Rural Electric Cooperative Debt Usage
Bacon, Frank W., Lavely, Joe, Adusei, Edward, Management Quarterly
Since the 1930s, rural electric cooperatives (RECs) have borrowed much-needed capital from the Rural Electrification Administration (REA) at below-market interest rates to construct and maintain their systems. Because of the "high risks" and low consumer density associated with providing electric energy to rural areas, investor-owned utilities (IOUs) opted not to invest in rural electrification. With the help of REA-subsidized loans, RECs have developed a massive electric service infrastructure throughout rural America.
Recently the REA loan program has come under serious attack. The gist of the argument is that RECs have grown to a substantial level of financial strength and therefore should be weaned from subsidized federal financing. RECs maintain that such an abrupt reduction in low-cost capital would severely threaten the financial stability of the rural electrification program. Since consumer density remains around six consumers per mile (compared to 40/mile for neighboring IOUs) and most rural areas already suffer from a weakening farm economy and little economic development, REC officials fear that reduced low-interest loans would represent the proverbial "straw that breaks the economic backs" of many rural systems.
Additionally, RECs maintain the IOUs have enjoyed similar if not more intense tax subsidies that may even outweigh the magnitude of the REA loan program. Examples include corporate subsidies from the recent "investment tax credit" and the current "tax deductibility of interest" provisions. In a previous article (Bacon and Lavely, 1992), we compared the usage of debt by RECs and IOUs for the years 1985-1988 and found only a small difference in the debt levels for the two groups. The difference declined over the time period with RECs posting the sharper reductions in debt usage from year to year. In fact, the REC industry shows a declining dependence on debt while at the same time IOUs relied more heavily on debt financing over the time period. The data suggest that the below-market interest rate subsidy was not unreasonably more advantageous to the RECs than was the tax-deductibility of interest to the IOUs.
In this article, we continue our study of the REC debt issue by examining: The nature and importance of debt usage, some significant geographic differences in REC debt usage, and some possible reasons for these findings. In yet another study, we plan to analyze some of the possible motivations that might explain the various levels of debt RECs chose to employ.
In the following section, we demonstrate the impact of debt usage (also referred to as financial leverage) on the margins of RECs. Next, we present a brief description of RECs and of the database that we analyze. Then, we present analyses that show marked differences in debt levels of RECs in different areas of the country. Finally, we offer some possible reasons for the differences we observe.
Physical leverage is a relationship between input and output; a relatively small change at the input end of the lever produces a relatively large change at the output end of the lever. The term "financial leverage" is fitting because the usage of debt allows a relatively small change in Operating Margins Before Interest (OMBI) of an REC to produce a relatively large change in its Margins After Interest (MAI).
The basic rationale for using debt is quite simple. When a savings-oriented firm (or, a person, for that matter) can obtain funds at a rate of cost lower than the rate that it expects to earn on the use of the funds, it ought to do so (unless risk rises enough to more than offset the benefit). Essentially, if the firm can borrow at 10% and invest the funds at 20% without raising its risk, it should.
TABLE 1 REC With No Interest Operating Margins Before Interest $1,000,000 $1,200,000 Interest 0 0 Margins After Interest $1,000,000 $1,200,000 Dollar Increase in Margins After Interest $200,000 Percent Increase in Operating Margins Before Interest 20% Percent Increase in Margins After Interest 20% REC With No Interest Operating Margins Before Interest $1,000,000 $1,200,000 Interest 400,000 400,000 Margins After Interest $ 600,000 $ 800,000 Dollar Increase in Margins After Interest $200,000 Percent Increase in Operating Margins Before Interest 20% Percent Increase in Margins After Interest 33%
Because interest on debt is a fixed dollar amount, it remains constant regardless of the level of IMBI. …