Lecture 7 - Amortization and NPV

Amortized Loans
Another topic in finance where compound interest is very useful is loan amortization, or the payment of a loan in
instalments over a specified period of time. An amortized loan is a loan that is to be repaid in equal payments over a
specified period of time.
In computing for amortization loan it is important to make an amortization schedule. An amortization schedule is
a table showing payments to be made, the due dates and the breakdown of each payment – the portion that goes to the
principal and how much goes to the interest.
The formula to calculate the equal payments in an amortized loan is:
𝑃 (𝑖)
𝑃𝑀𝑇𝑎𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛 =
1 − ((1 + 𝑖)−𝑛 )
Example
A home improvement loan in the amount of P100,000 with an interest rate of 6%. The term loan is for 5 years. Compute
for the equal payments at the end of every year that should be made until the loan (including interest) is paid off.
where:
P = Principal amount = P100,000
i = 6%
n = 5 years
𝑃 (𝑖)
𝑃𝑀𝑇𝑎𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛 =
1 − ((1 + 𝑖)−𝑛 )
P100,000 (0.06)
=
1 − ((1 + 0.06)−5 )
P 6,000
=
1 − (1.06−5 )
P 6,000
=
1 − (0.74725 … . )
P 6,000
=
0.252741 …
𝑃𝑀𝑇𝑎𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛 = 𝐏 𝟐𝟑, 𝟕𝟑𝟗. 𝟔𝟒

Amortization Schedule
Amount Borrowed : P 100,000

Years: 5
Interest rate: 6%
PMT = P 23,739.64
Year Beginning Payment Interest Repayment of Ending Balance
Amount Principal
1 P100,000 P23,739.64 P 6,000 P17,739.64 P82,260.36
2 82,260.36 23,739.64 4,935.62 18,804.02 63,456.34
3 63,456.34 23,739.64 3,807.38 19,932.26 43,524.08
4 43,524.08 23,739.64 2,611.44 21,128.20 22,395.89
5 22,395.89 23,739.64 1,343.75 22,395.89 0.00
Consider the following:
1. The amount if interest paid each year is calculated by multiplying the beginning balance for that year by the
interest rate of 6%. For instance, the interest rate of 6% was multiplied by the full amount of the loan of P100,000
on the first year (P6,000).
2. Each payment is split into two different parts. A portion goes to interest and a portion goes to the principal. As in
the case of the first year again, since the interest payment is P6,000, it was deducted from the payment of
P23,739.64. The remainder went to the payment of the principal in the amount of P17, 739.64.
3. By the end of the first year, the amount of the loan has been reduced to P82, 260.36. That same amount will be
the beginning balance on the second year.
4. The process is repeated until the loan balance is P0.00, meaning the loan is fully paid.
5. Notice that the portion of the payment that goes to interest gets smaller as more payments are made and the
portion that goes to the principal gets bigger.
BASIC APPLICATION OF THE TIME VALUE OF MONEY ON INVESTMENT PROBLEMS
(COMPUTING FOR NET PRESENT VALUE OR NPV)
One very useful application of the time value of money is when the Net Present Value Method is used to
determine whether a project should be accepted or rejected by a company. The basic decision rule is to accept the project
if the net present value is positive and reject if the net present value is negative. This capital budgeting technique is
applied by determining first all the relevant cash flows, positive and negative, of a project then calculating the present
values of these cash flows using an appropriate discount rate (given the riskiness of the project).
For example, a project requires an initial outlay of P100,000. The relevant inflows associated with the project are
P60,000 in year one and P50,000 in years two and three. The appropriate discount rate for this project is 11%. To compute
the present value:
P60,000 P50,000 P50,000

NPV= - P100,000 + + +
(1+i)n (1+i)n+1 (1+i)n+2
P60,000 P50,000 P50,000

NPV= - P100,000 + + +
(1+11%)1 (1+11%)2 (1+11%)3
NPV= - P100,000 + (P60,000 x 𝑃𝑉𝐼𝐹(11%,1) ) + (P50,000 x 𝑃𝑉𝐼𝐹(11%,2) ) + (P50,000 x 𝑃𝑉𝐼𝐹(11%,3) )
NPV= - P100,000 + P54, 054.05 + P40, 581.12 + P36, 560.40
NPV= P 31, 195. 57

Since the net present value or NPV is positive, then the company should accept the project.
RISK AND RETURN TRADE OFF
The risk-return trade off is the principle that potential return rises with an increase in risk. Low levels of uncertainty
or risk are associated with low potential returns, whereas high levels of uncertainty or risk are associated with high
potential returns. According to the risk-return trade off, invested money can render higher profits only if the investor is
willing to accept the possibility of losses.
The appropriate risk-return trade off depends on a variety of factors including risk tolerance, years to retirement
and the potential to replace lost funds. Time can also play an essential role in determining a portfolio with the appropriate
levels of risk and reward. For example, the ability to invest in equities over the long-term provides the potential to recover
from the risks of bear markets and participate in bull markets, while a short time frame makes equities a higher risk
proposition.
For investors, the risk-return trade off is one of the essential components of each investment decision as well as
in the assessment of portfolios as a whole. At the foundation of this assessment, the consideration of the risk as well as
the reward of an investment can determine whether taking action makes sense or not. At the portfolio level, the risk-
return tradeoff can include assessments on the concentration or the diversity of holdings and whether the mix presents
too much risk or a lower than desired potential for returns.

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Amortized Loans

The formula to calculate the equal payments in an amortized loan is:

P = Principal amount = P100,000

𝑃𝑀𝑇𝑎𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛 = 𝐏 𝟐𝟑, 𝟕𝟑𝟗. 𝟔𝟒

Amount Borrowed : P 100,000

Consider the following:

BASIC APPLICATION OF THE TIME VALUE OF MONEY ON INVESTMENT PROBLEMS

(COMPUTING FOR NET PRESENT VALUE OR NPV)

P60,000 P50,000 P50,000

P60,000 P50,000 P50,000

NPV= - P100,000 + (P60,000 x 𝑃𝑉𝐼𝐹(11%,1) ) + (P50,000 x 𝑃𝑉𝐼𝐹(11%,2) ) + (P50,000 x 𝑃𝑉𝐼𝐹(11%,3) )

NPV= - P100,000 + P54, 054.05 + P40, 581.12 + P36, 560.40

NPV= P 31, 195. 57

RISK AND RETURN TRADE OFF

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