you to compare the
cooperative membership investment to other investments with similar risks. This leads to
the next question.
What Risks are the Cooperatives Exposed to?
Determining the risks surrounding a new venture cooperative is one of the most
difficult questions to answer. This is because there are many sources of risk, and each is
hard to measure. To make things easier, the sources of risk can be grouped into two broad
categories: business risks and financial risks.
Business risks are those associated with conducting business operations, without
considering the financial structure. The five sources of business risk are:
- Production (including both construction and operation)
- Market or price
- Technological
- Legal and social
- Human
Financial risk is the magnification of business risks caused by debt financing. This
includes the uncertainties surrounding the availability of borrowed capital, credit terms,
and changing interest rates.
The Cooperative's Business Risk
Each of the five sources of business risk should play a role in your analysis of the
new venture cooperative.
Production risk refers to the unforeseen events that can change the projected
construction, startup, and operating costs and efficiencies. These events can influence
both product quantity and quality. A realistic and thorough economic feasibility analysis
will provide information about projected construction and startup costs, typical operating
costs and efficiencies, and operating margins. The projected operating margins should be
based on realistic forecasts and be sufficient to cover unforeseen cost overruns and
operating problems. Typically, the cost projections for the first several years of
operation are larger than average to compensate for these risks. Be sure to carefully
review the major assumptions of the feasibility study, and feel comfortable with the
results.
Market or price risk refers to both sales volume and product price. The fundamental
information needed to analyze price or market risk is included in the marketing plan. The
marketing plan should discuss the size of the current market, the market growth factors,
the major competitors, the cooperative's market advantage, how market share will be
established, and how co-products from processing will be marketed. Once again, it is not
unusual to see lower than normal price projections for the first several years. This
allows the cooperative to establish market share and customer loyalty, and compensate for
unforeseen reactions by competitors.
Another aspect of market risk is the ability of the cooperative to adjust its product,
or product line, to meet changing customer preferences. The ability to profitably adjust
products is directly tied to the technology used, which leads to technological risk.
Technological risk is the potential for current efficiencies to be offset by
improvements in future technology. The cooperative must consider the tradeoffs between
adopting the most current technology to gain possible efficiencies with the increased cost
of that technology and the risk that the new technology is not completely tested and
proven.
Legal and social risks are those which refer to changes in local, state, and federal
laws and regulations governing the cooperative business and its industry. These include
changes in tax law, environmental regulations, interstate commerce, import/export
regulations, or industry subsidies. The key is to look at how sensitive the cooperative's
business plan, and resulting net return, is to changes in relevant laws and regulations.
The cooperative's business plan should be flexible enough to adjust to changing legal and
regulatory conditions.
The final source of business risk is human risk. Human risk is associated with the
availability and quality of labor, management, and board of directors. The first human
risk is the selection of high quality personnel. The second human risk is the impact on
the cooperative if one, or several, of the key people leave the business.
Human business risks are frequently underestimated. One of the most commonly cited
reasons for a successful business is the abilities of the people on the management team.
The management team of a cooperative, both hired managers and the elected board of
directors, is especially critical. The cooperative management team must not only be
concerned with the efficient operation of the business, but also with the sometimes
conflicting needs of the member/patrons. Always remember, it's the people who make the
plan work.
The Cooperative's Financial Risks
Financial risk is the second category of risks and is defined as the increase in
business risk caused by debt financing. The lowest risk situation for the cooperative is
to be completely equity financed and not borrow any money. However, this is difficult to
accomplish, especially for large projects, and may put unwanted restrictions on the
cooperative's business plan.
From a member's point of view, financial risk may not seem large, relative to the
business risks discussed earlier. However, financial risk and the ability of the
cooperative to adjust to business risks using borrowed capital can have a substantial
impact on the cooperative's performance and ability to succeed.
It is important that the cooperative have a lender, or lenders, that has experience
with the unique aspects of financing cooperatives. It is also important that the total
financing package, both debt and equity, meet the needs of the cooperative and leave it
flexible enough to adjust to changing business conditions. This usually means that the
business plan needs to have solid member investment capital and sufficient operating
funds, or working capital.
How Will Cooperative Membership Influence the Farm/Ranch Operation?
The impacts of new venture cooperative membership on the farm/ranch operation can range
from minor to far-reaching, depending on your current farm/ranch operation and the
structure of the cooperative and its membership agreement. To capture all of the potential
consequences, we evaluate the impacts on farm/ranch production, marketing, and finance
individually.
