Expansion Opportunity at Triple F Farms: A Case Study

Thoroughly enjoying the crisp Monday afternoon, Craig watches as the pile of wheat in the box of his truck slowly grows. A brief trip to the cab of the truck to move it ahead as the box fills is all that is required of him, as the grain auger is doing all of the heavy work. He spends the idle minutes sitting on the foundation of the next bin, listening for any imperfections in the steady drone of the grain auger. He watches his two children, ages 10 and 12, playing on the snow pile in the middle of the farmyard. With the children less than fifty yards away, he can watch them while he is working, giving his wife Cathy a well-deserved break. It is days like this December afternoon that he realizes the value of working at home and being his own boss. He wants to maintain his profitability into the future so that he can continue to enjoy days like this.

Triple F Farms

Craig, the sole-proprietor of Triple F Farms, farms 2,600 acres. He owns 180 acres, and the rest is cash rented. He and his wife Cathy raise sugar beets, corn, dry edible beans, soybeans, and spring wheat in the Red River Valley (RRV). The valley is located along both sides of the Red River, which forms the border between North Dakota and Minnesota. The valley is known for its deep, fertile, rock-free soils as well as its short and unpredictable growing season; it is notorious for floods, drought, and frost.

Craig grew up on his father Allan's farm. Allan did everything he could to make farming a career possibility for Craig, but Allan's farm did not have enough income to support two families. Cathy's father had a sufficiently large farm to bring Craig into the business. After marrying Cathy, Craig began to work on his father-in-law's farm. The farm is only ten miles from Allan's farm, so Craig was already familiar with the farming practices. In 1997, Cathy's father retired, leaving Craig as the owner and manager. While the size of Triple F Farms is not much larger than when Cathy's father was farming, Craig has diversified the farm by adding sugar beets and edible beans, both high-value crops, to the rotation.

Craig owns a modest line of machinery. He has owned most items for at least seven years, with the exception of a few recently purchased items. He purchased a new pull-type sprayer in the summer of 2003 so that he could do more of his own spraying. He also bought two large triple-axle grain trucks that same summer, which enhance his ability to get the sugar beets and corn out of the fields in a timely fashion. He has been able to keep costs down by doing his own maintenance and putting in long hours on his machinery. Coupled with his solid yield averages and management abilities he has been able to have an average annual net income of $95,000. After covering family living expenses and term debt principal payments, Craig and Cathy save the additional funds for retirement and business opportunities by investing in bonds and securities. The farm balance sheet as of December 31, 2006, is shown in Table 1.

Cathy had an off-farm job before the children were born but has been at home caring for the children and helping Craig with the farm ever since. They want to maintain their current lifestyle while considering changes to the farm business. The farm's income has been sufficient in the past, but Craig realizes that more income may be necessary in the future. “When our children reach college age we may need an additional $20,000 per year. We also want to set aside $10,000 more per year for retirement,” Craig says. With those needs in mind, he has set a goal of increasing his annual net income to $125,000 within five years. In addition, he wants to have a farm with enough income potential for at least one of his children to join the business in the future.

Another concern of Craig's is related to shrinking profit margins due to the rising costs for fuel and fertilizer. Craig says that in 2006 alone, “My fertilizer costs increased by 25%,” with similar increases in the costs for fuel and oil. The rising costs were in part due to sharp increases in prices for natural gas, which is a major input in the production of many commercial fertilizers. In addition, rising crude oil prices were directly responsible for higher fuel and oil costs on Craig's farm.

Crop Operations at Triple F Farms

The corn, soybean, and wheat crops are grown using practices that are familiar to most grain farmers. Craig uses conventional tillage on all of his crops. He grows 450 acres of conventional hybrid corn, 650 acres of public wheat varieties, and 900 acres of soybeans that are genetically modified to be tolerant to glyphosate. Portions of the crops are hauled directly to local grain elevators at harvest. The remainders of the wheat, corn, and soybean crops are placed in on-farm storage to be delivered and sold later.

