Prepayment Discounts Must Have Protection

You've just opened your apparatus bids and - along with the heart-stopping prices - are some large prepayment discounts. What should you do?

We'll explore the reasons manufacturers offer prepayment discounts, how to measure if they are a good financial move and, finally, how to protect yourself when entering into these complex financial transactions.

Why would your manufacturer want to lower the price and give you a prepayment discount?

Well, an apparatus maker isn't really lowering the price. Every apparatus price includes all the costs of building the apparatus. Some are easy to see such as the chassis, pump, metal, tanks and lighting. But some costs are not tangible costs. These include engineering, insurance, administration and testing. One of the intangibles is the financial cost of building a new apparatus.

Because the construction period of a new apparatus takes several months, manufacturers must buy parts - such as a chassis - early in the process, but not get repaid for several months while the apparatus is being built. So the manufacturer incurs some kind of financial cost - either by borrowing money from a bank or by losing earned interest on a lower savings account balance - to provide these parts before getting paid.

The manufacturer realizes how much it costs and offers a discount to use a customer's (your) money instead of borrowing or reducing their savings. In effect, you, as the customer, are also becoming the banker to the manufacturer.

Two Considerations

Is it smart to take the prepayment discount?

The answer is maybe. There are really two considerations to determine if you should prepay your apparatus and take the discount - an emotional one and a financial one.

You are assuming some risk when you prepay a fire apparatus. You may be put into a position where you have paid for the truck and don't get it on time or don't receive it at all. The truck may not meet your expectations upon completion, and your recourse is limited because you've already paid the funds. While rare, these occurrences can and have happened.

You have to ask yourself if you'll sleep nights forking over hundreds of thousands of dollars in anticipation of a new apparatus a few months down the line. For some people, the risk is acceptable. For others, it's just too much. So, before you even start analyzing the financial merits of prepaying your truck, determine your comfort level of engaging in this type of transaction.

What Do You Give Up?

If you feel comfortable with the idea of prepaying the truck, the next step is to analyze if the financial benefit of prepaying outweighs the cost of prepaying. So often I talk to fire department officials who only see the discount and fail to calculate what they are giving up to get the discount.

The first question is how you will be prepaying. Will you be borrowing the funds or drawing them from your savings or reserves? Either way, you incur higher costs - by paying interest on the funds you are borrowing to prepay or by losing income because you're reducing your savings to prepay.

You must determine what you are paying or losing for the period that you don't have the money or the apparatus. If you are borrowing, your banker should be able to tell you how much interest you are paying for the months during construction. If you are prepaying for six months and are borrowing at five percent on the $300,000 prepayment amount, then you will be paying $7,500 in interest.

In the case of prepaying the apparatus from your savings, instead of calculating how much interest you pay, you must calculate how much interest income you lose. Get some help to know how much less interest you'll earn by reducing your savings to prepay the apparatus.

Whatever the method of funding the prepayment, compare the cost of prepaying against the prepayment discount (the benefit). The best way is to simply subtract the cost from the discount. If the number is greater than zero, it makes financial sense to prepay (if you're comfortable). If it's less than zero, it does not make financial sense to prepay.

Protecting Yourself

Often, the "net" discount is far smaller than the larger stated discount in the manufacturer's offer. It may even be greater than zero and make financial sense. Yet many departments look at the true prepayment discount and determine that the benefit is not enough to warrant the risks they may take by prepaying.

How can you protect yourself?

At this point, you understand why the manufacturer offers the prepayment discount, you've determined that you're comfortable prepaying and that the prepayment makes financial sense. The next step is managing the risks.

First, require a performance bond. A performance bond is a type of insurance policy (usually issued by an insurance company) to ensure that your manufacturer "performs" by completing your apparatus. The bonding company will have analyzed the manufacturer's financial strength and assigned a risk rating for its ability to complete contracts.

Each manufacturer pays a bond cost that is stated in terms of dollars per thousand. As an example, the manufacturer may pay a bond cost of $5 per $1,000 of contract. For a $300,000 truck, the manufacturer will pay $1,500. Bond costs are like golf scores, the lower the better. This means a manufacturer with a higher bond cost is deemed to be more likely to fail or "not perform."

If the bond cost is not included in the price of the apparatus, you may have to pay this bond cost, and this will further reduce your benefit from prepaying.

If you have to call a bond because your manufacturer does not perform, remember that the bonding company is in the money business, not the apparatus business. So, the bonding company will not really have another truck built for you. Rather, it will issue you a check for your damages by the non-performance.

Replacement Cost

I hear all the time that a bonding company is obligated to build a new apparatus. That's not true. You may get a check for the full amount of the contract, but you'll have to contract with another manufacturer to build the apparatus. This may mean that the replacement cost of the apparatus has increased significantly, and you now have to buy a higher priced apparatus and pay for the difference.

Or, if the truck is partially built, you may end up with the half-built truck and a check for some amount that the bonding company determines covers your damages. Again, you will probably be stuck paying the difference for the higher replacement cost.

A performance bond is not a magic bullet. It simply eliminates total loss of your prepaid funds. You may still be at risk for some costs even with this protection.

A second protection is a payments bond. This is a bond to ensure that all suppliers are paid in the event of non-performance by the manufacturer. You will be protected against owning a truck encumbered with a mechanic's lien for an unpaid chassis, for example.

In summary, prepayment discounts are common in the fire apparatus industry. While seemingly simple, they are really fairly complex financial offers with a lot of repercussions. Yet, they can lower your apparatus purchasing costs if they are analyzed and managed properly.

Editor's Note: John R. Hill, an apparatus budgeting consultant, is president of ENVIZION Financial and a nationally-recognized speaker and author regarding the issues of buying and financing fire apparatus. He lives in Indianapolis and is working on a book about how fire departments can strengthen their financial condition.

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