notes receivable
DESCRIPTION
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 - PowerPoint PPT PresentationTRANSCRIPT
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• 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.
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%.
Notes Receivable
Since notes tend to be longer-term, inflation whittles away the amount we can expect to recover from the note’s proceeds.
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.
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.
Valuing Notes Receivable
To properly value long-term notes, we need the following information:
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)
Valuing Notes Receivable
Using this information, do the following:
Valuing Notes Receivable
Using this information, do the following:
1. Set up repayment timeline.
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.
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).
Valuing Notes Receivable
Example: 4 year note; no stated interest; $10,000 face value
Valuing Notes Receivable
Example: 4 year note; no stated interest; $10,000 face value
1. Set up repayment timeline.
Year0
Year2
Year1
Year3
Year4
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.
Year0
Year2
Year1
Year3
Year4
$0
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.
Year0
Year2
Year1
Year3
Year4
$0 $0
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.
Year0
Year2
Year1
Year3
Year4
$0 $0 $0
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.
Year0
Year2
Year1
Year3
Year4
$0 $0 $0 $0
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.
Year0
Year2
Year1
Year3
Year4
$0 $0 $0 $0 $10,000
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).
Year0
Year2
Year1
Year3
Year4
$0 $0 $0 $0 $10,000
Assume discount rate = 7%.
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).
Year0
Year2
Year1
Year3
Year4
$0 $0 $0 $0 $10,000
Assume discount rate = 7%.
Therefore, discount multiplier =1
1.07year
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).
Year0
Year2
Year1
Year3
Year4
$0 $0 $0 $0 $10,000
0 x 1/1.070
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).
Year0
Year2
Year1
Year3
Year4
$0 $0 $0 $0 $10,000
$0
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).
Year0
Year2
Year1
Year3
Year4
$0 $0 $0 $0 $10,000
$0 $0
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).
Year0
Year2
Year1
Year3
Year4
$0 $0 $0 $0 $10,000
$0 $0 $0 $0 10,000 x 1/1.074
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).
Year0
Year2
Year1
Year3
Year4
$0 $0 $0 $0 $10,000
$0 $0 $0 $0 $7,629
Valuing Notes Receivable
Example: 4 year note; no stated interest; $10,000 face value
The journal entry to record this note is:
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 $10,000Discount, Notes Rec. $2,371Cash $7,629
Valuing Notes Receivable
Example: 4 year note; 9% stated interest; $10,000 face value
1. Set up repayment timeline.
Year0
Year2
Year1
Year3
Year4
Valuing Notes Receivable
Example: 4 year note; 9% stated interest; $10,000 face value
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.
Year0
Year2
Year1
Year3
Year4
$0 $900 $900 $900 $900$10,000
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.
Year0
Year2
Year1
Year3
Year4
$0 $900 $900 $900
9% x $10,000of interest paid annually
$900$10,000
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.
Year0
Year2
Year1
Year3
Year4
$0 $900 $900 $900
Repayment of principal (stated amount) at the maturity of note
$900$10,000
Valuing Notes Receivable
Example: 4 year note; 9% stated interest; $10,000 face value
Year0
Year2
Year1
Year3
Year4
$0 $900 $900 $900
3. Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).
Assume discount rate = 13%.
Therefore, discount multiplier =1
1.13year
$900$10,000
Valuing Notes Receivable
Example: 4 year note; 9% stated interest; $10,000 face value
Year0
Year2
Year1
Year3
Year4
$0 $900 $900 $900
3. Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).
$0 900 x 1/1.131
$900$10,000
Valuing Notes Receivable
Example: 4 year note; 9% stated interest; $10,000 face value
Year0
Year2
Year1
Year3
Year4
$0 $900 $900 $900
3. Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).
$0 $796
$900$10,000
Valuing Notes Receivable
Example: 4 year note; 9% stated interest; $10,000 face value
Year0
Year2
Year1
Year3
Year4
$0 $900 $900 $900
3. Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).
$0 $796 $705 $624 $6,685
$900$10,000
Valuing Notes Receivable
Example: 4 year note; 9% stated interest; $10,000 face value
Year0
Year2
Year1
Year3
Year4
3. Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).
NPV = 796 + 705 + 624 + 6,685 = $8,810
$0 $900 $900 $900
$0 $796 $705 $624 $6,685
$900$10,000
Valuing Notes Receivable
The journal entry to record a purchase of this note for cash is:
Notes Receivable $10,000Discount, Notes Rec. $1,190Cash $8,810
Example: 4 year note; 9% stated interest; $10,000 face value
Valuing Notes Receivable
Example: 4 year note; 9% stated interest; $10,000 face value
Year0
Year2
Year1
Year3
Year4
$0 $900 $900 $900
Now assume that inflation is low, so discount rate is only 6%.
