1. Notes Receivable A written promise to pay Usually longer-term and more formal Usually for a stated amount and a specified period Either formally stated or implicit interest rate

2. Notes Receivable A written promise to pay Usually longer-term and more formal Usually for a stated amount and a specified period Either formally stated or implicit interest rate Implicit interest is when there is no formally stated interest rate, but the note is priced at a discount.

3. Notes Receivable A written promise to pay Usually longer-term and more formal Usually for a stated amount and a specified period Either formally stated or implicit interest rate Implicit interest is when there is no formally stated interest rate, but the note is priced at a discount. For example, a $1,000, 1-year note (with no stated interest rate) that sells for $900 has an implied interest rate of 11.1%.

4. Notes Receivable Since notes tend to be longer-term, inflation whittles away the amount we can expect to recover from the note’s proceeds.

5. Notes Receivable Since notes tend to be longer-term, inflation whittles away the amount we can expect to recover from the note’s proceeds. To handle this, we generally carry long-term notes receivable on the balance sheet at their net present value.

6. Notes Receivable Since notes tend to be longer-term, inflation whittles away the amount we can expect to recover from the note’s proceeds. To handle this, we generally carry long-term notes receivable on the balance sheet at their net present value. Short-term notes can be carried at face value, since they will likely not suffer from inflation.

7. Valuing Notes Receivable To properly value long-term notes, we need the following information:

8. Valuing Notes Receivable To properly value long-term notes, we need the following information: Stated interest rate Date of issue Interest payment schedule Principal payment schedule (usually end of note term) Market interest rate for similar risk note (discount rate)

9. Valuing Notes Receivable Using this information, do the following:

10. Valuing Notes Receivable Using this information, do the following: 1.Set up repayment timeline.

11. Valuing Notes Receivable Using this information, do the following: 1.Set up repayment timeline. 2.Plot actual cash inflows on timeline, using stated interest rate and face value of the note.

12. Valuing Notes Receivable Using this information, do the following: 1.Set up repayment timeline. 2.Plot actual cash inflows on timeline, using stated interest rate and face value of the note. 3.Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

13. Valuing Notes Receivable Example: 4 year note; no stated interest; $10,000 face value

14. Valuing Notes Receivable Example: 4 year note; no stated interest; $10,000 face value 1.Set up repayment timeline. Year 0 Year 2 Year 1 Year 3 Year 4

15. Valuing Notes Receivable Example: 4 year note; no stated interest; $10,000 face value 2.Plot actual cash inflows on timeline, using stated interest rate and face value of the note. Year 0 Year 2 Year 1 Year 3 Year 4 $0

16. Valuing Notes Receivable Example: 4 year note; no stated interest; $10,000 face value 2.Plot actual cash inflows on timeline, using stated interest rate and face value of the note. Year 0 Year 2 Year 1 Year 3 Year 4 $0

17. Valuing Notes Receivable Example: 4 year note; no stated interest; $10,000 face value 2.Plot actual cash inflows on timeline, using stated interest rate and face value of the note. Year 0 Year 2 Year 1 Year 3 Year 4 $0

18. Valuing Notes Receivable Example: 4 year note; no stated interest; $10,000 face value 2.Plot actual cash inflows on timeline, using stated interest rate and face value of the note. Year 0 Year 2 Year 1 Year 3 Year 4 $0

19. Valuing Notes Receivable Example: 4 year note; no stated interest; $10,000 face value 2.Plot actual cash inflows on timeline, using stated interest rate and face value of the note. Year 0 Year 2 Year 1 Year 3 Year 4 $0 $10,000

20. Valuing Notes Receivable Example: 4 year note; no stated interest; $10,000 face value 3.Discount plotted cash inflows using market equivalent- risk rate of interest (discount rate). Year 0 Year 2 Year 1 Year 3 Year 4 $0 $10,000 Assume discount rate = 7%.

