Optimal capital structure in agricultural cooperatives and implications for equity retirement

Purpose This paper presents a model for determining the optimal capital structure for cooperatives and explores the relationship between financial leverage and the ability of cooperatives to retire member equity. Design/methodology/approach A model is developed to determine the optimal capital structure and explore the relationship between capital structure and the rate at which a cooperative can retire member equity. Using data from cooperative financial statements, ordinary least-squares regressions are conducted to test two hypotheses on capital structure and equity retirement. Findings The model shows that the optimal capital structure is determined by the ratio of the rate of return on capital employed to the interest rate on borrowed capital and the required level of interest coverage. The regressions suggest that cooperatives choose their capital structure largely according to the rate of return on capital employed and the interest rate in a manner consistent with maximizing the rate of return on equity and that the rate at which cooperatives can retire member equity is directly related to leverage. Research limitations/implications The model does not consider unallocated earnings. Analysis of the relationship between leverage and equity retirement yields results contrary to the assumptions of earlier studies. Practical implications Cooperatives can use the model because the necessary parameters are easily understood and readily available from financial statements, lenders and industry sources. Originality/value The model is developed specifically for determining the capital structure of cooperatives and differs substantially from the corporate model. A theoretical basis is provided for the relationship between leverage and equity retirement.