AGRICULTURAL ECONOMICS 330

Assignment 12

Instructor: Dr. David J. Leatham

Name: Row Number: Section:

Mr. Agirich has provided the following information and ratios for the Aggie Farms 19X0 operations:

Average Total Assets= $840,000

Average Total Liabilities= $395,000

Net Farm Income before taxes= $74,800

Interest Paid and accrued= $26,000

Income Taxes Paid= $9,000

ra=Net Farm Income before tax + Interest/Average Farm Assets

Assets = Debt + Equity

1.Based on this information, what is the projected Rate of Return on Equity after taxes, re, for Aggie Farms in 19X1? (Assume that the tax rate, t, is 15% and the Rate of Return on Assets before taxes, ra, will continue as reflected for 19X0 and that the future cost of debt, i, will be 10%. Use the equation presented in class to calculate the projected re. Use the information above to calculate ra. Remember that Net Farm Income before taxes is from the Income statement and is after interest. [re= 11.71%]

2.What might Mr. Agirich do to increase the rate of return on equity after taxes?

3.What is the projected re for Aggie Farms in 19X1, if Mr. Agirich projects ra to be 5%? Keep everything else the same as before. [re= 0.5%]

4.Mr. Agirich feels he needs to increase re to 13.6%. If he cannot increase return on assets nor decrease interest cost or the tax rate, how much additional debt will he need to incur to achieve the desired rate level of profitability (use the same ra that was calculated in problem 1)? [Additional debt = $495,000]

  1. Suppose Mr. Agirich borrows the additional money (problem 4). What is the projected re for Aggie Farms for 19X1, if Mr. Agirich projects the ra to be 5%? Keep everything else the same.

[re= -4.3%]

6.Graph the relationship between growth and leverage. Use the solutions to problems 1, 3, 4 &5. In addition, calculate the projected re for the ra calculated in problem 1 and ra=5% assuming that leverage is zero. Put this information on the graph as well.

7.Use the graph prepared in problem 6 to discuss why leverage is sometimes called a two-edged sword.

8.Assume you have been asked to help Mr. Agirich determine the optimal leverage for his firm. Mr. Agirich provides you with the following probability distribution for ra and you determine that his level of risk aversion is 2. Assume that i is 10%, and t=15%. Calculate the optimal leverage, expected re, the standard deviation of re and the coefficient of variation of re.

ra / Probability
0 / .05
.05 / .30
.12 / .30
.19 / .30
.24 / .05

Optimal leverage = 0.3302; Expected re = 10.76%; The standard deviation of re = 0.752; and The coefficient of variation of re.= 0.6988

9.You have tried to convince Mr. Agirich that it is important to prepare an accurate and professional set of pro forma financial statements to present to his lender to increase the credit available to Aggie Farms. Mr. Agirich says that he has borrowed all the money he wants to, therefore, any additional credit doesn't have any value. Please explain to him why it does.

10.Outline the risks faced by agricultural producers and the methods of managing these risks.