Chapter 11 Promissory Notes, Simple Discount Notes, and the Discount Process Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

Chapter 11

Promissory Notes, Simple Promissory Notes, Simple Discount Notes, and Discount Notes, and the Discount Processthe Discount Process

Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

11-2

1. Differentiate between interest-bearing and noninterest-bearing notes

2. Calculate bank discount and proceeds for simple discount notes

3. Calculate and compare the interest, maturity value, proceeds, and effective rate of a simple interest note with a simple discount note

4. Explain and calculate the effective rate for a Treasury bill

Promissory Notes, Simple Discount Notes, and the Discount Process#11#11Learning Unit ObjectivesStructure of Promissory Notes; the Simple Discount Note

LU11.1LU11.1

11-3

1. Calculate the maturity value, bank discount, and proceeds of discounting an interest-bearing note before maturity

2. Identify and complete the four steps of the discounting process

Promissory Notes, Simple Discount Notes, and the Discount Process#11#11Learning Unit ObjectivesDiscounting and Interest-Bearing Note before Maturity

LU11.2LU11.2

11-4

Structure of a Promissory NoteFigure 11.1

___________a. LAWTON, OKLAHOMA __________________c.

__________________________b. AFTER DATE _______ PROMISE TO PAY TO

THE ORDER OF ___________________________________________d.

____________________________________________DOLLARS

PAYABLE AT ____________________________________

VALUE RECEIVED WITH INTEREST AT ______e. REGAL CORPORATION f.

NO. ______ DUE _____________________g. ________________

TREASURER

a. Face value d. Payee g. Maturity dateb. Time e. Ratec. Date f. Maker

$10,000 October 2, 2010

Sixty days We

G.J. Equipment Company

Ten Thousand and 00/100 -------

Able National Bank

9%

114 December 1, 2010 J.M. Moore

11-5

Simple Discount Note

Simple discount note - A note in which the loan interest is

deducted in advance

Bank discount - the interest that banks deduct in advance

Bank discount rate - the percent of interest

Proceeds - the amount the borrower receives after the bank

deducts its discount from the loans maturity value

Maturity Value – The total amount due at the end of the loan

11-6

Simple Discount Note - Example

Terrance Rime borrowed $10,000 for 90 days from Webster Bank. The bank discounted the note at 10%.

What proceeds does Terrance receive?

$10,000 x .10 x 90 = $250 360

$10,000 - $250 = $9,750Proceeds

Bank Discount

Bank DiscountRate

11-7

Table 11.1 - Comparison of simple interest note and simple discount note

Simple interest note (Chapter 10)

1. A promissory note for a loan with a term of usually less than 1 year. Example: 60 days

2. Paid back by one payment at maturity. Face value equals actual amount (or principal) of loan (this is not maturity value)

3. Interest computed on face value or what is actually borrowed. Example: $186.67

4. Maturity value = Face value + Interest Example: $14, 186.67

5. Borrower receives the face valueExample: $14,000

6. Effective rate (true rate is same as rate stated on note). Example: 8%

7. Used frequently instead of the simple discount note. Example: 8%

Simple discount note (Chapter 11)

1. A promissory note for a loan with a term of usually less than 1 year. Example: 60 days

2. Paid back by one payment at maturity. Face value equals maturity value (what will be repaid)

3. Interest computed on maturity value or what will be repaid and not on actual amount borrowed. Example: $186.67

4. Maturity value = Face valueExample: $14, 000

5. Borrower receives proceeds = Face value - bank discount. Example: $13,813.33

6. Effective rate is higher since interest was deducted in advance. Example: 8.11%

7. Not used as much now because in 1969 congressional legislation required that the true rate of interest be revealed. Still used where legislation does not apply, such as personal loans.

