Using Net Present Value Analysis in Cooperatives

Using Net Present Value Analysis in Cooperatives

By

J. Frederick Johnson, CPA

Manager of Accounting and Finance

Farmers Telephone Cooperative, Inc.

Rainsville, Alabama

And

Thomas I. Smythe, Jr.*

Assistant Professor of Finance

The University of Tennessee at Chattanooga

College of Business Administration

615 McCallie Ave.

Chattanooga, Tennessee 37403

(423) 755-5252

And

John G. Fulmer, Jr.

Vieth Professor and Head

Department of Accounting and Finance

The University of Tennessee at Chattanooga

Chattanooga, Tennessee

*Corresponding author.

Using Net Present Value Analysis in Cooperatives

Introduction

Historically, industry insiders and outsiders have viewed America’s rural electric and telephone cooperatives as being fundamentally different from traditional for-profit shareholder-owned companies. This view is based in part on the fact that the cooperative’s owners are also its customers. While cooperative membership represents an ownership claim, it is also true that the primary relationship is one of service provider and customer. In the past, cooperative management has at times used this unique relationship as a rationalization for not using common business principles when making critical business decisions. This article provides a framework for using the principle of shareholder wealth maximization in the cooperative decision making process. Specifically, the application of Net Present Value analysis is recommended to enhance cooperative decision making. By following the example illustrated below, cooperative managers can implement this widely used business tool thereby directly benefiting cooperative members.

Background

The general field of business evolved a great deal during the twentieth century. Of the developments in the field of Finance, Net Present Value (NPV) or Discounted Cash Flow (DCF) analysis is arguably one of the most important. For example, a 1999 survey of Fortune 500 firms, published in the Financial Practice and Education journal, indicates that over 80% of respondents use NPV analysis to make financial decisions.[1] In effect, NPV analysis provides the framework necessary to evaluate capital projects in the context of shareholder wealth maximization. The fundamental principle behind NPV analysis is that people who invest and expose capital to risk should be adequately compensated for taking that risk. On the surface, the goal of wealth maximization may sound somewhat brutal and may appear to ignore other valued corporate traits such as social responsibility. However, in its simplest form, wealth maximization means to do what is best for owners, which encompasses all aspects of a firm’s operations. It is in this context that wealth maximization in general, and NPV analysis in particular is applied to the domain of rural cooperatives.

Most cooperatives, beginning with the Rochdale Pioneers, serve rural areas that would otherwise go without electric or telephone service. Operationally, cooperatives have historically emphasized providing services at or below cost. While cooperatives certainly play a unique role in the provision of these services, the goal of wealth maximization is likewise very applicable in the cooperative domain. Two of the fundamental issues to reconcile are “who a cooperative’s shareholders are” and “how does the shareholder receive his or her return on invested capital.” Initially and even today, one primary way of returning invested capital is by providing the service at a price below that offered by comparable for profit firms. Another method is to return patronage capital credits to owners at year-end or at regular disbursement periods over time, which is effectively a dividend.

More recently, customers are demanding more than basic telephone or electric service. Specifically, customers want more reliable and thereby more value enhancing service from cooperatives. In other words, the cheapest telephone or electric service may no longer be enough; customers are demanding greater value in the form of service reliability. Since cooperative members are the “owners” of the cooperative, then all financial decisions should be made in a way that provides them with the maximum benefit, whether that be lower prices or more reliable service at a comparable price. Stated differently, cooperative management’s decisions should be guided by the principle of shareholder wealth maximization. While creating additional value at a comparable price is an increasingly important business objective for cooperatives, the remainder of this article emphasizes low cost production because cash flow savings are more readily identifiable. To the extent improved service value can be quantified with cash flows, the following methodology is equally applicable.

The Methodology

Given that cooperative members are its owners, standard net present value analysis can be readily applied to decisions ranging from new equipment purchases or major capital investment decisions to simple projects undertaken to reduce costs. The fundamental question to be answered is whether the project in question adds wealth to members or more concretely, generates enough risk adjusted cash flow to warrant the project’s cost to members. The NPV calculation itself is very straightforward and is simply the process of discounting all after-tax cash flows back to the present. There are three types of cash flows to be considered in the analysis: initial investment outlays, normal (after-tax) net operating cash flows, and terminal year cash flows. Initial investment outlays are those made to get the project started and generally include the installed cost of equipment and/or increases in working capital. The terminal year cash flows reflect not only those generated by normal operations, but also any after-tax cash flow from estimated equipment salvage value and the return of working capital.

