The All Cost The All Cost Alternatives ProblemAlternatives Problem

©2002 Dr. Bradley C. Paul©2002 Dr. Bradley C. Paul

Types of ProblemsTypes of Problems

We’ve met Invest and EarnWe’ve met Invest and Earn Objective is to find whether a single cash flow Objective is to find whether a single cash flow

meets an earnings of objectivemeets an earnings of objective Usually is Rate of Return high enough - do NPVUsually is Rate of Return high enough - do NPV Sometimes concerned about a future accumulation Sometimes concerned about a future accumulation

of money - do NFVof money - do NFV

Some Problems require expendituresSome Problems require expenditures Decision is already made to do somethingDecision is already made to do something Objective becomes to find most cost effectiveObjective becomes to find most cost effective

All Cost AlternativesAll Cost Alternatives

Engineers design something - sales marketsEngineers design something - sales markets engineers see only cost sideengineers see only cost side

Environmental LawsEnvironmental Laws an investment is required as a condition of doing an investment is required as a condition of doing

businessbusiness

In Personal Life you have basic needsIn Personal Life you have basic needs must meet them as a condition of being able to must meet them as a condition of being able to

function productivelyfunction productively

Some Events in Both Personal and Some Events in Both Personal and Business Life are Measured by the Business Life are Measured by the Cost of Something Needed, Rather Cost of Something Needed, Rather than by Profitthan by Profit

Example - Herby Housing needs a place for his Example - Herby Housing needs a place for his family to live while he goes to school at SIU. family to live while he goes to school at SIU. Herby is debating whether to rent an apartment Herby is debating whether to rent an apartment or buy a houseor buy a house (he has military benefits and his wife (he has military benefits and his wife

Hanna will be working).Hanna will be working). Herby finds that the cost of Herby finds that the cost of renting will be $650/month. Herby does some renting will be $650/month. Herby does some house shopping and finds he can get a house in house shopping and finds he can get a house in DeSoto for $28,000. Herby expects to take 5 DeSoto for $28,000. Herby expects to take 5 years for school and wants to know what his years for school and wants to know what his housing is really going to cost?housing is really going to cost?

Herby Builds a Cash FlowHerby Builds a Cash Flow

$650Rent

$650Deposit

$650 Rent $730 Rent

$650 DepositRefund0 1 2 3 4 5 6 7 8 54 55 56 57 58 59 60

61

Cash Flow for Renting Scenario

Herby assumes rent will go up $20/year with inflation

The NPV of this cash flow will surely be negative - does that mean no go?

Herby Studies BuyingHerby Studies Buying

The house will cost Herby $28,000. (Herby will The house will cost Herby $28,000. (Herby will finance that)finance that)

Herby needs a 10% down payment $2,800Herby needs a 10% down payment $2,800 Herby Herby discovers discovers that there are “Closing Costs” that there are “Closing Costs”

when you buy a housewhen you buy a house Appraisal fee $250Appraisal fee $250 Flood Determination Letter $150Flood Determination Letter $150 Credit Report $25Credit Report $25 Dead Registration $15Dead Registration $15 Mortgage Registration $15Mortgage Registration $15 Private Mortgage Insurance $280Private Mortgage Insurance $280

Herby’s first time home Herby’s first time home buyers adventure buyers adventure continuescontinues

Herby will need to get Home Owners Insurance $600/yearHerby will need to get Home Owners Insurance $600/year Herby Herby discoversdiscovers that banks also like to charge their little that banks also like to charge their little

“fees” for starting up a loan“fees” for starting up a loan Herby can get a local loan from Union Shafters BankHerby can get a local loan from Union Shafters Bank

Union Shafters will simply recover closing costsUnion Shafters will simply recover closing costs Union Shafters will charge 8% annual interest compounded monthly Union Shafters will charge 8% annual interest compounded monthly

over 15 yearsover 15 years

Herby could also get a loan over the internet from Inter Your Herby could also get a loan over the internet from Inter Your Pocket Mortgage LendersPocket Mortgage Lenders 5% of face amount loan initiation - covers all closing costs5% of face amount loan initiation - covers all closing costs 1.5 points (rolled into the mortgage)1.5 points (rolled into the mortgage) 6.25% annual interest compounded monthly over 30 years6.25% annual interest compounded monthly over 30 years

