Abstract
The cost of capital is important in the financial management of agricultural coopera-
tives. 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, guide-
lines for capital structure choice, and applications of these guidelines through coopera-
tive 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 bal-
ance 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 liabili-
ties and equity capital side of the balance sheet). The component costs of equity and
debt c