The Cost of Debt and the Risk-Adjusted Discount Rate for Owner Cash-Flows: Co-Operatives vs. Investor-Owned Firms

Abstract

This paper values an input co-operative (co-op) that procures a single commodity from farmers and then processes and markets the output, and an otherwise identical firm structured as an Investor-Owned Finn (IOF) using the Capital Asset Pricing Model (CAPM) and the Black-Scholes option pricing model. The paper focuses on the right to residual claims aspect of ownership, ignoring the formal right to control, and uses a single-period model. Four conclusions emerge when co-op members are assumed not to make pre-emptive payoffs to themselves. First, the risk-adjusted discount rate (RADR) of equity of an unlevered IOF will always be higher than the RADR of the 'owner' claims of an unlevered co-op. Second, for a given absolute level of debt the co-op will have lower effective financial leverage than an otherwise identical IOF. Third, for a given financial leverage the co-op owner claims will have a lower RADR than IOF equity. Finally and importantly, the cost of debt for an IOF will be higher than that of a co-op for the same leverage and/or absolute debt levels.While an IOF can alter risk through both operating and financial leverage; a co-op has in addition a third dimension of risk - pre-emptive payoffs to members. Such pre-emptive payoffs increase risk to lenders.