Never a better time to fund capital investment

With cereal prices at record highs and interest rates likely to rise, it looks like a good time to borrow money to fund much-needed capital investment. Robert Harris gets some timely advice



Many businesses will be considering upgrading ageing plant and machinery now that commodity prices have rebounded to new highs. But, while it’s tempting to think such values are here to stay, fuelled by increased demand from a rising global population, only two years ago a similar price spike was followed by a spectacular crash.


That could easily be repeated, says Philip Wynn of Wynn Business Partnerships. “Grain prices may be good at the moment, but commodity market volatility has not gone away. There will be a market correction at some stage, and you don’t want to be left with a high cost structure and low margins.”


Question plans hard, he advises. “Carefully assess the need, benefit and risk, as well as the effect on the overhead cost structure of the business. Be sure the loan stacks up on average returns.”


Dick Mason, policy director for Lloyds Banking Group Agriculture, also urges caution. “I have no doubt that a lot more thought goes into choosing a new piece of kit or grain storage than how to finance it.


“So often, the availability of the finance seems to be the main concern, while structuring the loan to match the needs of the business and manage risk are given little thought.”


Assessing the cost of a loan is essential. The bank base rate has been at an all-time low for 22 months, which has certainly helped a lot of businesses through some tough times, says Mr Mason. “It’s tempting to think it will stay at 0.5%, but it won’t.


“Inflationary pressure in the economy is certainly focusing attention on a rise in the base rate, although we don’t expect a rise until quarter four this year, to 0.75%. In 2012 we expect a gradual increase, with prospects of a return to a rate of 4-5% by 2013.”


Fixed rates have been gradually rising since November in response to the outlook for base rates. Currently, borrowers can obtain funds over 15 to 20 years for about 4% before lenders’ margin, says Mr Mason.


“Base rates have averaged 8% over the past 30 years, so fixing long-term money should be given serious consideration. As a rule of thumb, if a 7% hike in the base rate would put significant pressure on the business, fix the rate.”


Mr Wynn suspects the base rate might move up faster, this year at least. “Inflation is remaining at stubbornly high levels – the Consumer Price Index rose to 3.7% at the end of 2010, which is likely to increase the pressure to raise interest rates.”


Money markets are factoring in higher rates – the five-year rate increased by 0.75% in four weeks to end 2010 at 2.95%, and three-year swap rates stand at 3.75%. “A normal base rate is around 5%, and markets are suggesting we could see that again in two to three years.”


The very real prospect of higher interest rates means shorter-term deals have obvious attractions. “But be sure to relate your plans to business profitability and risk of return – ensure you can pay back the higher amounts in an average year in line with cashflow.”


Choice of loan is never straightforward and depends on the size and type of investment, says Mr Wynn.


“Whatever you choose, carefully consider its effect on existing business cashflow. Repayments or overdraft increments must be timed so they avoid periods of peak working capital requirement.”


For machinery, manufacturer financing often makes sense, he notes. “It is generally subsidised – often the makers are part of a large European operation with access to cheaper money. And finance is a relatively small proportion of the purchase cost, so rates can be pretty competitive.”


An overdraft can be useful to fund short-term loans, he advises. “Provided you stay within current limits, it is probably cheaper than taking out a two- to five-year loan, because interest rates are likely to go up and you won’t have to pay an arrangement fee.”


Hire purchase typically costs around 5%, which has made it relatively expensive since base rates fell. “Nevertheless, a lot of people use it to buy machinery over three to five years – it is easy and secured against the equipment. And once interest rates rise, hire purchase could look increasingly attractive again.”


For those looking for longer-term loans, a fixed rate is the obvious choice, says Mr Wynn. “If you are borrowing a larger amount, look for a competitive rate and secure it. You can draw up budgets and cashflows with confidence – with a variable rate loan, you don’t know where interest rates will end up, and how quickly they will get there.”


Mr Mason believes the overdraft should be reserved for working capital, funding the ongoing operation of the business.


“With increasing input costs, notably fertiliser, fuel and machinery, many limits have come under pressure. Funding capital expenditure on the overdraft adds to this pressure and distorts the working capital requirement.” That could, in some cases, cause a bank manager undue concern, he warns.


Loan funding clearly identifies the investment and its repayment, he maintains. “Contrary to popular belief, there should be little or no difference in the cost.”


It might be worth dividing the loan into a number of different terms, fixing some for 10 years, some for 15 years and some for 20 years, he adds. “That way, if cash generation allows, you can pay some of the loan off earlier without facing an early redemption fee.


“I see little point in loan terms over 20 years, as the annual repayments are only marginally less and the risk increases, often with the next generation being saddled with your debt.”


Ideally, the length of term should match the life of the investment, given that the investment should generate income to repay it, he advises.


“It is poor planning to still be paying for an investment that now needs replacing with additional debt.” On the other hand, he says, locking in to a very short capital repayment term can put too much pressure on the overdraft, giving the impression that the business is struggling, when it is not.


Only in exceptional circumstances, such as an anticipated asset sale, is an interest-only loan justified. These often carry a premium, given the cost of such capital in the money markets, says Mr Mason.


 


Time to borrow?


• High cereal prices


• Cost of borrowing low, but rising


• Assess plans for need, benefit and risk


• Fix rate for longer term loans


• Avoid overly short terms which can hit cash flow


 


Need for speed?


Those considering borrowing to fund plant or machinery purchases should think about acting soon, Mr Wynn advises.


“Capital allowances are in a transitional period. You have 13 months to take advantage of 100% tax relief on the first £100,000 – after April 2012 this will drop to just £25,000. If everything else stacks up, it makes absolute sense to invest in the next year.”