The Cooperative's Impact on Farm/Ranch Production
In most cases, a new venture processing cooperative requires its members to deliver
consistent, high quality commodities. High quality products allow the cooperative to
capture and maintain market share. Because of this, the cooperative may develop
recommended production practices to increase overall quality and quantity and to reduce
quality variation among members.
It is important to determine if these production practices are voluntary or mandatory.
You must gauge how easy it is to incorporate proposed changes into your current operation,
and estimate changes in the commodity's per-unit cost of production.
Changes in production practices could be as simple and low cost as changing seed
varieties or animal vaccinations, or as complex and expensive as altering machinery
complements or building and facility configurations.
The spinoff impact on the production and cost efficiencies of other enterprises on the
farm/ranch is typically underestimated or even overlooked. A common example is an increase
on the demands of the farm/ranch's labor and management. If changes in production
practices increase the demands on labor and management at the expense of another
enterprise, the net result may not be positive.
The timing of delivery and final point of delivery for the commodity can also have
significant impacts on the cost of production. If the commodity must be stored from the
time of production until delivery, the added costs of storage, handling, interest, and the
risk of reduced quality should be included. The cost of transporting the commodity from
the point of production to the point of delivery should be adjusted if delivery is
required outside your normal trade area.
Some farmers have found that the cooperative's recommended production practices have
improved enterprise and whole-farm efficiencies.
The Cooperative's Impact on Farm/Ranch Marketing
It is important that the terms and conditions of any marketing agreement are completely
understood. In most cases, the responsibility for profitably marketing the commodity is
turned over to the cooperative, through its processing activities. This allows the
farm/ranch to diversify its commodity marketing activities.
It is not unusual for the cooperative's business plan to provide partial payment for
the commodity at the time of delivery, with the remainder received as cash and retained
patronage at some time in the future. The timing and level of these payments can have a
significant impact on the farm/ranch cash flow. It may be necessary to alter the normal
marketing plan of other commodities or change short-term borrowing needs to adjust to the
cooperative's payment schedule.
Another important issue is what happens if you are unable to deliver the specified
quantity or quality of product listed in the marketing contract. Some cooperatives have
established a member marketing pool which can be used to fill shortfalls in quantity or
quality. In this case, the cooperative buys the commodity from the pool, in your name, and
reduces your payments by that amount, plus a handling fee. Other cooperatives require the
delivery of the commodity, and you are responsible to purchase and deliver any shortfalls.
The Cooperative's Impact on Farm/Ranch Finances
There are both long-term and short-term impacts on farm/ranch finances. The extent of
these impacts will vary greatly from one farm/ranch operation to the next.
The best way to capture all of the long-term financial impacts is to use whole
farm/ranch budgeting. This process provides estimates of the long-term profitability of
the operation and gives an indication of its financial progress and staying power.
Two long-term budgets should be prepared. The first reflects business as usual and
includes normal farm/ranch operating practices, machinery replacement, and building or
facilities renovation. The second will add the new cooperative investment, with all of the
adjustments to production and marketing for each enterprise on the farm/ranch. These two
estimates should be prepared assuming that changes are fully implemented. This means that
the cooperative is in operation, and generating and distributing returns as projected. We
are trying to assess what the farm/ranch business may look like in the future.
The main objective of this process is to estimate the net effect of cooperative
membership on the long-term financial health of the farm/ranch. By comparing the results
of the two budgets, we see the influence the cooperative has on net farm income, change in
net worth, and long-term cash flow. It is the combination of these three measures that
provide an indication of long-term financial health. If the long-term benefits are
positive, we need to make sure that the farm/ranch can meet all of its short-term cash
flow needs.
It is not unusual for a new venture cooperative to need several years of start-up and
operation before its net returns are positive. Because of this, members typically will not
receive returns from the cooperative until several years after the initial investment has
been made. It is critical that the farm/ranch operation be able to meet all of its
financial obligations on time during this period. A short-term cash flow projection will
show if this is possible.
Every farm/ranch operation has some level of short-term borrowing and cash flow
limitations. Because of this, the cooperative membership investment must compete with
other uses for limited short-term capital. If a conservatively prepared short-term cash
flow is positive, the chance of major cash flow problems is small. However, if the cash
flow is slightly positive or negative, decisions must be made between the alternative uses
of money.