Herby Compares LoansHerby Compares Loans

Union ShaftersUnion Shafters Closing Costs $735Closing Costs $735 Down Payment $2,800Down Payment $2,800 Needs $3,535 nowNeeds $3,535 now

Mortgage PaymentsMortgage Payments Loan Amount $28,000 - $2,800 Loan Amount $28,000 - $2,800 (down payment)(down payment) = =

$25,200$25,200 Loan over 15 years at 8% interest - How do I get Loan over 15 years at 8% interest - How do I get

the Payments?the Payments?

Enter Our Super HeroEnter Our Super Hero

I need to convert a present value amount I need to convert a present value amount into an annuityinto an annuity A/P * Present Loan = Annuity of Loan A/P * Present Loan = Annuity of Loan

PaymentsPayments cancellation of units checks outcancellation of units checks out

What is the value of n?What is the value of n? 15 years * 12 months/year = 18015 years * 12 months/year = 180 What is the value of i?What is the value of i?

Oh NO You Don’tOh NO You Don’tWe is smart students. We know We is smart students. We know that interest rate did not match that interest rate did not match the compounding period.the compounding period.

Annual interest is 8%Annual interest is 8% But it is compounded monthlyBut it is compounded monthly Get the monthly rateGet the monthly rate

8%/12 = 0.006678%/12 = 0.00667

Plug and CrankPlug and Crank { 1.00667{ 1.00667180 180 * 0.00667}/{1.00667* 0.00667}/{1.00667180 180 -1} = -1} =

0.0095590.009559 $25,200 * 0.009559 = $240.88/month$25,200 * 0.009559 = $240.88/month

Now Check Out the Now Check Out the Internet BankInternet Bank

Loan Amount $25,200Loan Amount $25,200 5% initiation fee $25,200*0.05 = $1,2605% initiation fee $25,200*0.05 = $1,260

Whats this point businessWhats this point business Lenders discount interest rate on the loan for an up Lenders discount interest rate on the loan for an up

front payment of a percentage of the loan amount. A front payment of a percentage of the loan amount. A point is a catchy way of saying what percent of the point is a catchy way of saying what percent of the loan amount they will charge (they often roll it into loan amount they will charge (they often roll it into the loan)the loan)

$25,200 * 0.015 = $378$25,200 * 0.015 = $378 Loan amount is $25,578Loan amount is $25,578

Get Our Monthly Get Our Monthly PaymentsPayments

What is n (30 year loan) n= 360What is n (30 year loan) n= 360 Watch out for i compounding period Watch out for i compounding period

mismatch trickmismatch trick 6.25%/12 = 0.00520836.25%/12 = 0.0052083

Plug and CrunchPlug and Crunch A/P A/P 0.0052083, 360 0.0052083, 360 = 0.006157= 0.006157

$25,578 * 0.006157 = $157.49$25,578 * 0.006157 = $157.49

Some Initial StatisticsSome Initial Statistics

Action Up Front Cost Monthly CostAction Up Front Cost Monthly Cost Rent $1,300 $650Rent $1,300 $650 Buy with US $3,535 $240.88Buy with US $3,535 $240.88 Buy with IYP $4,060 $157.49Buy with IYP $4,060 $157.49

Buying is looking really good right now Buying is looking really good right now except for those scary up front costs.except for those scary up front costs.

Which loan should Herby get if he does Which loan should Herby get if he does buy the house?buy the house?

Building some cash flowsBuilding some cash flows

………………………...

0 1 2 3 4 5 6 7 8 9

Resell theHouse

Interest is tax deductible but the loans have different interestrates

Loans have different terms so one loan will be more paid-offwhen the house sells (they will build “equity” faster)

69 months(assumed takes9 months to sellhouse)