Developing a firm level cost of capital for Kansas farms

The risk and return on capital markets is well documented in the academic literature. A well known model to examine the risk and return of capital markets is the capital asset pricing model. This model investigates risk as diversifiable risk and non-diversifiable risk. To apply this model to the production agriculture capital market, this study analyzed the relative risk and return of a sample of 398 farms in Kansas from 1985 to 2005. Beta coefficients, which represent the degree of non-diversifiable risk associated with an individual farm, were calculated against a market index created for this study. The market index was created to represent a completely diversified capital market of bonds, equities, and agricultural assets in the form of farm land. The beta coefficients calculated were used in the capital asset pricing model to compute a cost of equity for the farms. A weighted average cost capital was calculated using an average cost of debt for the farm multiplied against the percent of debt on the farm, plus the cost of equity calculated times the percent of equity for the farm. Results indicate that the average farm in the sample had a beta of 0.070 and a weighted average cost of capital of 6.015% across the 20 year study. This suggests that investment in an agricultural firm from a pure investment objective would result in little added risk to a well diversified portfolio and a low weighted average cost of capital. Capital invested in production agricultural equity earns a lower return on average across the 20 year study than Treasury securities, Municipal securities, corporate bonds, and the S & P 500, but a higher return than a pure investment in agricultural land.