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

11-2 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 Promissory Notes, Simple Discount Notes, and the Discount Process #11 Learning Unit Objectives Discounting and Interest-bearing Note before maturity LU11.2

11-3 Differentiate between interest-bearing and noninterest- bearing notes 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 Explain and calculate the effective rate for a Treasury bill Promissory Notes, Simple Discount Notes, and the Discount Process #11 Learning Unit Objectives Structure of Promissory Notes; the Simple Discount Note LU11.1

11-4 Structure of a Promissory Note Figure 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 valued. Payee g. Maturity date b. Timee. Rate c. Datef. Maker $10,000October 2, 2007 Sixty daysWe G.J. Equipment Company Ten Thousand and 00/ Able National Bank 9% 114December 1, 2007J.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 0.10 x 90 = $ $10,000 - $250 = $9,750 Proceeds Bank Discount Rate The actual amount the borrower receives after paying the discount to the bank.

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

11-8 Comparison - Effective Rate Rate = Interest Proceeds x Time Rate = $ $14,000 x Rate = 8% Simple Interest Note - Ch. 10 Simple Discount Note - Ch. 11 Rate = Interest Proceeds x Time Rate = $ $13, x 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

11-9 Table 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: $ Maturity value = Face value + Interest Example: $14, Borrower receives the face value Example: $14, 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: $ Maturity value = Face value Example: $14, Borrower receives proceeds = Face value - bank discount. Example: $13, 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.

11-10 Practice Non-interest bearing note of $12,000. Simple discount rate of 9.5% 60-day note. 1.What is the maturity value? 2.What is the bank discount? 3.What is the proceeds to the borrower? 4.What is the effective rate? Is it 9.5%?

11-11 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 x 60/360 = $190 Proceeds = Maturity value – Bank discount Proceeds = $12,000 - $190 = $11,810 Effective rate = Interest$190 _________________ = ____________ =9.65% Proceeds x Time/11,810 x 60/360

11-12 Treasury Bills Loan to Federal Govt. Terms of Purchase 91 days (13 Weeks) or 1 Year If you buy a $10, week Treasury bill at 8%, how much will you pay and what is the effective rate? $10,000 x.08 x 13 = $ Cost to buy = $10,000 - $200 = $9,800 Effective Rate = $200 = 8.16% $9,800 x 13 52

11-13 Problem 11-13: Solution: $10,000 x 0.05 x = $ Effective rate = = 5.06% $125 _ $9,875 x Treasury bill $10,000 at 5% rate; 13-week Treasury bill. Interest earned Actual cost to pay for Treasury bill = 10,000 – 125 = $9,875

11-14 Practice Solution: ($10, $23.90) = $9, (Actual cost to buy Treasury bill) $10, $9, $23.90 _ $9, x $23.90 $2, = =.95829% =.96% Treasury bill for $10,000 for 13 weeks; Discount value in buying bill = $23.90 Find the effective rate of Treasury bill.

11-15 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

11-16 Discounting an Interest-Bearing Note before Maturity Camille Wilson sold the following promissory note to the bank: Date of Face ValueLength of InterestBank DiscountDate of note of note note rate ratediscount March 8 $2, days 10% 9% August 9 Date of Date of Date note discountnote due March 8 August 9 Sept days before note is discounted 31 days Bank waits 185 days total length of note

11-17 Discounting an Interest-Bearing Note before Maturity Camille Wilson sold the following promissory note to the bank: Date of Face ValueLength of InterestBank DiscountDate of note of note note rate ratediscount March 8 $2, 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 x0.10 x 185 = $ MV = $2,000 + $ = $2, $2, x 0.09 x 31 = $ – = $2, Calculation on next slide

11-18 Calculation of days without table Manual Calculation March April30 May31 June30 July31 August days - length of note -154 days Camille held note 31 days bank waits Table Calculation August 9221 days March days 154 days passed before note is discounted 185 day note discount pd.

11-19 Problem 11-14: Solution: Aug days May days passed 180 – 100 = 80 days (discount period) $3,000 x.08 x = $120 $3,000 + $120 = $3,120 (Maturity Value) Bank Discount $3, x.09 x =62.40 $3, (MV) (Bank discount) $3, proceeds May 8: $3,000, 8%, 180-day note August 16: Discounted at bank at 9% discount rate

11-20 Problem 11-15: Solution: Oct days Aug days passed 120 – 64 = 56 days (discount period) $5,000 x.08 x = $ $5,000 + $ = $5, Maturity Value August 8: $8,000, 8%, 120-day note Oct 11: discounted at bank at 9% Interest earned on original note Bank discount= $5, x 0.09 x 56/360 = $71.87 Proceeds = $5, – = $5,061.46

11-21 Homework