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What is Amortization? How does it calculate?


Amortization: It is a way of paying long term debt on intangible assets at regular interval and in fixed amounts.
Example: A company spends Rs. 5, 00,000 for purchasing trademark for a product and they write off that expense by equally distributing for 5 years means Rs.1, 00,000  write off each year and in monthly (1, 00,000/12) Rs. 8333 that is known as amortization.

 
Advantages of Amortization :
·         A loan amount is divided into equal monthly payments which makes it easy for borrower to pay in time.
·         It is good for borrower who does not have enough money to purchase such assets like machinery , furniture etc.
·         It also give tax- benefits to borrower.

Disadvantages of Amortization:
·         The interest rate is high if the loan period is more.
·         If the interest rate is high and in the rate falls in that case borrower has to pay more interest.

Amortized Vs Unamortized Loan :
Amortized loan is divided into equal monthly payment which includes interest and principal amount. But in unamortized loan the borrower has to pay only interest amount and at the end of the loan period he will pay full principal amount.

Amortization Vs Depreciation:
Amortization is charged on intangible assets like loan. But depreciation charged on tangible assets like machinery.


Formula:
A = P *r (1+r) n/ (1+r) n-1
&
P = A [1-(1/ (1+r) n) /r]
Where,
A = Payment amount per month
P = Principal Amount
R = rate of interest
N = number of years

Example: A loan of Rs.5, 00,000 at 9.6% compounded monthly is to be amortized by 60 monthly payments. Find out the monthly payments.

Solution:
A = P *r (1+r) n/ (1+r) n-1
P = Rs. 5, 00,000; r =0.096/12 = 0.008; n = 60
A = 5, 00,000 *[0.008 (1+0.008) 60/ (1+0.008) 60-1]
= 5, 00,000*[0.01290/0.612990]
= 5, 00,000*0.021050

=10525

Example: A Company purchases a copyright of Rs. 10, 00,000 and the estimated life is 10 years. Find out the amortization expense value per year.

Solution:
Total amount = Rs. 10, 00,000
Estimated life = 10 years
Amortization expense per year = 10, 00,000/10 = Rs. 1, 00,000

Example: A company makes a quarterly payment of Rs. 20,000 at 5.7% compounded quarterly that is amortized in 4 quarterly payments. Find out the Initial loan value.

Solution:
P = A [1-(1/ (1+r) n) /r]
= 20, 000 [1-(1/ (1+0.014) 4) /0.014]
= 20, 000 [0.0550/0.01425]
= 20, 000* 3.86147

=77,229

Example: A debt of Rs. 6, 00,000 at 6.3% compounded monthly of 3 years.  Find out the monthly payments.

Solution:
A = P *r (1+r) n/ (1+r) n-1
A = 6, 00,000 *[0.00525 (1+0.00525) 36/ (1+0.00525) 36-1]
= 6, 00,000*[0.00633908/0.20744385]

= 18334.83 

Note: To construct schedule first you have to calculate first period  monthly  or quarterly interest on actual loan  amount and then subtract it from monthly payment you will get principal amount and then principal amount is subtracted from loan amount to find balance amount of loan and  for second period you can calculate your interest amount on balance amount and after getting principal amount you have to subtract your principal amount from balance amount in that way you can make one year or long term amortization schedule.



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