Chapter 11 Promissory Notes Simple Discount Notes and

Chapter 11 Promissory Notes, Simple Discount Notes, and The Discount Process Mc. Graw-Hill/Irwin © 2008 The Mc. Graw-Hill Companies, All Rights Reserved

#11 Promissory Notes, Simple Discount Notes, and the Discount Process Learning Unit Objectives Discounting and Interest-bearing Note LU 11. 2 before maturity • Calculate the maturity value, bank discount, and proceeds of discounting an interest-bearing note before maturity • Identify and complete the four steps of the discounting process 11 -2

#11 Promissory Notes, Simple Discount Notes, and the Discount Process Learning Unit Objectives Structure of Promissory Notes; the LU 11. 1 Simple Discount Note • • Calculate bank discount and proceeds for simple discount notes • Calculate and compare the interest, maturity value, proceeds, and effective rate of a simple interest note with a simple discount note • 11 -3 Differentiate between interest-bearing and noninterestbearing notes Explain and calculate the effective rate for a Treasury bill

Structure of a Promissory Note Figure 11. 1 $10, 000 ______a. LAWTON, OKLAHOMA October 2, 2007 ___________c. _____________b. AFTER DATE _______ PROMISE TO PAY TO Sixty days We G. J. Equipment Company THE ORDER OF ______________________d. ______________________DOLLARS Ten Thousand 00/100 ------Able National Bank PAYABLE AT __________________ 9% VALUE RECEIVED WITH INTEREST AT ______e. REGAL CORPORATION f. NO. ______ 114 ________ J. M. Moore DUE ___________g. December 1, 2007 TREASURER a. Face value b. Time c. Date 11 -4 d. Payee e. Rate f. Maker g. Maturity date

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 Maturity Value – The total amount due at the end of the loan Bank discount rate - the percent of interest 11 -5 Proceeds - the amount the borrower receives after the bank deducts its discount from the loans maturity value

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 0. 10 x 90 = $250 360 Bank Discount Rate $10, 000 - $250 = $9, 750 The actual amount the borrower receives after paying the discount to the bank. 11 -6 Proceeds

Comparison of Simple Interest Note vs Simple Discount Note Simple Interest Note - Ch. 10 Simple Discount Note - Ch. 11 Interest I = Face Value (Principal) x R x T I = $14, 000 x. 08 x 60 360 I = $187. 67 Maturity Value MV = Face Value + Interest MV = $14, 000 + $ 187. 67=$14, 187. 67 Interest I = Face Value (Principal) x R x T I = $14, 000 x. 08 x 60 360 I = $186. 67 Maturity Value MV = $14, 000 Proceeds = Face Value Proceeds = $14, 000 Proceeds = MV - Bank discount Proceeds = $14, 000 – 186. 67 Proceeds = $13, 813. 33 11 -7

Comparison - Effective Rate Simple Interest Note - Ch. 10 Rate = Interest Proceeds x Time Rate = $186. 67 $14, 000 x 60 360 Rate = 8% Simple Discount Note - Ch. 11 Rate = Interest Proceeds x Time Rate = $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 -8

Table 11. 1 - Comparison of simple interest note and simple discount note Simple interest note (Chapter 10) 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 actual amount (or principal) of loan (this is not maturity value) 2. Paid back by one payment at maturity. Face value equals maturity value (what will be repaid) 3. Interest computed on face value or what is actually borrowed. Example: $186. 67 3. Interest computed on maturity value or what will be repaid and not on actual amount borrowed. Example: $186. 67 4. Maturity value = Face value + Interest Example: $14, 186. 67 4. Maturity value = Face value Example: $14, 000 5. Borrower receives the face value Example: $14, 000 5. Borrower receives proceeds = Face value - bank discount. Example: $13, 813. 33 6. Effective rate (true rate is same as rate stated on note). Example: 8% 6. Effective rate is higher since interest was deducted in advance. Example: 8. 11% 7. Used frequently instead of the simple discount note. Example: 8% 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 -9

Practice Non-interest bearing note of $12, 000. Simple discount rate of 9. 5% 60 -day note. 1. 2. 3. 4. 11 -10 What is the maturity value? What is the bank discount? What is the proceeds to the borrower? What is the effective rate? Is it 9. 5%?

