ࡱ> `b_q ibjbjt+t+ AA_+ ]LLL\lll8D <<RRRRRR$  ilRRRRRVllRR<VVVRplRlRllllRVLV:L,llR$ Wx 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 Tom-Smythe@utc.edu 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 Americas 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 cooperatives 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. 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 firms 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 cooperatives 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 managements 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 projects 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 cooperatives Weighted Average Cost of Capital (WACC). The Weighted Average Cost of Capital is the discount rate used to determine the present value of the projects 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 cooperatives 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 firms tax status could unknowingly bias the cooperatives 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 cooperatives taxable income. The exclusion is only allowed if 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. 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 cooperatives tax status. The debt component of the WACC is represented by the after-tax cost of the debt (debt cost times one minus the firms marginal tax rate). In the event the cooperative is fully tax exempt, the debt component of the WACC is simply the cooperatives 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 firms 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 cooperatives 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 members equity. As such, an estimate of the cooperatives required return to shareholders is necessary. A cooperatives proportion of equity is represented by the proportional amount of patronage capital on the cooperatives 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 members 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 + b(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 (b), 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 cooperatives 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 cooperatives 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 cooperatives 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 cooperatives 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 managers perception of the cooperatives 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 cooperatives 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 cooperatives WACC is calculated using one of two weighting approaches. First, management could use the existing proportional weighting of long-term debt and members 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. An Example An example of how a cooperative financial manager would use NPV analysis is presented in Table 4. The cooperative is considering one of two possible new pieces of equipment, Project A and Project B. The assumption is that the projects are mutually exclusive. The projects have an expected economic life of 15 years and straight-line depreciation is used. The before-tax cash flows are net cash flows that already account for expenses and depreciation. It is assumed that twenty percent of cash flows will come from non-patronage sources. We also assume that investment in the project will occur one year from today and all other cash flows are at the end of each subsequent year. The assumptions are recapped in Panel A. The calculation of net cash flows appears in Panel B, and two points in this section are worth noting. First, the positive tax effects, i.e. adding back the non-cash depreciation expenditure, only apply to the taxable non-patronage activity. Additionally, taxes are only applied to the portion of the terminal year salvage value allocated to non-patronage activity (the $8,000 and $9,600 respectively). Panel C summarizes the cash flows and shows the results of discounting the cash flows using the WACC of 8.19% calculated in Table 3. As is evident, both projects have a positive NPV, but Project Bs NPV is larger and should be accepted since it is assumed that the projects are mutually exclusive. Conclusion The cooperative industry has at times looked upon itself as being so different from for-profit firms that financial managers have at times ignored using valuable financial principles when making decisions. This article broadly outlines how the principle of wealth maximization should be applied to the cooperative industry. More specifically, a methodology for implementing NPV analysis in the cooperative setting is provided. In doing so, two of the unique issues facing cooperatives in their attempt