Do lender‐imposed sweeps affect ethanol technology investment?

Abstract

PurposeNew federal legislation proposes to reduce greenhouse gas (GHG) emissions associated with biofuel production. To comply, existing corn ethanol plants will have to invest in new more carbon efficient production technology such as dry fractionation. However, this will be challenging for the industry given the present financial environment of surplus production, recent profit declines, numerous bankruptcies, and lender‐imposed covenants. The purpose of this paper is to examine a dry mill ethanol firm's ability to invest in dry fractionation technology in the face of declining profitability and stringent lender cash flow repayment constraints. Firm level risk aversion also is considered when determining a firm's willingness to invest in dry fractionation technology.Design /methodology/approachA Monte Carlo simulation model is constructed to estimate firm profits, cash flows, and changes in equity following new investment in fractionation to determine an optimal investment strategy.FindingsThe addition of a lender‐imposed sweep, whereby a percentage of free cash flow is used to pay off extra debt in high profit years, reduces the firm's ability to build equity and increases bankruptcy risk under investment. However, the sweep increases long‐run equity because total financing costs are reduced with accelerated debt repayment.Practical implicationsResults show that while ethanol firm profits are uncertain, imposition of a lender sweep combined with increased profit from dry fractionation technology helps the firm increase long‐run financial resiliency.Originality/valueExamination of ethanol plant financial structures and investment capabilities has received scant research attention to date.