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A Model of CooperativeFinance
John J. VanSickleand GeorgeW. Ladd
The uniquecharacteristicsof cooperativesrequirethey be analyzeddifferentlyfromthe
moretraditionalnoncooperativefirm.A modelof cooperativefinanceis developedthat
has the objectiveof maximizingthe total, aftertaxprofitsof the cooperativemember
patrons.A mathematicalanalysisderivesthe relationshipsamongthe variousfinancial
instruments,anda numericalanalysisderivesresultsfor a cooperativeundervarious
hypothesizedscenarios.We suggestthata modelincorporatingthe unique
characteristicsof cooperativesis the moreappropriatetool for studyingcooperative
financethanis the noncooperativemodel.
maximize the total profits, after taxes, of the Table 1. Definitions of Symbols Used, In
memberpatrons(Ladd). This objective is sen Order of Appearance
sible because it can be used in studies of
Definition
shortrunproductionand pricingand longrun Symbol
financial structure. In this paper we follow
Tubbs, Fenwick, and Vickers and do not de CS Total value of common stock out
termine the amount of capital. standing
P Price share of common stock
per
(fixed)
tM Number of members in the co
CooperativeFinanceModel operative (fixed)
7 Total number of years deferred
This paper studies financialstructureof Sec patronage refunds are deferred
s Proportion of patronage refunds
tion 521 cooperatives that use revolving fund paid in cash
financing. This is done mainly for conve QPR Amount of net savings allocated as
nience. A qualitativemodel for cooperatives qualified patronage refunds
that do not meet Section 521 criteria can be TKQP Total capital supplied by qualified
patronage refunds
formulated, but is much more complex. K Total capital employed by the co
Hereafter, the word "cooperative" means operative (fixed)
"Section 521 cooperative." The cooperative D Total debt employed by the co
must determinethe total amount of debt and operative
Members' total profits after taxes
owners' equity. Owners' equity includescapi Tr
Members' total net revenues after
tal stock, deferred qualified patronage re T,,, taxes from products traded in
funds, and nonqualifiedpatronagerefunds. side and outside the cooperative
during the current year (fixed).
These net revenues represent all
Supply of Capital current income and outlays of
members before allocations of
Cooperativesorganizedas stock corporations net savings from the cooperative
commonly require a common stock purchase PVPR,m Present value of patronage refunds
for membership. Membershipallows the pa paid to members
Net (of income taxes) dividends on
tron to be involved in the managementof the DS,,
capital stock paid to members
cooperative. The price of common stock will T Members' total net revenues be
be assumed fixed to reflect point (b) in the fore taxes from products traded
opening paragraph.The numberof members inside and outside the coopera
also is assumed fixed in this paper. This is tive during the current year
done mainly for convenience. It is assumed (fixed). These net revenues rep
resent all current income and
that the cooperative limits common stock outlays of the members before
ownership to one share per member. This allocations of net savings from
satisfies an early principle of cooperation es the cooperative
Members' average income tax rate
tablishedby the Rochdale Society (Abraham t,M
p Ratio of member business to the
sen, p. 48). The contributionof common stock sum of member and nonmember
to the financialstructurethen may be written business
d Members' discount rate defined as
(1) CS = P  M. equal to the members' average
marginal interest cost of debt
i,. Dividend rate on capital stock
See table 1 for definitionsof all symbols used. ? Maximum allowed dividend rate
The other form of memberequity, deferred on capital stock (fixed)
patronage refunds, is derived from the DS Total (before income taxes) divi
dends on capital stock paid to
cooperative's net savings. Net savings are al members
located to dividends on capital stock and to NS Net savings of the cooperative
qualified and nonqualified patronage refunds. r Average interest rate on all current
Griffin et al. (p. 38) report that in 1976 only and longterm debt used by the
1.2% of the equity capital in cooperatives was cooperative
0 Net operating income of the co
supplied by nonqualified patronage refunds. operative defined as equaling
Because of their negligible use, nonqualified total receipts less all expendi
patronage refunds are assumed to be zero. tures except the interest cost of
The capital supplied each year' by qualified debt (fixed)
Van Sickle and Ladd A Coop Finance Model 275
(23) d > 0.