to use NPV analysis have been addressed and solved. These two issues are the special tax environment cooperatives are faced with and how to estimate the weighted-average cost of capital and the cost of equity. Following the example outlined in Table 4 will allow cooperatives to implement a most useful financial tool (NPV analysis) in their efforts to make better decisions for their members. References Brigham, Eugene F. and Joel F. Houston, 1999, Fundamentals of Financial Management, The Dryden Press Harcourt Brace Publishers. Ryan, Harely E. and Emery A. Trahan, Spring/Summer 1999, Financial Practice and Education Vol. 9, pp. 46-58. Table 1 Calculation of Patronage Exclusion and Taxable Income Patronage Non-Patronage Sourced Sourced Total Operating Income $8,000,000 $2,000,000 $10,000,000 Operating Expense ($6,000,000) ($500,000) $6,500,000 Non-operating Income and Expense Investment Income $100,000 $500,000 $600,000 Interest Expense ($400,000) ($100,000) ($500,000) Net Income Before Taxes $1,700,000 $1,900,000 $3,600,000 Patronage Exclusion* $1,700,000 Taxable Income $1,900,000 Income Taxes (40%) ($760,000) Net Income $1,140,000 * The patronage exclusion is generally limited to the lessor of the actual amount assigned to the members patronage capital accounts or the net income from activities that are patronage sourced. Table 2 Determination of Tax Effects on Cash Flows Project Cash Flows Before Tax Tax Effects* After Tax Applicable only to patronage activity $100,000 NA $100,000 Applicable only to non-patronage activity $100,000 ($40,000) $60,000 Applicable to both activities** $100,000 ($8,000) $92,000 * Assuming a marginal tax rate of 40%. **This assumes that for this example that cash flows are related to and split between patronage and non-patronage activities in the proportion of 80% and 20% respectively. As a result, the tax is calculated as ($100,000) (0.2) (0.4) = $8,000. Table 3 Calculation of Weighted Average Cost of Capital (WACC) Panel A: Calculation of after-tax cost of long-term debt Assume that 80% of $10 million of long-term debt is allocated to patronage activity and 20% to non-patronage. Additionally, the marginal tax rate is 40% and the long-term debt rate is 5%. Patronage Non-Patronage Source Source Total Annual Interest Cost ($400,000) ($100,000) ($500,000) Tax Effects NA $40,000 $40,000 After-tax cost ($400,000) ($60,000) ($460,000) After-tax cost as percent 4.6% Equivalently: kd  [kd x %NP x T] = 0.05  (0.05x0.2x0.4) = 0.05 0.004 = 0.046 = 4.6% Panel B: Calculation of required return to shareholders using the CAPM Assume: The average  b from estimating the returns of electric utilities on the S&P500 is 0.75. The expected return on the one-year T-bill (Rf) is 5.5%. The expected return on the S&P 500 is 11%. Ri = Rf + b(Rm-Rf) ( 0.055 + (0.75)(0.11-0.055) = 0.0963 = 9.63% Panel C: Calculation of WACC Assume the cooperative s capital is in the form of $10 million of long-term debt and members equity amounts to $25 million. Then the WACC is: WACC = (wd)(ATCD) + (we)(Ri) = (10/35)(0.046) + (25/35)(0.0963) = 0.0819 = 8.19% Table 4 Project NPV Analysis Example Panel A: Assumptions Project A Project B Initial Investment $1,000,000 $800,000 Annual Depreciation ($66,667) ($53,333) Expected Project Life 15 yrs 15 yrs Before-tax operating cash flows, excluding Depreciation for years 2-15 $200,000 $180,000 Salvage value in year 15 $100,000 $120,000 Marginal tax rate 40% 40% Percent of cash flows from non-patronage Activity 20% 20% Panel B: Calculation of after-tax cash flows (outflows in parentheses) Year Cash Flow Type 1 Initial investment ($1,000,000) ($800,000) Total Year 1 ($1,000,000) ($800,000) 2-14 Before-tax operating cash flows $200,000 $180,000 Taxes ($16,000) ($14,400) Operational cash flows $184,000 $165,600 Depreciation ($66,667) ($53,333) Cash flow from tax effects* $5,333 $4,267 Total net cash flows for 2-14 $189,333 $169,867 15 Net cash flow from operations $189,333 $169,867 Salvage Value $100,000 $120,000 Taxes** ($8,000) ($9,600) Net salvage values $92,000 $110,400 Total for Year 15 $281,333 $280,267 Panel C: Recap of cash flows and NPV calculations Year 1 ($1,000,000) ($800,000) 2-14 $189,333 $169,867 15 $281,333 $280,267 NPV using WACC of 8.19% $530,906 $574,705 * Calculated as (Depreciation x NP% x Tax Rate). ** Calculated as (Salvage Value x NP% x Tax Rate).  See Exhibit 2, p. 50, Ryan and Trahan (1999), FPE, Spring/Summer 1999.  While traditional NPV analysis often groups all operating cash flows together, cooperatives may find it useful to estimate cash flows by type, i.e. patronage and non-patronage, and then combine them prior to discounting.  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