Notice that in each year, the interest paid is given by the beginning balance multiplied by the interest rate. Also notice that the beginning balance is given by the ending balance from the previous year.

Probably the most common way of amortizing a loan is to have the borrower make a single, fixed payment every period. Almost all consumer loans (such as car loans) and mortgages work this way. For example, suppose our five-year, 9 percent, $5,000 loan was amortized this way. How would the amortization schedule look?

We first need to determine the payment. From our discussion earlier in the chapter, we know that this loan's cash flows are in the form of an ordinary annuity. In this case, we can solve for the payment as follows:

$5,000 = C X {[1 - (1/1.095)]/.09} = C X [(1 - .6499)/.09]

This gives us:

The borrower will therefore make five equal payments of $1,285.46. Will this pay off the loan? We will check by filling in an amortization schedule.

In our previous example, we knew the principal reduction each year. We then calculated the interest owed to get the total payment. In this example, we know the total payment. We will thus calculate the interest and then subtract it from the total payment to calculate the principal portion in each payment.

In the first year, the interest is $450, as we calculated before. Because the total payment is $1,285.46, the principal paid in the first year must be:

The ending loan balance is thus:

The interest in the second year is $4,164.54 X .09 = $374.81, and the loan balance declines by $1,285.46 - 374.81 = $910.65. We can summarize all of the relevant calculations in the following schedule:

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

PART THREE Valuation of Future Cash Flows

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