21. Valuing Notes Receivable Example: 4 year note; no stated interest; $10,000 face value 3.Discount plotted cash inflows using market equivalent- risk rate of interest (discount rate). Year 0 Year 2 Year 1 Year 3 Year 4 $0 $10,000 Assume discount rate = 7%. Therefore, discount multiplier = 1 1.07 year

22. Valuing Notes Receivable Example: 4 year note; no stated interest; $10,000 face value 3.Discount plotted cash inflows using market equivalent- risk rate of interest (discount rate). Year 0 Year 2 Year 1 Year 3 Year 4 $0 $10,000 0 x 1/1.07 0

23. Valuing Notes Receivable Example: 4 year note; no stated interest; $10,000 face value 3.Discount plotted cash inflows using market equivalent- risk rate of interest (discount rate). Year 0 Year 2 Year 1 Year 3 Year 4 $0 $10,000 $0

24. Valuing Notes Receivable Example: 4 year note; no stated interest; $10,000 face value 3.Discount plotted cash inflows using market equivalent- risk rate of interest (discount rate). Year 0 Year 2 Year 1 Year 3 Year 4 $0 $10,000 $0

25. Valuing Notes Receivable Example: 4 year note; no stated interest; $10,000 face value 3.Discount plotted cash inflows using market equivalent- risk rate of interest (discount rate). Year 0 Year 2 Year 1 Year 3 Year 4 $0 $10,000 $0 10,000 x 1/1.07 4

26. Valuing Notes Receivable Example: 4 year note; no stated interest; $10,000 face value 3.Discount plotted cash inflows using market equivalent- risk rate of interest (discount rate). Year 0 Year 2 Year 1 Year 3 Year 4 $0 $10,000 $0 $7,629

27. Valuing Notes Receivable Example: 4 year note; no stated interest; $10,000 face value The journal entry to record this note is:

28. Valuing Notes Receivable Example: 4 year note; no stated interest; $10,000 face value The journal entry to record a purchase of this note for cash is: Notes Receivable$10,000 Discount, Notes Rec.$2,371 Cash$7,629

29. Valuing Notes Receivable Example: 4 year note; 9% stated interest; $10,000 face value

30. 1.Set up repayment timeline. Year 0 Year 2 Year 1 Year 3 Year 4 Valuing Notes Receivable Example: 4 year note; 9% stated interest; $10,000 face value

31. Valuing Notes Receivable Example: 4 year note; 9% stated interest; $10,000 face value 2.Plot actual cash inflows on timeline, using stated interest rate and face value of the note. Year 0 Year 2 Year 1 Year 3 Year 4 $0$900 $10,000

32. Valuing Notes Receivable Example: 4 year note; 9% stated interest; $10,000 face value 2.Plot actual cash inflows on timeline, using stated interest rate and face value of the note. Year 0 Year 2 Year 1 Year 3 Year 4 $0$900 9% x $10,000 of interest paid annually $900 $10,000

33. Valuing Notes Receivable Example: 4 year note; 9% stated interest; $10,000 face value 2.Plot actual cash inflows on timeline, using stated interest rate and face value of the note. Year 0 Year 2 Year 1 Year 3 Year 4 $0$900 Repayment of principal (stated amount) at the maturity of note $900 $10,000

34. Valuing Notes Receivable Example: 4 year note; 9% stated interest; $10,000 face value Year 0 Year 2 Year 1 Year 3 Year 4 $0$900 3.Discount plotted cash inflows using market equivalent- risk rate of interest (discount rate). Assume discount rate = 13%. Therefore, discount multiplier = 1 1.13 year $900 $10,000

35. Valuing Notes Receivable Example: 4 year note; 9% stated interest; $10,000 face value Year 0 Year 2 Year 1 Year 3 Year 4 $0$900 3.Discount plotted cash inflows using market equivalent- risk rate of interest (discount rate). $0900 x 1/1.13 1 $900 $10,000

