Land Leasing and Debt on Farms: Substitutes or Complements?
Bierlen, Ralph, Langemeier, Larry N., Ahrendsen, Bruce L., Dixon, Bruce L., Quarterly Journal of Business and Economics
Ralph Bierlen [*]
The study follows the methodology of Ang and Peterson (1984) to test the hypothesis that U.S. farms substitute land leasing for debt. Tobit leasing models are fitted with U.S. farm panel data where the leasing ratio is defined as the value of leased land to total assets and the debt ratio as total debt to total assets. Model results indicate that land leasing and debt are substitutes. This result is robust to estimation by OLS and when the leasing ratio is defined as the value of leased land to total land assets and the debt ratio as long-term debt to total land assets. The rate of substitution between land leasing and debt is found to be sensitive to shifting farm business conditions, but not to heterogeneous farm characteristics. When the values of leased land and total debt are normalized by equity, land leasing and debt are found to be complementary.
Theory indicates that leasing and debt are substitutes (Myers, Dill, and Bautista, 1976; Ross, Westerfield, and Jaffe, 1990). This assumes that a lease payment, which is a fixed obligation like a loan, displaces debt and reduces debt capacity, i.e., if firms have optimal debt to equity ratios, then, o the extent that leasing represents off-balance sheet financing, it reduces debt capacity. The leasing-debt substitution hypothesis has been empirically tested in the corporate finance literature with leasing models fitted with firm-level corporate data. Ang and Peterson (1984)--the seminal work in the literature--fit Tobit models with 1976 through 1981 data from 600 U.S. firms. A leasing-to-book value of equity ratio is the dependent variable, and a debt-to-book value of equity ratio and other variables that control for debt capacity are the explanatory variables. Contrary to theory, model results indicate that leasing and debt are complements. Ang and Peterson suggest that inefficient capital markets, differen ces in tax brackets between leasing and nonleasing firms, and qualitative differences in the debt issued by leasing and nonleasing firms may be responsible for the complementary leasing-debt relation.
Subsequent studies indicate that Ang and Peterson's conclusions may result from shortcomings in the study. The Compustat data set utilized by Ang and Peterson contains firms from diverse industries and, therefore, with diverse debt capacity. Critics believe that the addition of the non-debt explanatory variables do not adequately control for diverse debt capacities that may explain the complementary relation between debt and leasing. A second criticism is that Ang and Peterson fail to include operating leases, focusing exclusively on capital leases. Graham, Lemmon, and Schallheim (1998) indicate that this may be a serious omission. Their 1981-1992 Compustat data set indicates that operating leases were present in 99.9 percent of firm-year observations, while capital leases were present in only 52.6 percent of firm-year observations. Similarly, for the same sample, operating leases accounted for 8.0 percent of firm assets, on average, while capital leases accounted for just 1.6 percent. Finally, Ang and Peter son use debt and leasing to equity ratios while other studies normalize debt and leasing with total assets. Results may be sensitive to normalization, especially when a substantial portion of total assets comprises leasing and debt.
Several studies seek to remedy the problems associated with Ang and Peterson's study. Finucane (1988) normalizes leasing and debt with total assets. Marston and Harris (1988), who examine changes in leasing and debt rather than levels, include both capital and operating leases and normalize leasing and debt with total assets. Erickson (1993) includes capital and operating leases and accounts for differences in debt capacity with industry dummy variables. Adams and Hardwick (1998) use a 1994 U.K. cross-sectional data set and, like Marston and Harris, they define leasing to include both operating and financial leases while leasing and debt are normalized by total fixed assets. …