(29) ps + (1 ) tm
Expression (23) is logical because d is the Q
LQPR = P (1+ d)T
average discount rate of the members. The
only possible value for r that satisfies both  X17(1  s)  X5 = 0.
equation (22) and (23) is zero. To prove this, Substituting equation (20) and (28) into ex
multiplythe expression inside the brackets of pression (29) and rearrangingyields
equation (22) by (1 + d)7 and rewrite as 1
1 = (1 + d)'  An(1 + d). (30) X5 = p (1  E
(24) ti)
1T (1 d)
n(30)
(1 + d)
Note that the series expansion for (1 + d)Tis
(25) (1 + d)' = 1 + iln(1 + d) (1 + d)'
The KuhnTucker condition for can be
+ I [In(1 + d)]i stated as ic
j?2 . j!
aL 
(31) L (1 X4 M
Substitutingequation (25) into (24) yields aic _ tm)PMPR0. OP•
If the cooperative pays a dividend on mem
(26) 1 1 + +
[n(1 d)y bers' capitalstock, (31) is an equality. Assum
ing (31) is an equality, substituting(30) into
(31) for X5 yields
Since d > 0, equation (26) is satisfied if and (32) Xh= PM (1  tm) p[(  tm)
only if 1 An(I + d)
 E1 (  (1 + d)' (1 + d)
(27) 7= 0.
1
But this contradictsthe assumptionin expres Eand the expression multiplyingEin (32) are
sion (16). The conjunctionof the assumptions positive. Because p is less than or equalto one
expressed in (10), (16), and (23), and the as then X4must be positive. Consequently,
sumption that X,2and X3 equal zero, yields a (33) i.
conclusion that contradicts expression (16). ic=
Thus not all of the conditionscan be true. The Values of D, r, and QPR
only condition that can be dropped is the as
sumptionthat both X2and X3 equal zero. Re The KuhnTuckercondition for D can be ex
jecting this assumptionmeans that either X,2is pressed as
negative (implying that s equals .2) or X3 is
positive (implyingthat s equals 1  E). Royer (34)  , r + D ?r0.
showed that for constant annualpatronagere aD [ aD
funds and constant total capital supplied by
deferredpatronagerefunds, highervalues of s The bracketedexpression in (34) is the margi
increased the present value of patronage re nal interestcost of debt (MIC) since the inter
funds. Therefore,we conclude that s is greater est cost of debt is rD. Substitutingequation
than 0.2 and X2equals zero. Then X3must be (20) for Xhand (30) for X. into expression (34)
positive, implying and rearrangingyields
(28) s = 1 E IInQ(1 15 C + d) 
(35) MIC  (1
(1 + d) tm)
for a maximum.
[ 1 _ rln(1 + d)'
Value of ie  (1+ d)' (1+ d) "
The KuhnTuckercondition for QPR will be Note from equation (6) that 1/(1 + d)' is the
an equality if the cooperative uses deferred present value of one dollar of patronage re
patronagerefunds in financing. That is, funds deferred 7 years. And
278 May 1983 Amer. J. Agr. Econ.
d[1/ (1 + d) 7]/dr =  [n(1 + d)/(1 + d) '] Table 2. Predetermined Variables for the
which is the negative of the first righthand Cooperative
side term of equation(35). This is the effect of Variable Value
varyingr on the present value of one dollarof
deferredpatronagerefunds. Label it ME1PV,. CL $775,000
If the cooperativeuses debt equation(35) is an R $3,400,000
P $500
equality and implies that the cooperative will M 1200 members
employ sufficientdebt so that MIC is greater 0 $400,000
than the negative of ME1PV,. p 0.8
t,,, 0.35
(36) MIC (1  t,,)  E 1i
[(1+ 1d)
d)T With no interest on current liabilities, the
average interest rate on debt may be written
rln(1 + d) MEIPV,.
(1 + d)7 r= rL LT
(41) r."