36. Valuing Notes Receivable Example: 4 year note; 9% stated interest; $10,000 face value Year 0 Year 2 Year 1 Year 3 Year 4 $0$900 3.Discount plotted cash inflows using market equivalent- risk rate of interest (discount rate). $0$796 $900 $10,000

37. Valuing Notes Receivable Example: 4 year note; 9% stated interest; $10,000 face value Year 0 Year 2 Year 1 Year 3 Year 4 $0$900 3.Discount plotted cash inflows using market equivalent- risk rate of interest (discount rate). $0$796$705$624$6,685 $900 $10,000

38. Valuing Notes Receivable Example: 4 year note; 9% stated interest; $10,000 face value Year 0 Year 2 Year 1 Year 3 Year 4 3.Discount plotted cash inflows using market equivalent- risk rate of interest (discount rate). NPV = 796 + 705 + 624 + 6,685 = $8,810 $0$900 $0$796$705$624$6,685 $900 $10,000

39. Valuing Notes Receivable The journal entry to record a purchase of this note for cash is: Notes Receivable$10,000 Discount, Notes Rec.$1,190 Cash$8,810 Example: 4 year note; 9% stated interest; $10,000 face value

40. Valuing Notes Receivable Example: 4 year note; 9% stated interest; $10,000 face value Year 0 Year 2 Year 1 Year 3 Year 4 $0$900 Now assume that inflation is low, so discount rate is only 6%. Assume discount rate = 6%. Therefore, discount multiplier = 1 1.06 year $900 $10,000

41. Valuing Notes Receivable Example: 4 year note; 9% stated interest; $10,000 face value Year 0 Year 2 Year 1 Year 3 Year 4 $0$900 $0$849$801$756$8,634 $900 $10,000

42. Valuing Notes Receivable Example: 4 year note; 9% stated interest; $10,000 face value Year 0 Year 2 Year 1 Year 3 Year 4 $0$900 $0$849$801$756$8,634 $900 $10,000 NPV = 849 + 801 + 756 + 8,634 = $11,040

43. Valuing Notes Receivable The journal entry to record a purchase of this note for cash is: Notes Receivable$10,000 Premium, Notes Rec.$1,040 Cash$11,040 Example: 4 year note; 9% stated interest; $10,000 face value

44. Valuing Notes Receivable The journal entry to record a purchase of this note for cash is: Notes Receivable$10,000 Premium, Notes Rec.$1,040 Cash$11,040 Example: 4 year note; 9% stated interest; $10,000 face value The premium reflects the amount we overpay in order to get a note with an interest rate that pays more than the inflation rate.

45. Notes Receivable Amortization of Discount

46. Notes Receivable Amortization of Discount Go back to our 13% interest rate example:

47. The journal entry to record a purchase of this note for cash is: Notes Receivable$10,000 Discount, Notes Rec.$1,190 Cash$8,810 Example: 4 year note; 9% stated interest; $10,000 face value Notes Receivable Amortization of Discount Go back to our 13% interest rate example:

48. Notes Receivable Amortization of Discount At date of purchase, the balance sheet carries the note:

49. Notes Receivable Amortization of Discount At date of purchase, the balance sheet carries the note: Note Receivable$10,000 Less: Discount$1,190 Carrying Value$8,810

50. Notes Receivable Amortization of Discount At date of purchase, the balance sheet carries the note: Note Receivable$10,000 Less: Discount$1,190 Carrying Value$8,810 Amortization amount each year =

51. Carrying value x interest rate (discount rate) – interest actually paid Notes Receivable Amortization of Discount At date of purchase, the balance sheet carries the note: Note Receivable$10,000 Less: Discount$1,190 Carrying Value$8,810 Amortization amount each year =