Preparing whole farm budgets and cash flows is not a small process and will take some
time and effort. However, these statements will ensure that all direct and indirect
impacts of changes in production, marketing and financing are included. Time spent now,
with a sharp pencil, could prevent problems in the future.
Your lender can play a key role in meeting both long-term and short-term financial
needs of a cooperative membership investment. This leads to the next question.
How Will My Lender View the Cooperative Investment?
It is important to discuss the new venture cooperative investment with your lender.
This should be done regardless of whether the investment is self-financed or
debt-financed. The investment in a new venture cooperative typically results in a notable
change in your financial condition and should be reviewed with your lender to maintain
good working relations.
Your lender will have many of the same questions about the cooperative, and its impact
on the farm/ranch, which have already been discussed. In some cases, the cooperative has
held special meetings for lenders in its membership area to review its business plan. In
other cases, your lender may have only heard about the cooperative's plans, and have very
few details. In either case, it is usually helpful to review the cooperative's business
plan with your lender. In addition, be sure to take time to review the long-term budgets
and short-term cash flow you have prepared. These statements will provide a condensed view
of the impacts on your farm/ranch operation.
There are two additional questions the lender may have which are important to you, and
may influence a loan decision and credit terms. The first is, "How will possible
losses from the cooperative be distributed?"; and second, "How easy, or
difficult, is it to transfer membership stock?"
The first question, concerning distribution of losses, is important because it helps
define the maximum loss potential. In some cases, the method for distributing cooperative
losses is defined in the cooperative's by-laws. In other cases, this decision is the
responsibility of the board of directors. In either situation, it is important to
understand what may happen to your initial investment, and any retained earnings, if the
cooperative sustains losses.
The second question, concerning stock transfer, is important because your lender is
trying to determine the liquidity of the stock. If the cooperative stock is easily
transferred from one producer to another, with few restrictions, the lender views it as
more liquid and lower risk. This is because the stock could be sold quickly and easily if
it is necessary to limit losses. However, if there are restrictions or a complex process
for stock transfer, it is considered less liquid and a greater risk.
Every lending institution, or system, treats a loan for cooperative membership
investment differently. Some lenders have even developed special loan terms which meet the
unique cash flow needs of a membership investment.
If you are requesting a loan, there are four key issues which need to be discussed;
they are:
- The annual interest rate of the loan and whether it is fixed or variable.
- The length of the loan.
- The number and timing of payments.
- The source(s) and amount of collateral.
The first issues will determine the annual loan payment, and influence the farm/ranch
cash flow. The final issue, concerning collateral, will influence the farm/ranch's
solvency and future borrowing capacity. Some lenders use only the cooperative stock as
security for a loan. However, most lenders require that additional farm/ranch assets be
pledged. The amount of collateral needed for a loan will depend on the current financial
strength of the farm/ranch, your credit history, and the risks surrounding the cooperative
business.
How Will Cooperative Membership Impact My Personal and Business Goals?
Up to this point we have focused primarily on the financial aspects of cooperative
membership. However, there are several other non-financial factors which may play a role
in your final decision.
One of the most commonly cited personal benefits of cooperative membership is the
ability to have a voice in the operation of the business. The ability to express opinions
and exert some control over the operation of a cooperative is considered important to many
of its members.
Many local communities, regions, and even states are actively involved in the
development and promotion of new venture processing cooperatives. Their goal is to bring
economic development and more jobs into their area. In some situations, the cooperative
has already selected a specific site to locate facilities and headquarters. In other
situations, the site has not yet been decided.
Many cooperative members list community economic benefits and increased job prospects
as factors which went into their membership decision. However, it is also important to
realize that the cooperative may not locate in your area, and that not all of the
community impacts are positive.
It is true that a new business creates more jobs, more people living within the
community, and increased retail business volume. However, some communities have found that
increased business activity and larger populations strain the community infrastructure,
such as water, sewage, fire fighting, police, medical services and schools. An expanded
job market can also increase the competition for labor and put additional financial
pressure on existing businesses.
Because of the long term nature of agri-business development and growth, some farmers
and ranchers will not enjoy the complete benefit of cooperative membership during their
farming/ranching career. Yet, they are active participants in the process. The desire to
improve their communities and assist the next farming/ranching generation are factors
which influence their membership decision.
Summary
The goal of this publication was to help you make an informed decision about becoming a
member of a new venture processing cooperative by focusing on key questions which need to
be addressed. Unfortunately, there are no easy answers to many of these questions. This
type of long-term investment decision is complex, and can have far-reaching impacts.