CL + LT
Finally, the KuhnTuckerconditions for X,
and X, can be written as By using equations (33) and (41), equation
aL
(38) may be rewrittenas
(37) PMl K  r(1  s)QPR
(42) 8  r1  LT  iPM  QPR = 0.
 D = 0, and Expressions (39) and (42) providetwo equa
tions in the three unknowns LT, 7 and QPR.
(38) = 0 rD  icPM  QPR = 0. To obtain solutions for all three, we combined
dX5 a search method with the GaussSeidel al
Because MIC is a function of D, equations gorithm.A numberof values of LT were spec
(36), (37), and (38) are three equationsin three ified. For each value of LT, the GaussSeidel
instrumentalvariables:D, 7 and QPR. These algorithmwas used to solve (39) and (42) for 7
eauations can be used to solve for D, 7 and and QPR. The values of LT, r, and QPR were
QPR given values for s, d, K, P, M, p, 7, t,,,
substitutedinto (8), alongwith (28) and (33) to
and an interest rate function for r. compute 7r  T,1. This combined search
A numerical analysis was performed to GaussSeidelprocedurewas used for a num
evaluate the nature of the solutions. For the ber of values of s;' 7 was requiredto be greater
analysis, the cooperative was assumed to than or equal to 1.0 in each case.
defer payment of a small percentage of pa Table 2 presentsthe assumedvalues for CL,
tronage refunds. The analysis considered val K, P, M, 6, p and t,, that were used in the
ues for s from 0.2 through 0.99. Then, the solutionprocess to determinevalues for LT, r,
values of D, 7, and QPR can be determined and QPR. The values for CL, K, P, 0, and M
from equations (36), (37), and (38). were obtainedfromdata suppliedby a market
We assumed that the cooperative employs ing and supply cooperative surveyed in July
currentand longtermliabilities as sources of 1979. The value d was assumed to be 12%,a
debt. Hence, equation(37) may be writtenas rough estimate of members'marginalinterest
cost for 1979, and i was set to 0.08.
(39) R  PAf  r(1  s)QPR Each line of table 3 shows the combination
 (CL + LT) = 0 of values of LT, r, and QPR that maximizedIr
Because currentliabilities (excludingthe cur less T,, for the specified value of s. The com
rent portion of longterm debt) often can be puted values of the objective function support
used for financing with relatively low or no the earlier conclusion that higher values of s
interest, we assumed that the average interest yield highermembers'total net revenue, equa
tion (28). Values for s below 0.52 used the
rate on current liabilities is zero. The average minimum amount possible for deferred
interest rate on longterm debt is assumed to be
an increasing function of the permanent lever An alternative is the following: fix CL so that dD = dLT and
age ratio [LT/(K  CL)], and is arbitrarily ar/8D = ar/aLT. Then substitute (40) into (41) and solve for MIC.
Substitute this result, the definition of MEIPV,, and (1  s) into
specified as (38) to obtain a third.equation to be solved with (41) and (44) by
the GaussSeidel algorithm. In using GaussSeidel for solving
(40) rL = 0.07 + O.OI[LT/(K  CL)] firstorder conditions, one needs to check that the solution is a
+ 0.03[LT/(K  CL)]'. maximum rather than a minimum.
Van Sickle and Ladd A Coop Finance Model 279
Table 3. Solutions for QPR, LT, and r for sidered for longterm debt. The optimumre
VariousValues of s sults from all combinationsfor these restric
tions are listed in table 4. In every case the
s QPR LT 7T  T,, results show that the cooperativeshould defer
(Years)  ($1,000) patronage refunds the maximum allowable
.2 1.0 176.8 1,883.5 111.0 time. The results also indicate that solutions
.3 1.0 175.1 1,902.5 111.7 for longterm debt depend on the maximum
.4 1.0 173.3 1,921.0 112.4
.5 1.0 171.7
allowed value of 7. As 7 is allowed to increase,
1,939.2 113.1
.51 1.0 171.5 1,942.0 113.2 the optimum value of longterm debt gener
.52 11.98 352.0 0 113.8 ally decreases. Also, for some prespecified
.6 14.38 352.0 0 123.7 maximumfor values of 7, the optimumlevel of
.7 19.17 352.0 0 139.4
.8 28.76 352.0 0 160.1
longtermdebt is less than the allowed level.
