Bill Fitzwater Cooperative Chair
In this series of articles I have been discussing reinvestment in equipment and infrastructure. We have seen that the growth or decline of the cooperative is a function of the reinvestment ratio and the cooperative’s return on equity. At first blush you might expect growth to be function of the return on assets. If I invest in my grain assets at a rate greater than they are wearing out (net investment) I would expect an income stream from the additional bins (return on assets). The final component of the growth rate equation is the leverage impact of debt financing. If you recall my newsletter on the DuPont formula, a firm’s return on equity is equal to its return on assets plus the amount by which the return on assets exceeds the interest rate. That extra “bump” is multiplied by the portion of the debt in the capital structure. In words, the return on equity is what you generate from the assets plus the gain you achieve by using the bankers money on the portion of the assets that the bank financed. Debt financing is advantageous only when the project’s return is higher than the interest rate.
Most cooperatives are not highly levered and have a return on equity that is higher but only moderately higher than their return on assets. When cooperatives take on large infrastructure projects they might take on additional debt. In theory the project could impact both their return on assets and their leverage. Because it is not impacted by the degree of debt financing or the interest rate, a projects internal rate of return actually provides the best bench mark for investment projects. . A good thumb rule is to only undertake projects with an internal rate of return equal to or higher than your desired return on equity. Most cooperatives conduct feasibility studies which include internal rate of return projections when they contemplate investing in new business areas. Many fail to consider the internal rate of return on infrastructure upgrades or replacement. That’s a mistake because the cooperative can’t grow unless it is reinvesting in projects with adequate return. If replacement investment does not generate an adequate internal rate of return, it might be a sign that the margin structure is inadequate.
Next week, I’ll expand on the concept of an internal rate of return and how it can be simply calculated.