Ultimately, it is up to each individual to decide if membership in a new venture
processing cooperative is right for them.
Sources of Additional Information
Net Present Value:
Barry, Peter J., Paul N. Ellinger, John A. Hopkin, and C.B. Baker. Financial
Management in Agriculture. 1995. Interstate Publishers Inc., Danville, Illinois.
Boehlje, Michael D., and Vernon R. Eidman. Farm Management. 1984. John Wiley
& Sons, New York, New York.
Hardie, Wallace C., Arlen G. Leholm, and David M. Saxowsky. The Time Value of Money.
1986. North Dakota State University Extension Service. EC-895
Rice, Billy B. Interpretation And Use Of The Amortization Table. 1980. North Dakota
State University Extension Service. Farm Management Planning Guide, Sec. VIII, No. 7.
Long-Term and Short-Term Budgeting and Cash Flow:
Hardie, Wallace, Arlen Leholm, and Tom Reff. Your Cash Flow. 1984. North Dakota State
University Extension Service. EC-820.
Reff, Tom, Arlen Leholm, and Glen Pederson. Your Income Statement. 1983. North Dakota
State University Extension Service. EC-819.
Leholm, Arlen, Tom Reff, and Glen Pederson. Your Balance Sheet. 1983. North Dakota
State University Extension Service. EC-818.
Reff, Tom, and David M. Saxowsky. Analyzing Your Farm Financial Statements. 1987. North
Dakota State University Extension Service. EC-920.
Carver, Robert D., and Billy B. Rice. A Complete Farm Budget: Steps In Planning and
Reorganizing The Farm Business. North Dakota State University Extension Service. Farm
Management Planning Guide Sec. III, No. 2.
Risk Management:
Barry, Peter J. Risk Management In Agriculture. 1984. Iowa State University
Press, Ames, Iowa.
Cooperatives:
Cobia, David W., Cooperatives In Agriculture. 1989. Prentice Hall, Englewood
Cliffs, New Jersey.
Selected Computer Software
Net Present Value:
Financial Analysis of Investments in Agricultural Capital Assets. Department of
Agricultural Economics and Department of Information, Cooperative Extension, Washington
State University. Willett, Gayle S. and Herb R. Hinmam.
Long-Term and Short-Term Budgeting and Cash Flow:
FINPACK. Center For Farm Financial Management, Department of Agricultural and Applied
Economics, Minnesota Extension Service, University of Minnesota. Hawkins, Richard O.
K-Farm Ver. 4.0 Kansas Extension Service, Kansas State University. Art Barnaby.
Cash Flow Projection, Transition Planning. IlliNet Software, University of Illinois.
Betty Burton.
Appendix
This appendix presents an example of a net present value calculation for a new venture
processing cooperative. Appendix Table 2 illustrates a summary of the calculation process
for each year of the investment.
Background Information
The new venture processing cooperative in this example is requesting a $200 common
stock, or membership, fee plus a minimum purchase of 500 shares of preferred stock, at $20
per share. Each share allows for the delivery of one unit of commodity to the cooperative
for processing. This results in a minimum total investment of $10,200.
Appendix Table 1 lists the projected per-unit net returns for the first five years of
the cooperative's operation. This information was supplied in the cooperative's
prospectus.
Appendix Table 1. Projected per-unit cooperative
net returns.
-----------------------------------------------------
Year 1 Year 2 Year 3 Year 4 Year 5
-----------------------------------------------------
Per-unit
net returns $ -1.50 $ -0.50 $ 1.00 $ 2.00 $ 3.25
-----------------------------------------------------
The cooperatives's prospectus does not include any discussion of the division of cash
versus retained patronage earnings. However, a discussion with one of the members of the
cooperative's interim board of directors reveals that the plan is to return a 20% cash
patronage in year three, 40% cash patronage in year four, and 60% cash patronage in the
following years. The interim board member stresses that these numbers are tentative and
may need to be changed based on actual business conditions.
The discussion with the interim board member also reveals that the cooperative plans to
redeem retained refunds on a 10 year revolving basis. And, that all accumulated retained
refunds will be redeemed when membership ends, either at death or when the stock is
transferred to another producer. (NOTE: Redeeming accumulated retained refunds at the time
of sale is not commonly used by cooperatives, but was included in this example because of
its simplicity.)
