Dear All: I don’t understand why, in the Band of Investment Method for valuing real estate, you add a sinking fund rate based on an annuity of $1 to the annual interest rate. Schweser says you use (mortgage weight*mortgage cost)+(equity weight*equity cost) where mortgage cost=annual rate+sinking fund rate. What the hell’s going on? -Richard
See pages 348-349 in Book 4 of Schweser to see what I’m talking about.
The mortgage interest rate does not reflect the fact that you have to pay back the principal too. The sinking fund provision takes care of this and gives you the “economically real” cost of the mortgage. After that you just use the respective weights of the mortgage/equity to find the required return.
Nirjaina is correct. The cost of the morgage is: Return on funds (stated interest cost) + Return of principal to lender (Sinking fund factor). In essence, the sinking fund factor tells u, the per unit amount you need to set aside each period to repay the principal at the end of the loan based on an annuity rate. Mathematically it is the FV of an annuity.