Real-Life Math
Mortgage brokers must have strong math skills. "They are very, very important," says Don Taylor. He is a commercial mortgage broker.
From calculating interest payments to penalties, mortgage brokers use math constantly. "You've got to be a numbers person because you are dealing with numbers on a regular basis," says Don Reehoorn. He is a residential mortgage broker.
Your clients want to know how much the property will be worth in the future using the current dollar value. But why would they want to know that? Because the dollar value of the property will inflate over time. And that "inflated" number does not tell the investors if they are getting their money's worth because the value of money will decrease over time. So they ask you to do a discounted cash flow analysis.
This has two uses. The first is to calculate the future value of revenues. This is called present value analysis. The second is to analyze the rate of return on an investment. This is called internal rate of return analysis.
The idea of the cash flow analysis is based on two principles. A dollar today is worth more than a dollar promised in the future. Second, inflation reduces the value of money. An investor needs some return just to preserve the value of the capital.
If inflation is 4 percent per year, an investor needs a minimum 4 percent after-tax return just to stay even. Part of return on investment, then, is compensation for inflation.
This minimum rate return is called the discount rate. It converts benefits promised in the future into today's value. That is called the present value. So how do you calculate the present value?
Use this formula:
Present Value = Future Return / Discount Rate
Discount Rate = (1 + I)
Consider this example. If the discount rate I = 15 percent, a future investment return of $115,000 has a present value of only $100,000.
Present Value = Future Return / Discount Rate
Present Value = $115,000 / 1.15
Present Value = $100,000
The example above is based on a one-year investment period.
You can also apply this formula over time. But note: the value of the discount rate changes over time. That is because a 15 percent return on your investment has more value now than in the future. So you need to calculate a discount factor that reflects this.
Here is the formula for a discount factor that calculates the present value of a dollar for each year of investment, N.
Discount factor = 1 / [(1 + I)N]
These two simple formulas allow lenders to find out the value of any property. The value of the property also tells you -- at least in theory -- how much investment that property is worth.
A store has a base cash flow of $100,000. Assume that earnings will go up by $20,000 a year for 3 years. The discount rate is 15 percent. What will the present value be at the end of the 3 years?