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.