The effects of liquidity costs and capital rationing on optimal farm planning in an uncertain environment

Michael Richard Langemeier, Purdue University

Abstract

This study determined the effects of liquidity costs and capital rationing on the firm's optimal activity mix, capital structure, and ending equity. Unlike previous empirical research, the model utilized explicitly incorporated capital rationing and liquidity costs associated with land, machinery, storage capacity, and hog buildings. Based on theoretical literature, several hypotheses concerning liquidity costs were developed. Reducing liquidity costs were hypothesized to increase the certainty equivalent of ending equity, initial debt, and the firm's ability to adjust to new conditions. An empirical model was developed to test these hypotheses. A four year discrete stochastic programming model of a representative Indiana farm with corn, soybeans, wheat, and a farrow-to-finish hog enterprise was constructed. The empirical equilibrium model contained 7616 variables, 6562 constraints, and 1296 terminal states. Several alternative liquidity cost scenarios were analyzed. The first liquidity cost scenario assumed that land, farm machinery, storage capacity, and hog buildings could not be liquidated. The second scenario assumed that only land could be liquidated. The third scenario assumed that investments in land, farm machinery, storage capacity, and hog buildings could be liquidated at normal costs. The fourth scenario assumed that liquidity costs used in the third scenario were 50 percent smaller. Initial debt and the certainty equivalent of ending equity were relatively lower for the first liquidity cost scenario, indicating land is an important source of liquidity. The second and third liquidity cost scenarios were similar with respect to the certainty equivalent of ending equity, initial debt, and activity mixes. Thus, there does not appear to be much additional benefit in terms of returns, risk, or flexibility from the ability to sell machinery, storage capacity, or hog buildings under normal operating conditions. Reducing liquidity costs increased the certainty equivalent of ending equity by about two to three percent. Reducing liquidity costs had no effect on initial debt for the moderate debt case and increased initial debt for the high debt case. Finally, reducing liquidity costs increased the firm's ability to adjust to new conditions.

Degree

Ph.D.

Advisors

Patrick, Purdue University.

Subject Area

Agricultural economics

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