.9 57.52 352.0 0 186.5
For instance, when r is restricted to twelve
.99 575.28 352.0 0 211.4 years, the cooperative should employ
1.00 0.0 352.0 2,025.0 113.4 $1,146,645 of longterm debt. Restricting
longtermdebt to an amount that is less than
the optimum amount leads to longtermdebt
used at the maximumallowed amount
patronagerefunds.Values for s greaterthanor being
and s decreasing to allow substitution of
equal to 0.52 used all deferred patronagere
funds and no longtermdebt. equity capitalfor debt capital. The results also
show that in six of the eight feasible solutions s
However, in the previous model some con was
straints that may be needed for practicality approximatelyequal to 0.7. In the cases
were omitted. The numericalanalysis shows where s was less than 0.7, no feasible solution
existed for values of s greaterthan those in the
the maximum solution to be where s equals
table.
0.99 and 7 equals 575 years. A revolving fund
of 575 years is not reallyfeasible. The numeri
cal analysis shows that for values of s below Analysis Two
0.51 the maximumsolutionexists where heavy The previous analysis assumed (16) and (17).
debt financing is used, i.e., the permanent We now assume s equals 1 and r equals 0.
leverage ratio ranges from 0.71 to 0.74. While Under this assumptionthere is only one solu
it is possible for cooperatives to have perma tion. Longtermdebt is derived from (39) as
nent leverage ratios this high, it is quite likely
the lenders would impose severe operating (43) LT = k PMf.
constraints on such cooperatives. If p is less than one, the solution for i, is (33).
Further restrictions were added to the And QPR is obtained from (42) as
model to evaluate the effect of limitationson
revolving fund length and debt. Adding these (44) QPR = 0  rLLT iPM.
restrictions required adding two additional
constraintsand Lagrangianmultipliersfor the
maximumallowed values of 7 and D. The re Table 4. OptimumSolutionswith Restricted
sults of the mathematical analysis can be Levels of 7 and LT
shown to indicate that with these restrictions Optimum Solution for
the cooperative must either pay the maximum Maximum Allowed
allowable cash patronage refund rate, i.e., s LT/

equals 1 E, or the cooperative must defer r LT s LT (K  CL) 7r T,,
patronage refunds as as
long possible, i.e., r (Years) ($1,000) ($1,000) ($1,000)
equals the maximum allowed value, or both 4 1,025 a a a a
conditions must hold. 4 1,525 .43 1,520. .58 109.5
The searchGaussSeidel algorithm was 4 1,875 .72 1,816. .69 113.0
modified to incorporate these additional re 8 1,025 .54 1,025. .39 112.8
strictions. Limits of four, eight, and twelve 88 1,525
1,875
.71
.72
1,507.
1,554.
.57
.59
116.3
116.4
years were considered for revolving fund 12 1,025 .69 1,011. .38 122.7
length and limits of $1,025,000 (a permanent 12 1,525 .72 1,147. .43 123.6
leverage ratio of 0.39), $1,525,000 (a perma 12 1,875 .72 1,147. .43 123.6
nent leverage ratio of 0.58), and $1,875,000 (a a No feasiblesolutionexists when 7 is
constrainedto be less than
permanentleverage ratio of 0.71) were con four years and LT is constrainedto be less than $1,025,000.
280 May 1983 Amer. J. Agr. Econ.
The last line of table 3 presents the results for of cooperativefinance. A study of cooperative
this solution. This value of r  T,,, almost finance must incorporatethe unique features
equals the value when s equals .52 and 7 of cooperatives listed at the beginningof this
equals 11.98. Values of 7  T,,,in table 4 are paper. Our study is an effort to incorporate
generally larger(up to $9,100 larger)than the these unique features into a practical model
last value in table 3. for analyzingcooperative finance. The model
could become more useful by developing ap
propriateinterest rate functions and discount
Conclusions and Implications rates for the membercustomers and consider
ing the dynamic aspects of variable earnings
We have studied a cooperative whose objec and interest rates, and growth.
tive is to maximize the aftertaxprofits of its
memberpatrons. Ourresults show that for the [Received May 1981; revision accepted
conditions studied here a cooperative can do September 1982.]
better for its memberpatrons if it pays about
70%of its patronagerefundsin cash than if it References
pays all in cash or only 20% in cash. Our
results also show that if a cooperative pays a
dividend on common stock, it should pay the Abrahamsen, Martin A. Cooperative Business Enterprise.
