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. (20 Marks)
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 Marks)
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? No
more than 200 words. (5 Marks)
Hint: Think about the advantages and disadvantages of each option and how are they being applied
in this case study.
Problem 2 (35 Marks)
Assume that your friend from Problem 1 had decided to go with the floating rate option and she bought the apartment. Now three years have passed, due to the work relocation, your friend is leaving Brisbane. She decides to rent out the apartment. She will hire an agent to look after the apartment, but she would
like you to help her to look at the financials of the property first.
The following are a few assumptions:
• The property is well maintained by your friend, and it is now available for move-in.
• The new tenants do not own any furniture, and your friend has agreed to provide furniture and
white goods. Since your friend already have some furnitures in the apartment, it will only cost her
another $400 to meet the tenants’ need. Assume that your friend could sell her old furniture for
$1,200, if not needed.
• The term of the contract is two years.
• The rent is paid fortnightly at $980. And the tenant will move in and start to pay the rent in two
weeks. (Assume there are 26 fortnights in a year)
• Ignore the bond payment that the tenant will lodges to RTA.
After this contract expires, the agent will go and find a new tenant. Assume he can find a new tenant
and sign a contract for three years, after which your friend is going to sell the apartment. The agent,
based on his experience, has provided you with the following estimations:
• After the previous tenant left, there will be some wear and tear on the furniture and the apartment.
Therefore, your friend expects to spend $300 to repair them before the apartment can be rented
out again.
• It is unlikely to have the new tenant move in right after the old tenants move out. Assume there is
a 40% chance you can rent out the apartment in six weeks.
• In the meantime, to make your apartment look more attractive to the market, your friend would
offer an incentive as 4 months free Internet to the new tenant, and it will cost $60/month.
Here are some additional assumptions:
• rent will increase by 3% yearly over the evaluation period.
• The apartment will appreciate by 2% per year.
• The agent charges a fixed rate commission of 7% of the rental income.
• Ignore tax.
• As the owner of the apartment, your friend should pay the following cost. Expenses will increase by
2% yearly over the evaluation period.
– City council rate would be $375, paid quarterly.
– Water and Waste bill would be $239, paid quarterly.
– Body corporate rate $4,500 per year.
Required:
1. Prepare two separate spreadsheets for Problem 2. One for the “Basic Cashflow” and another one
for the “Discounted Cash Flow (DCF)”. (30 marks)
Hints: The Guest Lecture provides an overview of how you would approach this question. You may
need to use some information from Problem 1. You can follow the templates provided in the Guest
Lecture.
2. Discuss what discount rate you have used in your calculation in part 1, the discussion should be no
more than 150 words. (5 marks)
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