Loans and homes

The “Current Use” value is determined in one of two ways:
1. Capitalization of rent, which is computed by dividing the average annual gross cash rental for comparable farmland in the locality, less average real property taxes, by the average annual effective interest rate for all new Federal Land Bank loans. Five year average data is used.   If there is no comparable land from which the average annual gross cash rental may be determined, “average net share rental” may be substituted for average gross cash rental. Net share rental is defined as the excess of the value of the produce received by the lessor of the land over the cash operating expenses of growing such produce, which are paid by the lessor under terms of the lease.
Each average annual computation is to be made on the basis of the five most recent calendar years. For decedents dying in 2006, the average interest rate was 7.75 percent. The following example assumes that the current average land rent is $32.50 per acre, taxes are $2.50 per acre, and the Federal Land Bank interest rate 75.75 percent.
32.50  -  $2.50  =  $ 387.10 per acre current use value .0775
2. If there are no comparable sales or the formula method is not used, the value of real property may be deter- mined by application of the following factors:
a.  The capitalization of income that the property can expect to yield for farming or for closely-held business purposes over a reasonable period of time under prudent management, using traditional cropping patterns for the area, taking into account soil capacity, terrain configuration, and similar factors.
b.  The capitalization of the fair rental value of the land for farming or for closely-held business purposes.
c.  The assessed land values in a state that provides a differential or use value assessment law for farmland or closely-held business property.
d.  Comparable sales of other farm or closely-held business land in the same geographical area far enough removed from a metropolitan or resort area so that nonagricultural use is not a significant factor in the sales price.
e.  Any other factor which fairly values the farm or closely-held business value of the property.

The executor may elect to value real property devoted to farming or other closely-held business at its “current use” value rather than market value if certain conditions are met. The conditions are as follows:
1. The adjusted value of the farm or other closely-held business assets (assets minus debt) must comprise at least fifty percent of the decedent’s adjusted gross estate (assets minus debts).
2. At least twenty-five percent of the adjusted value of the gross estate must be qualified farm or other closely-held business real property.
3. The farm or other closely-held business must pass to qualified heirs.
4. The real property must have been owned by the decedent or a member of the decedent’s family and held for use as a farm five out of the last eight years preceding the decedent’s death.
5. The decedent or member of the decedent’s family must have materially participated in the operation of the farm or other business for five out of the last eight years immediately preceding the decedent’s death (or retirement or disability).
Special rules for decedents who are retired or disabled are as follows: The material participation has to be satisfied during periods aggregating five or more of the eight year period ending before the earlier of (1) the date of death; (2) the date on which the decedent became disabled; or (3) the date on which the individual began receiving Social Security retirement benefits, which continued until decedent’s death.
If the property was passed to the surviving spouse, he or she will be treated as having materially participated during periods when engaged in active management of the farm or business. The term “active management” means the making of management decisions of a business that is more than just the daily operating decisions.
The definition of a member of a family means only (a) an ancestor, (b) the spouse, (c) a lineal descendent of decedent or of decedent’s parents or of decedent’s spouse, or (d) the spouse of any lineal descendent described in (c) above. For purposes of the preceding sentence, a legally adopted child of an individual shall be treated as the child of such individual by blood. Lineal descendents of the decedent’s grandparents are no longer considered to be family members unless they are also descendents of the decedent’s parents. This means that aunts, uncles, nieces, nephews, and cousins are excluded.
6. The special valuation cannot reduce the decedent’s gross estate by more than $940,000 for 2007 and will be in- dexed for inflation in the future.
7. An election to specially value the property must be made on the other decedent’s estate tax return.
8. A written agreement must be signed by each person who has an interest in the property for which the special use is elected, stating that additional estate taxes will be paid if there is a premature disposition or cessation of qualified use of the property.
9. Special rules exist relative to standing timber.

We have shown how the Standard Model of Finance came into existence, as each of its pillars appeared and achieved widespread success. Now we can look at a business decision and see how the Standard Model guides corporate financial managers to the correct decision.

Suppose there is a petrochemical company that processes crude oil and makes it into several different plastics. The company is known for the high quality of its products and is successful. It sells to more than 175 different customers, and no customer accounts for more than 2 percent of its annual sales, so in that sense it is stable. It does not rise or fall with any industry sector because its customers are in many different industries.