New York: McGrawHill Book Co., 1976.
maximumallowable rate.
Bar, Josef. "'A Mathematical Model of a Village Coopera
Griffinet al. (p. 32) showed that in 1976 tive Based on the Decomposition Principle of Linear
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aged approximately 0.33. Our analysis 57.
yielded optimumvalues for the leverage ratio Beierlein, James G., and Lee F. Schrader. "Patron Valua
from 0.39 to 0.69. Haugen's sample of tion of a Farmer Cooperative under Alternative Fi
cooperatives showed their average leverage nance Policies." Amer. J. Agr. Econ. 60(1978):636
in
ratio to be 0.54 1974 and in
0.71 1980. The 41.
results in table 4 show that shorteningthe de Coffman, Dick L. "Alternative LongRun Financial Im
ferralperiodfor patronagerefundsleads to the plications for the Local MultiEnterprise Farmers
Cooperative Elevator under Varying Levels of
cooperativeusing moredebt and payingless of Growth and Capital Rationing." M.S. thesis, Iowa
the patronage refunds in cash. These results State University, 1976.
coupled with the recent pressure to shorten Dahl, Wilmer A. "An Analysis of Financial Management
deferralperiods may explainwhy Haugenwit Practices and Suggested Alternative Strategies in
nessed the increase in debt use. Our results Wisconsin Local Supply Cooperatives." Ph.D.
are consistent with those of Snider and thesis, University of Wisconsin, 1975.
Kohler, Nervik and Gunderson, Korzan and Fenwick, Richard A. "Capital Acquisition Strategies for
Gray, Tubbs, Fenwick, and Dahl, who con Missouri Farm Supply Cooperatives." Ph.D. thesis,
cluded that cooperatives have in the past re University of Missouri, 1972.
lied too heavily on deferredpatronagerefunds Griffin, Nelda., Roger Wissman, William J. Monroe,
Francis P. Yager, and Elmer Perdue. The Changing
as a source of financing. Financial Structure of Farmer Cooperatives. Wash
Haugen argues that the leverage ratio for ington DC: USDA ESCS Farmer Coop. Res. Rep.
cooperatives moved in a dangerousdirection No. 17, Mar. 1980.
between 1974and 1980. The maximumlever Haugen, Rolf E. "Financing Growth While Coping with
age ratio in our study nearly equals the 1980 InflationA Financial Perspective.' Coop. Accoun
in
average Haugen's paper. Our results sug tant, no. 4(1981), pp. 6874.
that he be correct in that Helmberger, Peter G., and Sidney J. Hoos. Cooperative
gest may arguing
Enterprise and Organization Theory." J. Farm Econ.
currentleverage ratios are too high. The ques
tion is, how do we test this hypothesis? And 46(1964):60317.
Korzan, Gerald E., and Edward L. Gray. "Capital for
what can be prescribed if the hypothesis is Growth and Adjustment of Agricultural Coopera
accepted? We suggest that the responsible tives." Oregon Agr. Exp. Sta. Bull. No. 596, 1964.
individuals operate with inappropriate mod Ladd, George W. "The Objective of the Cooperative As
elscooperative decision makers and coop sociation." Development and Application of Coop
perative creditors use the familiar nonco erative Theory and Measurement of Coopera
operative finance model typified by Vickers. tive Performance. Proceedings of a symposium at the
We maintain that a noncooperative finance annual meeting, 27 July, 1981, Clemson, SC. Wash
model is an inappropriate tool to use for study ington DC: USDA ACS Staff Rep., Feb. 1982.
Van Sickle and Ladd A Coop Finance Model 281