Page 34 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes using various combinations and points. Points on a mortgage refer to a payment that is
made upfront to secure the loan. A single point is a payment of one per cent of the amount
of the total mortgage loan. If you were borrowing 200,000 a single point would require
an upfront payment of 2,000.
When you are evaluating alternative mortgages, you may be able to obtain a lower rate
by making an upfront payment. This comparison will not include an after-tax comparison.
When taxes are considered, the effective costs are affected by interest paid and the
amortization of points on the loan. This analysis will require you to compare only before-
tax costs.

Zeal.com allows you to compare the effective costs on alternative mortgages. You are
considering three alternatives for a 250,000 mortgage. Assume that the mortgage will
start in December, 2006. The mortgage company is offering you a 6% rate on a 30-year
mortgage with no points. If you pay 1.25 points, they are willing to offer you the mortgage
at 5.875%. If you pay 2 points, they are willing to offer you the mortgage at 5.75%.
Questions
1. What are the mortgage payments under the three alternatives?
2. Which alternative has the lowest effective cost?
3. Can you explain how the effective rate is being calculated?

2.6 Summary

 The compensation for waiting is the time value of money, called interest. Interest is a fee
that is paid for having the use of money

 The future value varies with the interest rate, the compounding frequency and the number
of periods.

 The general formula for the future value of 1, with n representing the number of
compounding period is fv = (1 + i)n

 Finding the present value of future receipts involves discounting the future value to the
present. Discounting is the opposite of compounding.

 The general formula for the present value of 1 is pv = 1/(1+i)n
 An annuity is a series of equal payments made at equal time intervals, with compounding
or discounting taking place at the time of each payment. Each annuity payment is called a
rent.

 The future value of an annuity or amount of annuity is the sum accumulated in the future
from all the rents paid and the interest earned by the rents.

 The present value of an annuity is the sum that must be invested today at compound
interest in order to obtain periodic rents over some future time.

 An annuity that goes on for ever is called a perpetuity. The present value of a perpetuity
of C amount is given by the simple formula: C/i where i is the rate of interest.

 Compound growth rate can be calculated with the following formula:
gr = Vo(1 + r)n = Vn

28 LOVELY PROFESSIONAL UNIVERSITY