52. Carrying value x interest rate (discount rate) – interest actually paid Notes Receivable Amortization of Discount At date of purchase, the balance sheet carries the note: Note Receivable$10,000 Less: Discount$1,190 Carrying Value$8,810 Amortization amount each year = Year 1 amortization =

53. Carrying value x interest rate (discount rate) – interest actually paid Notes Receivable Amortization of Discount At date of purchase, the balance sheet carries the note: Note Receivable$10,000 Less: Discount$1,190 Carrying Value$8,810 Amortization amount each year = Year 1 amortization = (8,810 x 0.13)

54. Carrying value x interest rate (discount rate) – interest actually paid Notes Receivable Amortization of Discount At date of purchase, the balance sheet carries the note: Note Receivable$10,000 Less: Discount$1,190 Carrying Value$8,810 Amortization amount each year = Year 1 amortization = (8,810 x 0.13) - 900

55. Carrying value x interest rate (discount rate) – interest actually paid Notes Receivable Amortization of Discount At date of purchase, the balance sheet carries the note: Note Receivable$10,000 Less: Discount$1,190 Carrying Value$8,810 Amortization amount each year = Year 1 amortization = (8,810 x 0.13) – 900 = $245

56. Notes Receivable Amortization of Discount So, we can set up an annual amortization table:

57. Notes Receivable Amortization of Discount So, we can set up an annual amortization table: Year(a) Beg. Carrying Value (b) Interest Rate (c) Interest Actually Paid (d) Amortization Amount [(a) x (b)] – (c) Ending Carrying Value (a) + (d) 0 1 2 3 4

58. Notes Receivable Amortization of Discount So, we can set up an annual amortization table: Year(a) Beg. Carrying Value (b) Interest Rate (c) Interest Actually Paid (d) Amortization Amount [(a) x (b)] – (c) Ending Carrying Value (a) + (d) 0--- 8,810 1 0.13900245 2 3 4

59. Notes Receivable Amortization of Discount So, we can set up an annual amortization table: Year(a) Beg. Carrying Value (b) Interest Rate (c) Interest Actually Paid (d) Amortization Amount [(a) x (b)] – (c) Ending Carrying Value (a) + (d) 0--- 8,810 1 0.139002459,055 2 3 4

60. Notes Receivable Amortization of Discount So, we can set up an annual amortization table: Year(a) Beg. Carrying Value (b) Interest Rate (c) Interest Actually Paid (d) Amortization Amount [(a) x (b)] – (c) Ending Carrying Value (a) + (d) 0--- 8,810 1 0.139002459,055 2 0.13900277 3 4

61. Notes Receivable Amortization of Discount So, we can set up an annual amortization table: Year(a) Beg. Carrying Value (b) Interest Rate (c) Interest Actually Paid (d) Amortization Amount [(a) x (b)] – (c) Ending Carrying Value (a) + (d) 0--- 8,810 1 0.139002459,055 2 0.139002779,332 3 0.139003139,645 4

62. Notes Receivable Amortization of Discount So, we can set up an annual amortization table: Year(a) Beg. Carrying Value (b) Interest Rate (c) Interest Actually Paid (d) Amortization Amount [(a) x (b)] – (c) Ending Carrying Value (a) + (d) 0--- 8,810 1 0.139002459,055 2 0.139002779,332 3 0.139003139,645 4 0.1390035410,000

63. Notes Receivable Amortization of Discount Actual interest revenue reported each year is equal to actual interest paid + the amount of discount amortized (or – the amount of premium amortized)

64. Notes Receivable Amortization of Discount Actual interest revenue reported each year is equal to actual interest paid + the amount of discount amortized (or – the amount of premium amortized) Journal entry to record receipt of year 1 interest:

65. Notes Receivable Amortization of Discount Actual interest revenue reported each year is equal to actual interest paid + the amount of discount amortized (or – the amount of premium amortized) Journal entry to record receipt of year 1 interest: Cash$900 Disc, Notes Rec$245 Interest Revenue, Notes Rec$1,145