Assume discount rate = 6%.
Therefore, discount multiplier =1
1.06year
$900$10,000
Valuing Notes Receivable
Example: 4 year note; 9% stated interest; $10,000 face value
Year0
Year2
Year1
Year3
Year4
$0 $900 $900 $900
$0 $849 $801 $756 $8,634
$900$10,000
Valuing Notes Receivable
Example: 4 year note; 9% stated interest; $10,000 face value
Year0
Year2
Year1
Year3
Year4
$0 $900 $900 $900
$0 $849 $801 $756 $8,634
$900$10,000
NPV = 849 + 801 + 756 + 8,634 = $11,040
Valuing Notes Receivable
The journal entry to record a purchase of this note for cash is:
Notes Receivable $10,000Premium, Notes Rec. $1,040
Cash $11,040
Example: 4 year note; 9% stated interest; $10,000 face value
Valuing Notes Receivable
The journal entry to record a purchase of this note for cash is:
Notes Receivable $10,000Premium, 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.
Notes ReceivableAmortization of Discount
Notes ReceivableAmortization of Discount
Go back to our 13% interest rate example:
The journal entry to record a purchase of this note for cash is:
Notes Receivable $10,000Discount, Notes Rec. $1,190Cash $8,810
Example: 4 year note; 9% stated interest; $10,000 face value
Notes ReceivableAmortization of Discount
Go back to our 13% interest rate example:
Notes ReceivableAmortization of Discount
At date of purchase, the balance sheet carries the note:
Notes ReceivableAmortization of Discount
At date of purchase, the balance sheet carries the note:
Note Receivable $10,000Less: Discount $1,190Carrying Value $8,810
Notes ReceivableAmortization of Discount
At date of purchase, the balance sheet carries the note:
Note Receivable $10,000Less: Discount $1,190Carrying Value $8,810
Amortization amount each year =
Carrying value x interest rate (discount rate) – interest actually paid
Notes ReceivableAmortization of Discount
At date of purchase, the balance sheet carries the note:
Note Receivable $10,000Less: Discount $1,190Carrying Value $8,810
Amortization amount each year =
Carrying value x interest rate (discount rate) – interest actually paid
Notes ReceivableAmortization of Discount
At date of purchase, the balance sheet carries the note:
Note Receivable $10,000Less: Discount $1,190Carrying Value $8,810
Amortization amount each year =
Year 1 amortization =
Carrying value x interest rate (discount rate) – interest actually paid
Notes ReceivableAmortization of Discount
At date of purchase, the balance sheet carries the note:
Note Receivable $10,000Less: Discount $1,190Carrying Value $8,810
Amortization amount each year =
Year 1 amortization = (8,810 x 0.13)
Carrying value x interest rate (discount rate) – interest actually paid
Notes ReceivableAmortization of Discount
At date of purchase, the balance sheet carries the note:
Note Receivable $10,000Less: Discount $1,190Carrying Value $8,810
Amortization amount each year =
Year 1 amortization = (8,810 x 0.13) - 900
Carrying value x interest rate (discount rate) – interest actually paid
Notes ReceivableAmortization of Discount
At date of purchase, the balance sheet carries the note:
Note Receivable $10,000Less: Discount $1,190Carrying Value $8,810
Amortization amount each year =
Year 1 amortization = (8,810 x 0.13) – 900 = $245
Notes ReceivableAmortization of Discount
So, we can set up an annual amortization table:
Notes ReceivableAmortization 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
Notes ReceivableAmortization 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 8,810 0.13 900 245
2
3
4
Notes ReceivableAmortization 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 8,810 0.13 900 245 9,055
2 9,055
3
4
Notes ReceivableAmortization 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 8,810 0.13 900 245 9,055
2 9,055 0.13 900 277
3
4
Notes ReceivableAmortization 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 8,810 0.13 900 245 9,055
2 9,055 0.13 900 277 9,332
3 9,332 0.13 900 313 9,645
4 9,645
Notes ReceivableAmortization 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 8,810 0.13 900 245 9,055
2 9,055 0.13 900 277 9,332
3 9,332 0.13 900 313 9,645
4 9,645 0.13 900 354 10,000
Notes ReceivableAmortization 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)
Notes ReceivableAmortization 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:
Notes ReceivableAmortization 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 $900Disc, Notes Rec $245
Interest Revenue, Notes Rec $1,145