The 150 acres of sugar beets are grown for a farmer-owned cooperative in the RRV of Minnesota and North Dakota. Farmers, like Craig, buy shares in the company. Each share represents one acre of sugar beets that the farmer is required to grow and deliver to the company. The machinery for planting and caring for the crop is the same as what Craig uses for his other row crops; however, the harvesting machinery is unique. First, a tractor pulls a defoliator, or topper, through the field, which removes the crop's above-ground leaves and stems. Another tractor follows with a beet harvester, or lifter, which pulls the beets out of the ground and elevates them into trucks. With average yields of around 20 tons per acre on Craig's farm, the trucking is much more intense than for other crops. The harvest is also very labor intensive, as the harvest continues 24 hours a day until it is finished. The harvest takes place in the first part of October, when the beets are cool enough to be piled outdoors without fear of spoilage. The beets are then processed by the cooperative before the next summer. The price that Craig receives for his sugar beets is determined by the cooperative.

The 450 acres of edible beans that Craig grows are primarily pinto beans. Pinto beans are often used in burritos and tacos and can be served in the whole or refried form. The crop is a legume, like soybeans, and has low requirements of nitrogen fertilizer. Edible beans are a food crop; therefore, a cool and dry harvest season is necessary in order to harvest a high-quality crop. The fall weather in the Northern Plains usually allows such a harvest. The machinery required for growing these beans is very similar to that of other row crops, with the exception of some of the harvesting equipment. Pinto bean pods lay very close to the ground when mature. Straight-cut combine headers cause too much crop loss for Craig. For this reason, a special tractor-mounted machine is used to cut the ground-hugging plants' stems just below the surface of the ground and collect several rows together into windrows. Craig is then able to use the same combine that he uses for his wheat, corn, and soybeans, with the use of a windrow-pickup header. The pinto beans are delivered directly to local buyers during harvest, as specialized equipment is required to handle the fragile beans. The buyer of Craig's pinto beans does allow him to price up to 50% of the beans before harvest. He is also allowed to delay the pricing of up to 25% of his beans after harvest for up to 12 months at no charge. The remainder is priced at harvest.

Craig makes a point of being well educated when it comes to his crop input needs. He likes to be in control of the decisions instead of relying on an agronomist for decision making, though he is not afraid to ask for advice. He bases his seed purchasing decisions on area yield trials and prior results on his own farm. He keeps a close eye on the chemical needs for each field and uses the products that will provide appropriate protection. He always soil tests his fields for fertilizer needs and follows university recommendations for each crop.

Craig insures his crops using Revenue Assurance Crop Insurance at the 70% coverage level. This provides him with a guarantee that he will receive compensation from his insurance company if his yields fall below 70% of his actual production history, which is an average of his yields for the previous five years. Revenue Assurance Crop Insurance replaces lost production at the harvest value. This allows Craig to manage production risk if he chooses to do any preharvest pricing. He can use preharvest pricing on up to 70% of his actual production history without exposing himself to additional production risk.

Financial Management of Triple F Farms

Craig uses his farm records from previous years when building his crop budgets and pro forma income statement. He then uses this information to build a pro forma balance sheet for the end of the upcoming year. He uses five-year averages for yields and prices when building his crop budgets and adjusts for any expected changes in the coming year. Craig's five-year crop yield and price history is reported in Table 2. His five-year average direct crop expenses are given in Table 3. His 2006-year-end income statement is given in Table 4. Craig usually estimates his projected income tax liability by multiplying the net farm income from operations by an estimated tax rate of 31%.

Craig likes to talk to his neighbors over breakfast at the local café. The farmers typically talk about the weather and markets. They also tend to talk about other farmers and the size of their farms. The larger farmers are generally regarded as being the most successful with their large collections of machinery, buildings, and equipment. Most of the farmers would like to expand the size of their farms if they had the opportunity. The most recent discussions have revolved around rumors that the prices for fuel and fertilizer might increase by 25%–50% within five years. Craig is wondering if farm expansion will be necessary in order to maintain his level of income.

