home
***
CD-ROM
|
disk
|
FTP
|
other
***
search
/
Business Shareware
/
Business Shareware.iso
/
start
/
finance
/
acceler8
/
acc-spl3.txt
< prev
next >
Wrap
Text File
|
1993-03-16
|
8KB
|
121 lines
GENERAL COMMENTS
----------------
There are two financing strategies that businesses
small and large, and even individuals, can use to consid-
erable advantage: skip payment loans (SPLs) and tapered pre-
payments.
In the cash-starved business climate of the 90s, the
SPL is an especially useful financing strategy, but,
unfortunately, most firms aren't aware of it. SPLs are very
effective in controlling cash flow, and can sometimes make
the difference between a viable or a marginal operation.
SPLs can be used advantageously by any business in any stage
of development, but small businesses tend to benefit more
because their cash flow is frequently more critical than in
larger organizations.
The essence of an SPL is a loan payback schedule that
includes skipped payments which are prenegotiated by the
borrower and lender, usually to reduce anticipated strains
on cash flow. The kinds of businesses that find SPLs
attractive are often seasonal in nature (tourism and
construction are commonly sighted as examples); but any
business, even individuals, can use SPLs. A simple
hypothetical shows how an SPL works.
Binary Computers Corp. is a small business about to
borrow capital for expansion into foreign markets. The
company's revenues show a strong seasonal component, with
most sales in the May-August and November-December time
frames. Binary plans an aggressive entry into the worldwide
market which, if successful, will level cash flow by
reducing seasonality. But during the overseas advertising
campaign, and before foreign sales begin ramping up, the
firm expects an even worse than usual cash flow crunch.
Binary's financial staff determines that a 3-year,
$50,000 commercial note at 9% starting in July '92 will
provide the needed capital. To level the company's expected
cash flow profile during the next 3 years, the bank has
agreed to the following skipped payments (in order of
occurrence): Jul (1st payment), Sep, Oct, Feb, Mar, Apr;
Sep, Jan, Feb, Apr; Oct, Mar.
With this payback schedule, Binary makes only 24
payments of $2422.83 during the 36 month term of the note.
Without skipped payments, 36 payments of $1589.99 would be
made. Using the SPL, the company pays an additional 12.5%
in interest ($908). Increased interest is the usual result
of skipping payments, but not an inevitable one. In long-
term notes, starting to skip payments far enough into the
term of the note may actually lower the loan's effective
interest rate!
In any case, the cost to Binary over 3 years is
relatively small, especially if it eases a serious cash flow
problem. If revenues happen to exceed projections so that
excess cash is available, then the SPL can be accelerated
(prepaid) to save interest. This simple case illustrates
how useful an SPL can be in dealing with cash flow
variability, and why it should be considered as a financing
tool by any company, small or large, needing to borrow
money.
The second financing strategy is tapered pre-payments.
Prepaying ("accelerating") a loan is a technique frequently
used by home owners to pay off their mortgage early. This
is accomplished by adding an extra amount to the regular
periodic payment, usually monthly, which is credited
directly against principal. This technique, however, is not
restricted to mortgages, and it can be used advantageously
in any direct reduction note. Unfortunately, the most common
strategy is to add the same extra amount in each payment,
and this happens to be a very poor prepayment strategy.
Prepaying unequal amounts towards principal by gradually
tapering the extra amount added in each payment greatly
improves this technique's benefits.
A simple example makes the point. In addition to its
foreign market expansion, Binary Computer is planning to
expand its warehousing space to handle the projected
growth. The planned building addition will cost $70,000.
The firm will finance $50,000 of this cost with the proceeds
of a $50,000, 30-year mortgage loan at 9% interest. The
finance department advises management of the following
differences in various payoff strategies.
With no prepayment, the mortgage is paid off in 360
monthly installments of $402.31 (total interest cost,
$94,832.07). The simplest prepayment strategy, and the one
most often used, is to add the same extra amount each
month. If an extra $50 were added to every payment, the
loan would be paid off in 237 payments at a savings of
$37,900 in interest. This strategy yields an effective
annual percentage rate (APR) of 8.978%. Over the life of
the loan, it prepays a total of $11,850 toward the
principal.
But significantly better results are obtained using a
strategy of unequal prepayments. If, instead, an extra $100
were added to the first 60 payments and $35 to the rest,
then the mortgage is retired in only 218 payments, and
$45,614 is saved in interest. The effective APR drops to
8.635%, a substantial reduction. And the total prepayment
against principal is actually a few hundred dollars less!
Still better strategies can be developed by gradually
tapering the prepayment amount, but this simple example
illustrates the general effect.
Another critical aspect of developing a sound prepay-
ment strategy is taking into account the effect of interest
rate changes. This is particularly important to anyone
financed with an adjustable rate mortgage. When, and by how
much, the interest is changed will materially affect the
performance of any prepayment schedule. Even the best
strategy can fall apart because of interest rate
fluctuations that weren't taken into account when it was
developed. Proper consideration of this issue is a must for
anyone thinking of prepaying an ARM.