Problem 1

Your friend wanted to buy a two-bedroom apartment in St. Lucia that is priced at $560,000. However, she does not understand the logic behind a mortgage payment. Your training at UQ Business School has prepared you well for this situation and you are going to help her with your knowledge from "FINM7401 Finance" to assess different finance options as shown in below:

Floating-rate Mortgage Option: ABC Bank offers a mortgage with a down payment of $100,000 (paid on the day of purchase of the apartment) and the balance financed by a 3.79% p.a. fixed interest (compounded quarterly) mortgage with a term of 20 years with quarterly payments (first payment is paid on the day of purchase of the apartment). Unfortunately, this fixed interest rate will last only two years and then the rate will be variable for the remainder of the mortgage. ABC Bank estimates that the variable rate will be 5.38% p.a. (compounded quarterly) at the beginning of year 3. For your calculation, this variable rate is assumed to remain constant over the remaining life of the mortgage. Application fees for this loan are $2,000, which must be paid in cash on the date of purchase.

Interest Only Option: ABC Bank also offers you an interest-only option. This option might be interesting for those who want to have a greater flexibility with their cash flows. You will be paying only interest for the first five years, after that, you will be paying interest and the principle for the remaining 25 years. You would make monthly payments over the full life of the loan. A down payment of $95,000 is to be paid on the day of purchase and the interest rate is fixed at 5% p.a. (compounded monthly).

Off-the-Plan Option: A real-estate agent told you that as a first-time homeowner, your friend will be eligible to receive a first home owner’s grant of $10,000 if you buy a brand new apartment. Luckily, there is a development project offering a new apartment that is almost the same as the one that your friend likes, and it also priced at $560,000. However, this new property is currently selling as ‘off-the-plan’ (‘off-the-plan’ means a property that hasn’t been built yet). It will be exactly two years before your apartment settles. For an off the plan purchase, you will be paying 10% deposit when you sign the contract with a developer (you will sign it today) and the remaining balance will due on the settlement date. Your 10% deposit with the developer will be earning an interest at 4% p.a. (compounded monthly).

Let’s assume on the settlement date. You decide to pay another 10% of the purchase price. The $10,000 grant will be credited to your saving account on the settlement date (for easy calculation purposes) and you will use it to pay off your mortgage. The remaining balance will be financed by the mortgage, where the first repayment happens one month after the settlement date. The application fee for this loan is $3,000 in cash on the settlement date. You will take out a 30-year mortgage paying a fixed at 5% p.a. (compounded monthly). Meanwhile, you will be renting a unit before your apartment is settled. The monthly expense for renting is $880 (due at the beginning of every month, beginning today).

Other Assumptions:

• To facilitate your analysis, assume that your bank allows you to lend (and borrow) at a rate of 4% p.a., compounded daily.

• Assume your friend will sign the contract to buy the apartment by the end of today, once you figured out which option is better.

Required:

1. Complete excel worksheets with the complete payment schedules for all three financing deals. The payment schedules should show the amount and timing of all payments. Graph, the Interest and Principal, amounts out of the payments across time, in each case.

Your Excel file should include all workings, calculations, schedules of payments, and graphs. Formulas for the calculations should have cell references wherever possible. If you have computed a number incorrectly and just typed that number into the spreadsheet (or typed a formula using numbers when cell references could have been used), you will not receive partial credit for any portion of you computation that is correct.

2. Complete a Comparison Chart. You should calculate and compare these three options using both methods: (1) Internal Rate of Return (IRR), and (2) Net Present Value (NPV). Draw a conclusion on which option you are going to choose using one or two sentences for each method (Only saying "option 1" is not sufficient, show some reasoning). (10

3. Based on your conclusion in Part 2 above, discuss the most viable option for your friend. Be sure to draw upon the financial knowledge you have learnt so far in this course when making your decision. You should discuss which method (IRR or NPV) is more suitable for your evaluation, and why?

Hint: Think about the advantages and disadvantages of each option and how are they being applied in this case study.