Key Assumptions
Planned length of investment: 20 years.
Estimated sales value of stock: $32,500
Marginal income tax rate:
We assumed a 15% marginal federal income tax (MFIT) rate, 15.3% self employment tax (SET)
rate (of which 50% can be claimed as a reduction in federal taxable income), and that the
state income tax (SIT) rate is 14% of the federal income tax due. This results in a 30%
marginal tax rate (see example below).
Example: Assume $100.00 Net Farm Income (NFI)
----------------------------------------------------------
($100.00 NFI X 0.9235 SET Adjustment) X 15.3% SET = $14.13
($100.00 NFI - ($14.13 SET)/2)) X 15% MFIT = $13.94
$13.94 MFIT X 14% SIT = $ 1.95
=======
$30.02
Resulting tax on additional income = $30.02/$100.00
= 0.3002%
OR, approximately a 30% marginal income tax rate.
----------------------------------------------------------
Choosing a Discount Rate:
Choosing an appropriate discount rate is a critical task because it can have a relatively
large impact on the analysis. You want to choose a rate which is large enough to provide
an appropriate return to risk and be competitive with other uses of your money, but not so
great that it is overstated and distorts the analysis.
One method for choosing a discount rate is to select a desired minimum rate of return.
Another alternative is to use the same rate as the highest interest rate paid on debt. In
either case, the selected rate must reflect an after-tax value to be used properly in this
example.
This example will use an 8% discount rate. This rate was calculated by adjusting the
highest interest paid on debt capital, 11% in this example, by the 30% marginal income tax
rate [(11.0 X (1- 0.30)) = 7.7] and rounding up.
Once a discount rate has been chosen, the discount factor for each year must be
calculated. This can be done by looking at a discount rate table, or using the following
formula:
Annual Discount Factor = 1/(1+i)n
-------------------------------------------------------
Where: i = the discount rate (8% in this example).
n = the number of years in the future. (1 to 20)
Example: Annual Discount Factor for year 3 =
1/(1+0.08)3 = 1/(1.08)3 = 1/1.2597 = 0.7938
-------------------------------------------------------
Appendix Table 2
Appendix Table 2. After-tax net present value calculation for
new venture cooperative investment.
-----------------------------------------------------------
Per-Unit Total Percent Cash
Patronage Patronage Cash Patronage Estimated
Refund Refund Refund Refund Tax (30%)
Year (A) (B) (C) (D) (E)
-----------------------------------------------------------
Present Initial Investment
1 $0.00 $0.00
2 $0.00 $0.00
3 $1.00 $500.00 20 $100.00 $-150.00
4 $2.00 $1,000.00 40 $400.00 $-300.00
5 $3.25 $1,625.00 60 $975.00 $-487.50
6 $3.25 $1,625.00 60 $975.00 $-487.50
7 $3.25 $1,625.00 60 $975.00 $-487.50
8 $3.25 $1,625.00 60 $975.00 $-487.50
9 $3.25 $1,625.00 60 $975.00 $-487.50
10 $3.25 $1,625.00 60 $975.00 $-487.50
11 $3.25 $1,625.00 60 $975.00 $-487.50
12 $3.25 $1,625.00 60 $975.00 $-487.50
13 $3.25 $1,625.00 60 $975.00 $-487.50
14 $3.25 $1,625.00 60 $975.00 $-487.50
15 $3.25 $1,625.00 60 $975.00 $-487.50
16 $3.25 $1,625.00 60 $975.00 $-487.50
17 $3.25 $1,625.00 60 $975.00 $-487.50
18 $3.25 $1,625.00 60 $975.00 $-487.50
19 $3.25 $1,625.00 60 $975.00 $-487.50
20 $3.25 $1,625.00 60 $975.00 $-487.50
20 Stock Sale $32,500.00 $-7,136.00*
-----------------------------------------------------------
-----------------------------------------------------------
Redeemed Net Discount
Retained Cash Factor Present
Refunds Flow (8%) Value
Year (F) (G) (H) (I)
-----------------------------------------------------------
Present Initial
Investment $-10,200.00 1.0000 $-10,200.00
1 $0.00 0.9259 $0.00
2 $0.00 0.8573 $0.00
3 $-50.00 0.7938 $-39.69
4 $100.00 0.7350 $73.50
5 $487.50 0.6806 $331.79
6 $487.50 0.6302 $307.22
7 $487.50 0.5835 $284.46
8 $487.50 0.5403 $263.40
9 $487.50 0.5002 $243.85
10 $487.50 0.4632 $225.81
11 $0.00 $487.50 0.4289 $209.09
12 $0.00 $487.50 0.3971 $193.59
13 $400.00 $887.50 0.3677 $326.33
14 $600.00 $1,087.50 0.3405 $370.29
15 $650.00 $1,137.50 0.3152 $358.54
16 $650.00 $1,137.50 0.2919 $332.04
17 $650.00 $1,137.50 0.2703 $307.47
18 $650.00 $1,137.50 0.2502 $284.60
19 $650.00 $1,137.50 0.2317 $263.56
20 $650.00 $1,137.50 0.2145 $243.99
20 $6,500.00 $31,864.00 0.2145 $6,834.83
----------------------------------------------------------
Net Present Value $1,214.67
-----------------------------------------------------------
*Capital gains taxed at 28%
Appendix Table 2 Discussion
Per-unit patronage refund(Column A):
Column A lists the projected annual per-unit patronage refund from the cooperative's
operations. Please note that the first two years have no patronage refund because of
projected losses. This is not uncommon for new, start up companies. Also note that we
assumed the per-unit patronage refund for years six through 20 are the same as year five.