Also of concern to Craig is his land tenure. The average RRV operation farms 1,727 acres and owns 355 acres (University of Minnesota 2007). The average of the most profitable 20% of RRV producers farm 2,818 acres and own 557 acres. Craig is near the average number of acres farmed for the most profitable farms but closer to the low 20% in acres owned. Owning a low percentage of his acres is a potential concern for Craig. While he rents 800 acres from his father-in-law, tenure is a concern. The number of tenants that he negotiates with continues to grow annually and the risk of losing control of these acres grows annually.

The Expansion Opportunity

Having completed most of his record keeping for 2006, Craig will be able to spend the rest of the month hauling grain and preparing for next year. As the owner of Triple F Farms, he spends a good portion of his time planning the future of his operation. He has also been wondering what he can do to achieve his goals and address his concerns. Several years ago, he chose to name his farm “Triple F Farms”; the three F's signifying his motto, which is “Farming for the Future.” He had no idea that he would be facing the kind of decision that he is facing today.

Craig's father Allan has decided that forty-two years of farming is enough. With the equity that he has built over the years, he can retire at age sixty-seven. By selling all of his farm assets, he will have enough income for him and his wife of 45 years to live comfortably for the rest of their lives. The decision to sell everything has been made. Allan and his wife want to dissolve themselves of all responsibilities so that they can travel. He wants to be able to sell to Craig, at a price that is fair to both of them, but only if it is the right move for his son.

While Allan's farm was not large enough to allow Craig to enter the operation at the time when he was getting started, it has since grown so that it is almost as large as Triple F Farms. Allan's farm is 2,200 acres, and he owns half of those acres. He grew mostly spring wheat and soybeans, with a few acres of corn and dry edible beans. He has a line of machinery that is mostly newer than Craig's and wants to sell all of it as a package for $500,000. Craig believes that buying the complete line of machinery will make certain that he has enough machinery to farm the larger number of acres. “I also look at it as a way to get some newer machinery on my farm,” says Craig. Adding his father's machinery to his own will require additional hired labor. He currently employs one farm laborer for $32,700 per year and assumes his labor requirements will increase to $59,450.

Allan will sell the 1,100 acres that he owns for $750 per acre. He believes $750 is a reasonable price, as recent area land auctions have fetched over $1,000 per acre. Craig would also take over the 1,100 acres that Allan rents at $65 per acre, for a total acreage increase of 2,200 acres. These additional acres would nearly double the size of Triple F Farms to 4,800 acres.

Craig's plan would be to increase all of his crop acres proportionately in the expansion since he has been successful with his existing crop rotation. The increase in sugar beet acres would require the purchase of an additional 100 shares of sugar beet stock. Craig talked to a retiring farmer and was told that he could purchase 100 shares at a price of $1,500 per share. This brings the total investment of the expansion¹ to $1,475,000.

The Financial Plan for Expansion

Allan will be selling his farmstead to another party on January 1, 2007. He also plans to complete the sale of his farmland and machinery by December 30, 2006. Craig would use his cash on hand to pay 10% down on all of the acquisitions, leaving the remainder to be financed. The total down payment would be $147,500.

Craig has talked to his local bank about borrowing money for the machinery and beet stock. He was told that the machinery would be placed on a seven-year note. The beet stock would be a twenty-year note. Craig plans to get a twenty-year mortgage from Farm Credit Services for the land purchase. He expects that the interest rates would be fixed at 8% for all of the new loans. The loan payments would be due on December 30 each year. In 2007, the new loan for machinery would have a principal payment of $50,433 and an interest payment of $36,000, the loan for the new beet stock would have a principal payment of $2,950 and an interest payment of $10,800, and the loan for the new land would have a principal payment of $16,225 and an interest payment of $59,400.

Over the years, Craig has built his equity in the business to a level of $913,780² with working capital of $329,118 ($287,118 if bonds and securities are not included). That level of working capital allows him to keep his borrowed operating funds needed per year at $300,000 at 7.5% interest. If he chooses to expand the farm, the borrowed operating funds he needs will increase to $550,000. He pays off the operating note by the end of each year. He estimates the operating interest expense to be $11,250. The estimate is $20,625 if he chooses to expand the farm. An end of year balance sheet for 2006 that includes the potential new purchases and new debt is shown in Table 5. Note, on his balance sheet Craig values the newly purchased farmland at $750/acre for cost-basis. For market value, he intends to value it at $1000/acre given recent land sales.