11-8

Comparison

InterestI = Face Value (Principal) x R x TI = $14,000 x .08 x 60

360I = $187.67

Maturity ValueMV = Face Value + InterestMV = $14,000 + $ 187.67=$14,187.67

ProceedsProceeds = Face Value Proceeds = $14,000

Simple Interest Note - Ch. 10 Simple Discount Note - Ch. 11

InterestI = Face Value (Principal) x R x TI = $14,000 x .08 x 60

360I = $186.67

Maturity ValueMV = $14,000

ProceedsProceeds = MV - Bank discount Proceeds = $14,000 - $186.67Proceeds = $13,813.33

11-9

Comparison - Effective Rate

Rate = Interest Proceeds x TimeRate = $186.67

$14,000 x 60 360

Rate = 8%

Simple Interest Note - Ch. 10 Simple Discount Note - Ch. 11Rate = Interest Proceeds x TimeRate = $186.67

$13,813.33 x 60 360

Rate = 8.11%

The effective rate for a simple discount note is higher than the stated rate, since the bank

calculated the rate on the face of the note and not on what Terrance received

11-10

Treasury BillsLoan to Federal Govt.

Terms of Purchase

91 days (13 Weeks)

or

1 Year

If you buy a $10,000 13 week Treasury

bill at 8%, how much will you pay

and what is the effective rate?

$10,000 x .08 x 13 = $200 52

Cost = $10,000 - $200 = $9,800

Effective Rate = $200 = 8.16% $9,800 x 13

52

11-11

Discounting an Interest-Bearing Note before Maturity

Step 1. Calculate the interest and maturity value

Step 2. Calculate the discount period (time the bank holds note)

Step 3. Calculate the bank discount

Step 4. Calculate the proceeds

11-12

Discounting an Interest-Bearing Note before Maturity

Roger Company sold the following promissory note to the bank:

Date of Face Value Length of Interest Bank Discount Date of note of note note rate rate discountMarch 8 $2,000 185 days 10% 9% August 9

Date of Date of Date note discount note due

March 8 August 9 Sept. 9 154 days before note is discounted

31 days

Bank waits

185 days total length of note

11-13

Discounting an Interest-Bearing Note before Maturity

Roger Company sold the following promissory note to the bank:

Date of Face Value Length of Interest Bank Discount Date of note of note note rate rate discountMarch 8 $2,000 185 days 10% 9% August 9

What are Camille’s interest and maturity value? What are the discount period and bank discount? What are the proceeds?

I = $2,000 x .10 x 185 = $102.78 360

MV = $2,000 + $102.780 = $2,102.78

$2,102.78 x .09 x 31 = 16.30 360 $2102.78 – 16.30 = $2,068.48

Calculation on next slide

11-14

Calculation of days without table

Manual Calculation

March 31

-8

23

April 30

May 31

June 30

July 31

August 9

154

185 days - length of note

-154 days Roger held note

116 days bank waits

Table Calculation

August 9 221 days

March 8 -67 days

154 days passed before note is discounted

185 day note -154

31 discount pd.

11-15

Problem 11-10:

Solution:

a. ($10,000.00 - $9,881.25) = $118.75

$118.75 _ $9,881.25 x 13

52

$118.75 _ $2,470.3125

= 4.8070841% or 4.81% effective rate

b. =

11-16

Problem 11-13:Solution:

$10,000 x .05 x = $1251352

Effective rate = = 5.06% $125 _ $9,875 x 13

52

11-17

Problem 11-14:

Solution:

Aug. 16 228 daysMay 8 -128 100 days passed

180 – 100 = 80 days (discount period)

$3,000 x .08 x = $120

$3,000 + $120 = $3,120 MV

180360

Bank Discount

$3,120.00 x .09 x = $62.40

$3,120.00 - 62.40$3,057.60 proceeds

80360

11-18

Problem 11-16:

Solution:

June 12 163 daysMay 12 - 132 31 days passed90 – 31 = 59 days (discount period)

Maturity Value = $8,000 x .08 x

90 360 = $240 + $8,000 = $8,240

Bank Discount = $8,240 x .10 x

59 360

Discount Period = 90 - 31 = 59 days

= $135.04

Proceeds = $8,240 - $135.04 = $8,104.96