NPV is determined by summing the future benefits of the project (in present value terms), and subtracting the initial investment outlay. If the resulting calculation is greater than zero, the project in question should be undertaken. If there are two mutually exclusive projects, then the project with the highest NPV should be undertaken. While the calculation itself is relatively simple, there are two issues that must be addressed and are unique for cooperatives. The first is the unique tax environment that cooperatives face, and the second is how to develop the cooperative’s Weighted Average Cost of Capital (WACC). The Weighted Average Cost of Capital is the discount rate used to determine the present value of the project’s future benefits. The WACC is calculated as the “weighted average” cost of debt and equity. More specifically, the after-tax cost of debt is multiplied by the proportion of the balance sheet supported by debt, and the cost of equity is multiplied by the proportion of the balance sheet supported by equity. In the example below, we assume the firm finances itself with long-term debt and equity.

Tax Issues

The complicated nature of cooperative tax structure presents a challenge when using NPV analysis. A cooperative’s tax status is important because all cash flows in the NPV analysis must be on an after-tax basis and the debt component of the WACC is adjusted to reflect any tax savings from using debt. The latter issue is extremely important because the effective cost of debt is higher when the cooperative is fully tax exempt. So, inaccurately projecting the firm’s tax status could unknowingly bias the cooperative’s WACC higher or lower, ultimately leading to poor decisions. In the event that the cooperative is fully tax-exempt this is not an issue. A brief review of cooperative taxation is helpful.

Some cooperatives are completely exempt from income taxation under § 501c(12) of the Internal Revenue Code of 1986. However, even for those that are not exempt, the determination of taxable income, and the related tax, is not as straightforward as for a regular taxable corporation. A primary reason for the difficulty is that taxable cooperatives can exclude (not deduct) net income derived from patronage sources from the cooperative’s taxable income. The exclusion is only allowedif the patronage net income is distributed to members under terms outlined in the Internal Revenue Code. For an example of such a calculation see Table 1.

Table 1 demonstrates that any projected income or expense related strictly to patronage-source activities has no tax effect, assuming the cooperative assigns all net income from patronage-source activities to members as capital credits. As such, a critical question is whether cash flows are related to patronage or non-patronage activity. If all items are strictly patronage related there is no tax effect. When all cash flows result from non-patronage activities, cash flows must be adjusted for tax effects as in traditional NPV analysis. The most complicated case arises when the cash flows are comprised of both patronage and non-patronage related activities. In this case, an estimate must be made as to the proportion of cash flow allocable to each class of activity and the effects of taxation computed accordingly for the non-patronage source cash flows.[2] Since NPV analysis examines marginal cash flows, management must simply estimate whether there will be non-patronage sources of income in future years. If so, the appropriate marginal tax rate should be applied to the non-patronage cash flows. Table 2 provides examples of each of these scenarios given certain assumptions and variables.

Estimating the Weighted Average Cost of Capital (WACC)

The second problem for cooperatives to address is the estimation of the appropriate WACC. The WACC is comprised of the proportional cost of debt and equity for the cooperative in question. Of the two components, the debt cost is the easier to determine, although not as straightforward as it might appear due to the cooperative’s tax status. The debt component of the WACC is represented by the after-tax cost of the debt (debt cost times one minus the firm’s marginal tax rate). In the event the cooperative is fully tax exempt, the debt component of the WACC is simply the cooperative’s cost to raise an additional dollar of debt.

However, if cooperative management believes that at least some future revenues are likely to be of the non-patronage variety, then the debt cost must be adjusted to reflect the tax savings from using debt. The difficulty arises in estimating the tax savings. Unlike a publicly traded corporation which has all revenues taxed in the same way, the cooperative likely has a large portion of revenue (patronage) that is tax exempt. At issue is that the interest cost (and therefore tax savings) must be allocated between patronage and non-patronage operations. As a result, the tax savings only apply to the non-patronage portion of revenues. A review of Panel A in Table 3 provides an example. In this case, we assume that 80% of the debt finances patronage operations and the remaining 20% non-patronage. As a result, the cooperative is only able to deduct $40,000 in interest expense. So, the after-tax cost of debt is not equal to:

After Tax Cost of Debt = kd x (1-T)

where ‘kd’ is the before tax cost of debt and ‘T’ is the firm’s marginal tax rate. Instead the after tax cost of debt is:

After Tax Cost of Debt = kd – [kd x %NP x T]

where ‘kd’ and ‘T’ are defined as above and ‘%NP’ is the estimate of the proportion of Non-Patronage operations to be financed by debt.