Total patronage refund(Column B):
Column B is the per-unit refund from Column A multiplied by the 500 shares of preferred
stock which are to be purchased.
Percent cash refund(Column C):
Column C is the assumed annual percentage of cash patronage refunded. The remaining amount
is retained by the cooperative and returned 10 years later.
Cash patronage refund(Column D):
Column D lists the annual patronage refund that was paid in cash. It is calculated by
multiplying Column B and Column C together.
Estimated tax(Column E):
Column E is the estimated annual tax liability. This is calculated by multiplying Column B
by the 30% marginal income tax rate. We must use the total patronage (column B) to
calculate the estimated tax because most cooperatives use qualified refunds, allowing for
taxable income to be passed through to the member/patrons. Therefore, the total amount
must be claimed as taxable income, even though only a percentage is received in cash. Note
that the estimated tax is greater than the cash patronage refund in year three.
Redeemed retained refunds(Column F):
Column F lists the annual retained refund. The amount of annual retained refund is
calculated by subtracting the cash refund (column D) from the total refund (column B).
In this example, the retained refunds are redeemed on a 10 year revolving basis. This
means that the retained refunds earned in year three will be returned in year 13. This
example also assumes that all remaining retained refunds will be redeemed when the stock
is transferred, in this case when it is sold in year 20. This assumption was made to
reduce complexity, and is not commonly used by cooperatives.
Net cash flow(Column G):
Column G is the annual net cash flow. This column is calculated by subtracting the
estimated tax (column E) from the cash patronage (column D) and then adding the redeemed
patronage (column F).
Discount factor(Column H):
Column H lists the annual discount factor. Once again, this can either be calculated by
using the formula listed previously or obtained from a table of discount factors.
Present value(Column I):
Column I is the annual present value of the net cash flow. This is calculated by
multiplying the net cash flow (column G) by the discount factor (column H).
The stock sale(LAST ROW):
There are some special considerations encountered in calculating the present value of the
stock sale. The estimated tax is calculated by subtracting the initial investment
($10,200) from the sale amount ($32,500) and multiplying the difference (capital gains of
$22,300) by the marginal tax rate (32%). This assumes that the capital gain ($22,300) will
be taxed at the same rate as ordinary income (self employment taxes do not apply), but
that the additional income in that year will move you from the 15% to the 28% marginal
federal income tax rate. Also note that the remaining retained patronage, of $6,500, is
redeemed at the time of the sale.
Therefore, the net cash flow at the time of the stock sale ($31,864) is the sale amount
($32,500) less the estimated tax ($7,136) plus the remaining retained patronage ($6,500).
The Answer=The Net Present Value:
The net present value is the sum of all of the annual present values. In this example, the
net present value is a positive $1,214.67. Because the net present value is positive, this
cooperative stock investment will return more than the minimum 8% after-tax return and
should be considered. However, if the net present value was negative, the investment would
return something less than the desired 8% after-tax return, and your money may generate a
higher return in other uses. A negative net present value does not mean that you should
not become a member in the cooperative, only that the cooperative will not generate the
selected rate of return. Your personal and business goals, as well as the potential
impacts on the farm/ranch, should also be considered.
EB-67, July 1996
