Amortized Loans

With a pure discount or interest-only loan, the principal is repaid all at once. An alternative is an amortized loan, with which the lender may require the borrower to repay parts of the loan amount over time. The process of providing for a loan to be paid off by making regular principal reductions is called amortizing the loan.

A simple way of amortizing a loan is to have the borrower pay the interest each period plus some fixed amount. This approach is common with medium-term business loans. For example, suppose a business takes out a \$5,000, five-year loan at 9 percent. The loan agreement calls for the borrower to pay the interest on the loan balance each year and to reduce the loan balance each year by \$1,000. Because the loan amount declines by \$1,000 each year, it is fully paid in five years.

In the case we are considering, notice that the total payment will decline each year. The reason is that the loan balance goes down, resulting in a lower interest charge each year, whereas the \$1,000 principal reduction is constant. For example, the interest in the first year will be \$5,000 X .09 = \$450. The total payment will be \$1,000 + 450 = \$1,450. In the second year, the loan balance is \$4,000, so the interest is \$4,000 X .09 =

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

III. Valuation of Future Cash Flows

6. Discounted Cash Flow Valuation

© The McGraw-Hill Companies, 2002

CHAPTER 6 Discounted Cash Flow Valuation

\$360, and the total payment is \$1,360. We can calculate the total payment in each of the remaining years by preparing a simple amortization schedule as follows:

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