The next task for the cooperative financial manager is to estimate its cost of equity or the return required by shareholders (or members). However, it must be remembered that cooperatives are not publicly traded companies. Additionally, a cooperative’s risk is lower than that of a for-profit firm since competition is limited. While cooperative risk may be lower than that for publicly traded firms, there is risk associated with a member’s “equity”. As such, an estimate of the cooperative’s required return to shareholders is necessary. A cooperative’s proportion of equity is represented by the proportional amount of patronage capital on the cooperative’s balance sheet.

For publicly traded utilities, the required return to shareholders is generally estimated using either a dividend growth model or the capital asset pricing model, where most of the model inputs are estimated based on existing market data for the firm. It is the lack of market data that makes estimating the required return to shareholders (members) different for cooperatives. One alternative currently being applied links the cost of cooperative equity to the capital credit rotation cycle or the member’s opportunity cost for not having use of the money. However, we believe that these methods do not adequately capture the relationship between risk and return. As such, four alternatives are presented below that more directly equate risk and return. The fourth approach is simply a composite of the other three.

The Modified Capital Asset Pricing Model (CAPM) Approach

The CAPM is commonly used to estimate the required returns to shareholders. The following formula, which effectively states that shareholders (members) require the market risk-free rate plus a risk premium, is used:

Ri = Rf + (Rm-Rf).

‘Ri’ is the expected return for the firm in question and is the required return for the firm’s shareholders. ‘Rf’ and ‘Rm’ are the expected return on a risk-free asset and the “market” respectively. Cooperatives can use the one-year Treasury bill to approximate the risk-free rate, and they can use a market index such as the S&P 500 to approximate the “market” return. Of the variables to be used, beta (), which captures the relative risk of the cooperative with the market, is the one that proves difficult for cooperatives to estimate. If cooperatives had publicly traded stock, the beta would be estimated by using a statistical technique (ordinary least squares) to determine the correlation between the cooperative’s historical returns and the market. Knowing beta and estimates for ‘Rf’ and ‘Rm’, one could estimate the required return.

In the absence of traded stock, cooperatives can create a proxy beta by using the average beta for the electric (telephone) industry. One criticism of this approach is that the firms that make up the average are exposed to more market risk than a cooperative, thereby overestimating the required return to cooperative members. While true, this approach represents an upper bound in the cooperative’s analysis. (See Panel B in Table 3 for an example.) With this beta, the calculation of the WACC can proceed.

The Accounting Beta Approach

The accounting beta approach is a variant of the CAPM. It is more likely to accurately account for a cooperative’s lower cash flow variability relative to a publicly traded counterpart. With this approach, an analyst can use ordinary least squares to estimate the correlation between the return on assets (ROA) for the cooperative and the average ROA for the S&P 500 or a group of publicly traded electric (telephone) companies. This approach has the advantage of focusing on variations in cash flow and therefore will likely produce an estimate for beta that is lower than the average market return beta discussed above. After estimating the accounting beta, it is then used in the CAPM equation above to develop an estimate of required return.

The Bond-Yield-Plus Risk Premium Approach

Another alternative for the cooperative financial manager to use as the estimate for member required returns is the bond-yield-plus risk premium approach. It is the simplest to implement (but probably the least rigorous theoretically). With this approach, the primary input is the cooperative’s yield on long-term debt. A “risk premium” is added to the long-term debt yield that reflects the increased risk of equity (relative to debt). The size of the risk premium is based on the financial manager’s perception of the cooperative’s level of risk. The subjective nature of determining the risk premium is both a plus and a minus. On the negative side, there is little theoretical rationale for choosing one premium or another; i.e. it is subjective. On the positive side, management can reflect the lower level of equity risk inherent in the cooperative environment. There is evidence to suggest that the premium usually ranges from three to five percent above the cost of debt. As a practical matter, the cooperative financial manager should feel relatively comfortable taking the cost of debt and adding three to five percent to obtain an estimate for the cooperative’s cost of equity.

The Pooling Approach

The pooling approach simply takes the average of the three approaches discussed thus far. By doing so, the weaknesses of any one approach are unlikely to unduly influence the estimation of the required return to shareholders. Regardless of the approach taken, cooperative financial managers should consider at least two of the alternatives in their analysis.

Once the after-tax cost of debt and the cost of equity have been estimated, the cooperative’s WACC is calculated using one of two weighting approaches. First, management could use the existing proportional weighting of long-term debt and member’s equity on the balance sheet as weights. Alternatively, management could set the weights based on a target capital structure that management wants to move toward over time. See Panel C of Table 3 for an example WACC calculation.