The general rule of thumb when prepaying debt is that if you are trying to cut costs, pay down the highest-interest-bearing debt that doesn’t carry any prepayment penalties.
Al Worknoplay came in to us in mid-January and said, “Gentlemen I got a problem and it’s unlike anything I’ve ever had before.” Our ears perked up and he had our interest. At first we were worried he had been hanging around with Tiger a. k. a. “Cheetah” Woods. We thought he had girl trouble and we knew he had come to the right place. To our dismay he whipped out his bank statement and our focus quickly shifted to the significant positive cash balance in his account. Al has never had this kind of cash available at this time of year and was looking for guidance as to where some of this cash should go.
We completed a cash flow projection and realized that Al would not be using his operating loan at any point in 2010. Although a very comfortable position, at current interest rates this wouldn’t be an efficient use of the capital. Today’s interest rate environment is such that funds sitting in an operating account or short-term deposit are basically providing no return. We discussed expansion options with Al and he doesn’t foresee anything big happening. His options at this point were then the following:
Pre-buy 2010 inputs at a discounted price
Make off-farm investments
Retain inventory and speculate on rising commodities
Purchase iron with cash
GOOD RETURN FROM
Al already purchased most of his 2010 inputs in an attempt to reduce taxable income. He also figured prices of these inputs were attractive. Further buying of 2010 inputs at this point will be minimal and not utilize a lot of cash.
Al’s opportunity to prepay debt is significant as he has some term loans that will be up for renewal in February. At this point he can pay down an 8.0 per cent term loan with no penalty. In effect, Al will be getting an 8.0 per cent return on his money, which is almost eight per cent more than what it would generate in the operating account. The general rule of thumb when prepaying debt is that if you are trying to cut costs, pay down the highest-interest-bearing debt that doesn’t carry any prepayment penalties. If you are trying to increase cash flow, pay down the debt with the shortest remaining amortization.
Al loved the idea of earning eight per cent on an investment, however he was concerned that if he prepaid too much here in January and he found out inventory didn’t store properly, he may regret prepaying that debt. To put his mind at ease,
we set up a schedule with three planned principle curtailments a year — one at seeding, one after spraying and one after harvest. At each point Al will reassess the situation and if concerns have propped up, the plan can be adjusted.
A big consideration when prepaying debt is that the principle curtailment is done with after-tax dollars. The other consideration is the accessibility of this cash in the future. If this money turns out to be needed in the future, costs will be incurred in setting up a new loan — loan fees, legal costs and time.
Al and his wife have never invested off the farm before and have built up significant room to contribute to RRSPs. Al’s wife works off the farm and consistently pays $10,000 to $12,000 in tax a year. Al
often forgets that she pays this tax as it comes right off her cheque. We discussed making a significant contribution and the fact that it would result in sizable refund. This refund when received could then be used to prepay debt.
STICK TO SOUND MARKETING
Al‘s present cash position allows him the luxury of delaying commodity sales from his earlier projection. We cautioned Al and reminded him that his primary business thus far has been a farming business and not a commodity speculation business. Just because you have some money doesn’t necessarily affect your ability to determine where the canola market is going!
At the start of the discussion Al also indicated he wanted to at least talk about some unnecessary machinery purchases. We went back to our machinery analysis that was done last year and it indicated that Al already had a higher machinery investment per acre than the industry average. Al agreed but we still spent most of the day talking about combines and tractors.
At the end of the day, Al has committed to a plan that includes a sizable RRSP contribution for him and his wife as well as prepaying some debt at three different periods during the year. This way he anticipates receiving an income tax refund, and he is investing the money in a secure spot — his farm — earning eight per cent.
Andrew DeRuyck and Mark Sloane manage two farming operations in southern Manitoba and are partners in Right Choice Management Consulting. With over 25 years of cumulative experience, they offer support in farm management, financial management, strategic planning, and mediation services. They can be reached at [email protected]and [email protected]or 204-825-7392 or 204-825-8443.