Loan Amortization

What is an amortizing loan?

An amortizing loan is a type of debt that requires regular monthly payments.
Each month, a portion of the payment goes toward the loan’s principal and
part of it goes toward interest.

Amortization Payment = Intertest Payment + Principal Payment.

There are three ways of amortizing:

1- Fixed term loans.
2- Fixed amortizing loans.
3- Fixed installment loans.

Example 1:
1000 $ loan with 10% annual interest rate for 4 years. Preparing the
amortization schedule and calculating the cost of the loan. Using fixed
term loans method.
Solution
Year Beginning Principal Interest Annual Remaining
amount payment 10% installment Balance
(1) (2) (3) = 10% (1) (4)=(2)+(3) (5)=(1)-(2)
1 1000 Zero 100 100 1000
2 1000 Zero 100 100 1000
3 1000 Zero 100 100 1000
4 1000 1000 100 1100 Zero
Cost of the loan = 100 + 100 + 100+ 100 = 400

Example 2:
1000 $ loan with 10% annual interest rate for 4 years. Preparing the
amortization schedule and calculating the cost of the loan. Using fixed
amortizing loans method.
Solution
Year Beginning Principal Interest Annual Remaining
amount payment 10% installment Balance
(1) (2) (3) = 10% (1) (4)=(2)+(3) (5)=(1)-(2)
1 1000 250 100 350 750
2 750 250 75 325 500
3 500 250 50 300 250
4 250 250 25 275 Zero
Cost of the loan = 100 + 75 + 50+ 25 = 250

Example 3:
1000 $ loan with 10% annual interest rate for 4 years. Preparing the
amortization schedule and calculating the cost of the loan. Using Fixed
installment (premium) loans method.
Solution
−n
1−( 1+ R )
P= A
R
P 1000
A= −n
= −4
=315.47
1−(1+ R) 1−(1+10 %)
R 10 %

Year Beginning Annual Interest Principal Remaining

amount payment 10% installment Balance
(1) (2) (3) = 10% (1) (4)=(2)-(3) (5)=(1)-(2)
1 1000 315.47 100 215.47 784.53
2 784.53 315.47 78.4 237.02 547.51
3 547.51 315.47 54.75 260.72 287.79
4 287.79 315.47 28.68 287.79 Zero
 Comparison between investment projects

Example:
A factory wants to own a new machine valued at 6000 pounds, which
will enable the production cost to be reduced by 1000 pounds annually
for a period of five years. If you know that the value of this machine
after five years (scrap) is estimated at 3000 pounds.
Should we buy this machine if you know that this investment will be
financed with a financial loan with an interest rate of 10%?
Solution
Calculate Net Present value (NPV):
NPV = Present value of revenue - present value of cost

( )
−5
1− (1+10 % ) −5
NPV = 1000 × + 3000 ( 1+10 % ) −6000
10 %

¿−346.4

So, we refuse to buy the machine.

Note:
If NPV (positive): buy it.
If NPV (negative): don't buy it.

Example:
The value of one of the machines is 10,000 pounds, and an annual cash
flow of 1500 pounds can be obtained by using this machine for a period
of 14 years, after which the scrap value of this machine is zero. Calculate
the internal rate of return (IRR) for this Investment.
Solution
To find internal rate of return (IRR), set NPV= zero
 −14
1−( 1+ R )
NPV =1500 × −10000
R

11% 12%
−14
1−( 1+11 % ) 1−( 1+12 % )−14
1500 × =472.8 1500 × −10000=−57.75
11 % 12 %
NPV 1∗( R2−R 1) 472.8∗( 12%−11 % )
IRR=R 1+ =11% + =0.1189145314
NP V 1−NPV 2 472.8−(−57.75)

IRR= 11.89%
Example:
It is required to analyze the following two projects through the payback
period method. If you know that the interest rate is 10%.
Sum V0 C1 C2 C3 C4
Project A 40 15 15 15 15
Project B 60 15 20 20 20

V 0 :investment amount

C : cash flow for each year

Solution:
Project A:
C 1=15<V 0=40

C 1+C 2=30<V 0=40

C 1+C 2 +C3 =45>V 0=40

So, this project requires three years to payback the investment amount.
Project B:
C 1=15<V 0=60

C 1+C 2=35<V 0=60

C 1+C 2 +C3 =55<V 0=60

C 1+C 2 +C3 +C 4 =75>V 0=60

So, this project requires four years to payback the investment amount.