The petrochemical company’s capital structure is optimal. Its management confers frequently with investment bankers, and as market sentiment changes, the company tailors each new issue of securities to stay in step with what the market wants. The company sometimes buys back its common shares and sometimes uses the shares it has bought back to pay for an acquisition.

Despite the quality of its products and its other advantages, the petrochemical company’s share price is not very high. Its earnings are too volatile, and its capacity to pay dividends is too low. The company operates in a mature industry, and investors see that it should have the capacity to generate steady earnings. They also see that it does not deliver stable performance, so they buy its shares only at times when the shares are relatively cheap. The company’s earnings are unstable because the price of crude oil fluctuates, and the company is not able to raise the prices of the plastics it sells every time the price of crude rises. The company tries to hedge its exposure to the fluctuations in the price of crude, but its hedging is not very successful. The company is underhedged, so its earnings fluctuate too much.

Now suppose there is an opportunity to buy a company that has oil wells. These are good wells, with many years of reserves, and they are located near the company’s petrochemical plants. From a strategic point of view, buying the oil company looks like a good decision. The petrochemical company would integrate vertically, and its cost of crude oil would no longer fluctuate. The petrochemical company would buy 100 percent of the shares of the oil company and then consolidate the oil company’s accounts into its own. The petrochemical company’s balance sheet would then show its original assets and liabilities together with the assets and liabilities of the oil company.

The acquisition might be a bad idea from a financial point of view. To see how financial considerations could block this acquisition that sounds so logical from a strategic point of view, suppose the oil company owed $900 million. Also suppose that its equity is worth only $100 million. To complete the beginning assumptions, suppose the petrochemical company owed $500 million, and its equity was worth $500 million. Also suppose the petrochemical company would issue new shares in exchange for 100 percent of the shares of the oil company. Before the merger, the petrochemical company has 10 million shares issued and outstanding, and its shares are trading at $50 a share. It would issue 2 million new shares and give those to the owners of the oil company, so after the merger there would be 12 million shares outstanding.

The petrochemical company’s stock price would probably go down as soon as it announced the transaction. This is normal because investors would be able to see that 2 million new shares are going to come into existence, so they would be wary of buying until they have seen whether the owners of the oil company decide to keep the shares of the oil company or sell them.

The big question the Standard Model can answer is whether the shares of the petrochemical company would rise in the weeks and months following the merger.

In this case the shares probably would not rise back to $50; instead, they might fall. The reason is that after the merger the petrochemical company would owe too much money. It would owe the $500 million it owed before the merger, and it would also owe the $900 million the oil company owed. To complete the merger, the petrochemical company would have had to assume the oil company’s debt. Its consolidated debt position would be $1.4 billion. If market participants considered that amount of debt prudent for the consolidated company, the market value of its equity would be $600 million. If market participants felt the consolidated company would be safer and more profitable after the merger, the market value of its equity could be greater than $600 million. Its stock price could rise above $50 a share in the months following the merger.

The more likely outcome, however, is that market participants would feel $1.4 billion is too much debt for the consolidated company to bear prudently. In that case they would be wary of buying the shares, so the shares would fall on the announcement of the merger and not rise later. They might fall to $40 a share and not rise until the consolidated company had paid back enough of the debt that its debt burden once again looked prudent.

The calculations to determine ahead of time whether the merger would raise the petrochemical company’s stock price or lower it are quite simple. The data inputs needed are also simple to obtain. Any junior analyst can quickly get the data and do these calculations.

What does the Standard Model suggest the petrochemical company should do if the merger would lower its stock price? The answer is the petrochemical company should improve its hedging. It can purchase a cap. This is a contract that puts a ceiling on the price the petrochemical company pays for crude oil. For example, if the petrochemical company buys a five-year cap with a price ceiling of $25 a barrel, and the price of crude oil rises above $25 a barrel, the counterparty that issued the cap will have to pay the excess over $25 a barrel to the petrochemical company. If the price of crude oil rises to $28 a barrel, the counterparty would have to pay $3 a barrel to the petrochemical company. Caps are now easy to buy, and there are several major financial houses that offer them.

This example shows that financial considerations now influence whether deals are done, and it shows that the main consideration is the effect of the deal on stock prices. The example also shows that new risk management products have appeared in the market. These new products meet the needs for hedging that are now greater because old-fashioned strategies, such as vertical integration, are not always helpful, since shareholders do not tolerate volatility.