Academic journal article Journal of Agricultural and Applied Economics

Determinants of the Strength of Strategic Adjustments in Farm Capital Structure

Academic journal article Journal of Agricultural and Applied Economics

Determinants of the Strength of Strategic Adjustments in Farm Capital Structure

Article excerpt

This study employs correlation relationships to measure the strength of trade-offs between business and financial risks as a representation of the strategic capital adjustment process. Under different business risk measures based on varying lengths of historical farm income data, results suggest that farmers tend to adopt a myopic perspective when contemplating risk-balancing plans. Cross-sectional regression results for two-time period models covering the decade of the 1980s and 1990s yielded important implications. The liquidity-constrained environment of the 1980s emphasizes the combination of risk-balancing plans, specialization, and market revenue-enhancing strategies. In the 1990s, risk balancing becomes compatible with risk-reducing crop diversification and insurance protection plans.

Key Words: business risk, correlation coefficient measure of risk balancing, expected utility mean variance model, financial risk, risk management strategy, stochastic interest rates, strategic capital adjustment

JEL Classifications: D21, D81, G11, Q12, Q14

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Recent financial structure analysis has found that farms can adjust their leverage positions to longer term targets, while following a pecking order approach in responding to shorter term deviations from the longer term targets (Barry, Bierlen, and Sotomayor). The pecking order reflects the lower transaction and agency costs of internal relative to external sources of funds, whereas the target concept includes the effects of risk, risk and time attitudes, financial costs of capital, and longer term profitability. The longer term target approach is consistent with earlier financial structure studies employing risk attitude, life cycle, and farm typology frameworks (Ahrendsen, Collender, and Dixon; Ellinger and Barry; Jensen and Langemeier), as well as with risk-balancing or equilibrium analysis approaches (Barry and Robison; Gabriel and Baker; Moss, Shonkwiler, and Ford).

Most prior studies have focused on factors affecting the level of the farmer's leverage or on its rate of adjustment, rather than considering the strategic adjustment process. Strategic adjustments, originally called risk balancing by Gabriel and Baker, reflect a farmer's potential use of changes in financial structure to offset or mitigate the effects of changes in business risk. This strategic adjustment process was developed using farm-level equilibrium analysis techniques that expressed additive and multiplicative relationships between business and financial risks (Barry; Gabriel and Baker). Subsequent work that addressed the consistency of risk-balancing behavior with a farmer's expected utility-maximizing choice of optimal leverage levels (Barry, Baker, and Sanint; Collins) provided empirical evidence on the relationships between expected utility maximization and leverage (Ahrendsen, Collender, and Dixon; Jensen and Langemeier) and demonstrated the possibility of increases in financial risk to offset reductions in business risk resulting from changes in agricultural or tax policy (Featherstone et al.; Moss, Ford, and Boggess).

This study empirically measures the extent and strength of the strategic adjustment process by utilizing a longitudinal farm data set from Illinois. One of the study's unique features is an empirical approach that employs correlation relationships to measure the trade-off between business and financial risks, as a representation of the strategic adjustment process. Moreover, this study identifies and tests the importance of demographic factors and business growth strategies that influence the strength and extent of the strategic adjustment process. Considering the farmers' preferences for combined strategies in responding to risk as revealed in a 1996 USD A survey (Harwood et al.), the potential influences of other risk management strategies on more significant financial structure adjustments are also considered in this study. …

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