Key to Practice Non-interest bearing note of $12, 000. Simple discount rate of 9. 5% 60 -day note. Maturity value = Face value = $12, 000 Bank discount = Maturity value x Bank discount rate x Time Bank discount = 12, 000 x 0. 095 x 60/360 = $190 Proceeds = Maturity value – Bank discount Proceeds = $12, 000 - $190 = $11, 810 11 -11 Effective rate = Interest $190 _________ =9. 65% Proceeds x Time/ 11, 810 x 60/360

Treasury Bills Loan 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? 11 -12 $10, 000 x. 08 x 13 = $200 52 Cost to buy = $10, 000 - $200 = $9, 800 Effective Rate = $200 = 8. 16% $9, 800 x 13 52

Problem 11 -13: Solution: Treasury bill $10, 000 at 5% rate; 13 -week Treasury bill. $10, 000 x 0. 05 x 13 = $125 52 Interest earned Actual cost to pay for Treasury bill = 10, 000 – 125 = $9, 875 Effective rate = 11 -13 $125 _ = 5. 06% $9, 875 x 13 52

Practice Solution: Treasury bill for $10, 000 for 13 weeks; Discount value in buying bill = $23. 90 Find the effective rate of Treasury bill. $23. 90 _ $23. 90 = =. 95829% =. 96% 13 $2, 494. 025 $9, 976. 10 x 52 ($10, 000. 00 - $23. 90) = $9, 976. 10 (Actual cost to buy Treasury bill) $10, 000. 00 - $9, 976. 10 11 -14

Discounting an Interest-Bearing Note before Maturity Step 4. Calculate the proceeds Step 3. Calculate the bank discount Step 2. Calculate the discount period (time the bank holds note) Step 1. Calculate the interest and maturity value 11 -15

Discounting an Interest-Bearing Note before Maturity Camille Wilson sold the following promissory note to the bank: Date of note March 8 Face Value of note $2, 000 Length of note 185 days Date of note Interest rate 10% Bank Discount Date of rate discount 9% August 9 Date of discount Date note due 31 days 154 days before note is discounted March 8 Bank waits August 9 185 days total length of note 11 -16 Sept. 9

Discounting an Interest-Bearing Note before Maturity Camille Wilson sold the following promissory note to the bank: Date of note March 8 Face Value of note $2, 000 Length of note 185 days Interest rate 10% Bank Discount Date of rate discount 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 0. 10 x 185 = $102. 78 360 $2, 102. 78 x 0. 09 x 31 = 16. 30 360 MV = $2, 000 + $102. 780 = $2, 102. 78 $2102. 78 – 16. 30 = $2, 068. 48 Calculation on next slide 11 -17

Calculation of days without table Manual Calculation Table Calculation March August 9 March 8 April May June July August 11 -18 31 -8 23 30 31 9 154 221 days -67 days 154 days passed before note is discounted 185 day note -154 31 discount pd. 185 days - length of note -154 days Camille held note 31 days bank waits

Problem 11 -14: Solution: May 8: $3, 000, 8%, 180 -day note August 16: Discounted at bank at 9% discount rate Bank Discount Aug. 16 228 days May 8 -128 100 days passed 80 $3, 120. 00 x. 09 x 360=62. 40 180 – 100 = 80 days $3, 120. 00 (MV) (discount period) - 62. 40 (Bank discount) $3, 057. 60 proceeds 180 $3, 000 x. 08 x = $120 360 $3, 000 + $120 = $3, 120 (Maturity Value) 11 -19

Problem 11 -15: Solution: Oct 11 Aug 8 August 8: $8, 000, 8%, 120 -day note Oct 11: discounted at bank at 9% 284 days - 220 64 days passed 120 – 64 = 56 days (discount period) $5, 000 x. 08 x 120 = $133. 33 Interest earned on original note 360 $5, 000 + $133. 33 = $5, 133. 33 Maturity Value Bank discount= $5, 133. 33 x 0. 09 x 56/360 = $71. 87 Proceeds = $5, 133. 33 – 71. 87 = $5, 061. 46 11 -20

Homework • 11 -1 • 11 -4 • 11 -6 • 11 -10 • 11 -16 11 -21