Farm financing strategy and the lending policy from financial institutions

Capital structure theories, which are well developed and best understood in corporate finance, summarize the financing strategies from corporate firms. The application of those concepts to agricultural production businesses, however, is not widely investigated. Studying the financing strategies of farm businesses could not only improve farm financial management but also enable lending institutions to better understand financing characteristics, improve their evaluation of credit risks from agricultural borrowers, and formulate more effective lending policies.;This study explores the applicability of three capital structure theories---the pecking order theory, the trade-off theory, and signaling---to the unique setting of farm businesses and agricultural credit relationships. Through a dynamic simultaneous equation system estimated with Illinois farm-level data, the three capital structure theories are tested within the endogenous relationships among internal cash flow, short-term debt, long-term debt and the investment variables. The results indicate that financing strategies, implied by each capital structure theory, work in a complementary fashion on farm businesses. Moreover, the signaling effect enters the agricultural relationship through credible signals, such as, previous cash flow and profitability.;The analytical framework is extended to a Monte-Carlo simulation after the econometric examination of the applicability of capital structure theories to farm businesses. Farm business performance under different combinations of financial strategy scenarios is simulated for a 10 year period to determine the benefits for both farmers and lenders in the agricultural credit relationships. Based on the forecasted net equity, credit score and the default rate, the simulation results demonstrate that farm businesses can expand at a faster speed with a relatively high financial safety when they jointly employ the pecking order financing in the short-run, and trade-off their capital structure in the long-run. Concurrently, low credit risk farm businesses which send credible signals to lenders could benefit from lower interest rates, further strengthening their financial performance. The simulation results document that responding to borrowers' signals and adopting risk-adjusted interest rates is a dominant lending policy for lending institutions to improve the management of their loan portfolio.