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Notes Receivable

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. Notes Receivable. A written promise to pay Usually longer-term and more formal

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Notes Receivable

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  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: • Set up repayment timeline.

  11. Valuing Notes Receivable Using this information, do the following: • Set up repayment timeline. • 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: • Set up repayment timeline. • Plot actual cash inflows on timeline, using stated interest rate and face value of the note. • 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. Year 0 Year 1 Year 2 Year 3 Year 4 Valuing Notes Receivable Example: 4 year note; no stated interest; $10,000 face value • Set up repayment timeline.

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

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

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

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

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

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

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

  22. Year 0 Year 1 Year 2 Year 3 Year 4 Valuing Notes Receivable Example: 4 year note; no stated interest; $10,000 face value • Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate). $0 $0 $0 $0 $10,000 0 x 1/1.070

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

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

  25. Year 0 Year 1 Year 2 Year 3 Year 4 Valuing Notes Receivable Example: 4 year note; no stated interest; $10,000 face value • Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate). $0 $0 $0 $0 $10,000 $0 $0 $0 $0 10,000 x 1/1.074

  26. Year 0 Year 1 Year 2 Year 3 Year 4 Valuing Notes Receivable Example: 4 year note; no stated interest; $10,000 face value • Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate). $0 $0 $0 $0 $10,000 $0 $0 $0 $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. Year 0 Year 1 Year 2 Year 3 Year 4 Valuing Notes Receivable Example: 4 year note; 9% stated interest; $10,000 face value • Set up repayment timeline.

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

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

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

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

  35. Year 0 Year 1 Year 2 Year 3 Year 4 Valuing Notes Receivable Example: 4 year note; 9% stated interest; $10,000 face value • Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate). $0 $900 $900 $900 $900 $10,000 $0 900 x 1/1.131

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

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

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

  39. Valuing Notes Receivable Example: 4 year note; 9% 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. $1,190 Cash $8,810

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

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

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

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

  44. Valuing Notes Receivable Example: 4 year note; 9% stated interest; $10,000 face value 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 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. Notes Receivable Amortization of Discount Go back to our 13% interest rate example: Example: 4 year note; 9% 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. $1,190 Cash $8,810

  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 =

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