Initially, Craig had concerns regarding the tax implications of the proposed land purchase. Given that he would pay $750/acre, but values the land at $1000/acre, he worried that the Internal Revenue Service might consider the difference to be a gift and tax it accordingly. However, Craig's loan officer assures him that land transfers between family and neighbors often occur at similar discounts. His loan officer handles many such transactions and none has resulted in IRS action. However, there will be tax implications when the land is sold, so deferred tax liability will increase. (Craig uses a tax rate of 31% when estimating his deferred tax liability.)

The cropping plan would be very similar to last year if Craig decides to expand the farm, with acreage increases in all crops. He plans to increase the crop acres to 250 acres of beets, 800 of corn, 800 of edible beans, 1,750 of soybeans, and 1,200 acres of spring wheat. He expects all direct crop input costs to increase directly with the increase in acres as well as the total cost for repairs, farm insurance, utilities, fuel, and oil. Craig's real estate tax liabilities would increase dramatically with the increase in the number of owned acres. He estimates real estate taxes would be $8 per acre. His costs for land rent would not increase as dramatically because half of the new land would be owned. His financing costs would increase disproportionately due to the new interest costs associated with the land and machinery purchases. His interest expense for term debt and mortgages for 2007 is expected to be $10,826 per year and would increase to $117,026 if he chose to expand. The depreciation expense would also increase dramatically due to the new machinery purchases. The new machinery would be depreciated using a seven-year straight-line schedule with a salvage value of zero.

The Expansion Decision

When the truck is full, Craig embarks on the 16-mile round trip to the elevator and back home. By the end of the day, he has hauled six loads. With about 15,000 bushels of wheat left to haul in order to fill his December delivery contract, he needs to spend several more days hauling grain. While finishing this task he will be mulling over the expansion decision.

Craig needs to know what his net income might be if he chooses to expand. He also wants to see what his balance sheet might look like at the end of 2007 for the two different options. When he talked to his banker, he was told there are five key ratios he needs to calculate: Current Ratio, Equity/Asset Ratio, Return on Equity, Net Farm Income from Operations Ratio, and Term Debt Coverage Ratio. Those five ratios will be used in a credit-scoring model to determine Craig's credit score. The credit score will influence the interest rate that the bank would charge and ultimately the decision as to whether or not the loan will be approved. In addition to providing the ratios for use in the credit-scoring model, Craig wants to know what the ratios mean for his farm and how they may affect his decision.

Craig often seeks management advice from his closest neighbor, Jeremy. Jeremy has recently graduated from college with training in farm management. While discussing the potential cost increases for fuel and fertilizer, Jeremy suggested that Craig needed to include a sensitivity analysis in his pro forma analysis. When Craig asked what that meant, Jeremy described to him how to conduct a sensitivity analysis and what the results will mean for his farm. Craig has decided that a sensitivity analysis will be necessary in order to determine the potential effects of cost increases of 25% to 50% for fuel and fertilizer on his farm. He also realizes the value of comparing and contrasting the results of a pro forma analysis between the two possible farm sizes.

While discussing the possible farm expansion Craig mentioned most farmers would choose to expand if they had the opportunity. He feels that he would be doing the wrong thing if he did not expand. Jeremy told Craig that there is a difference between farm size goals and financial goals. Craig had told him about his financial goal of increasing his net income to $125,000, and Jeremy reminded him that his focus should be on whether or not the farm expansion will help him achieve his financial goal. Craig believes that an expansion of his farm will help him reach his goal, but he is unsure. Of further concern to Jeremy is Craig's plan to withdraw all excess cash for nonbusiness-related investments. Jeremy questions the impact on the business' future viability if excess cash is continually withdrawn.

He has to get the analysis done quickly, since he only has a few weeks before Allan will sell the farm. In order to be ready in time, he needs to have the analysis done by the end of this week. When those data needs are filled, he can make his decision and finish his grain hauling chores for 2006.

Discussion Questions