Chapter Eleven PROMISSORY NOTES, SIMPLE DISCOUNT NOTES, AND THE DISCOUNT PROCESS Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

11-2 LEARNING UNIT OBJECTIVES LU 11-1: Structure of Promissory Notes; the Simple Discount Note 1. Differentiate between interest-bearing and non-interest-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. LU 11-2: Discounting an Interest-Bearing Note before Maturity 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.

11-3 PROMISSORY NOTES To borrow money, you must find a lender (a bank or a company selling goods on credit). You must also be willing to pay for the use of the money. In Chapter 10 you learned that interest is the cost of borrowing money for periods of time. This chapter begins with a discussion of the structure of promissory notes and simple discount notes. We also look at the application of discounting with Treasury bills. The chapter concludes with an explanation of how to calculate the discounting of promissory notes. Money lenders usually require that borrowers sign a promissory note. This note states that the borrower will repay a certain sum at a fixed time in the future. The note often includes the charge for the use of the money, or the rate of interest.

11-4 STRUCTURE OF A PROMISSORY NOTE The following figure is a sample promissory note with its terms identified and defined.

11-5 PROMISSORY NOTES Although businesses frequently sign promissory notes, customers also sign promissory notes. For example, some student loans may require the signing of promissory notes. A promissory note can be noninterest bearing or interest bearing In this section you will learn the difference between interest-bearing notes and noninterest-bearing notes. If you sign a noninterest-bearing promissory note for $10,000, you pay back $10,000 at maturity. The maturity value of a noninterest-bearing note is the same as its face value. Usually, noninterest-bearing notes occur for short time periods under special conditions. For example, money borrowed from a relative could be secured by a noninterest- bearing promissory note. The total amount due at the end of the loan, or the maturity value (MV) is the sum of the face value (principal) and interest. Some banks deduct the loan interest in advance. When banks do this, the note is a simple discount note

11-6 SIMPLE DISCOUNT NOTE TERMINOLOGY 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 loan’s maturity value. Maturity Value – The total amount due at the end of the loan. In the simple discount note, the bank discount is the interest that banks deduct in advance and the bank discount rate is the percent of interest. The amount that the borrower receives after the bank deducts its discount from the loan's maturity value is the note's proceeds. Sometimes we refer to simple discount notes as noninterest- bearing notes. Remember, however, that borrowers do pay interest on these notes.

11-7 SIMPLE DISCOUNT NOTE 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 = $ $10,000 - $250 = $9,750 Proceeds Bank Discount Rate Example: Bank Discount

11-8 COMPARISON OF SIMPLE INTEREST NOTE AND SIMPLE DISCOUNT NOTE

11-9 COMPARISON OF SIMPLE INTEREST NOTE AND SIMPLE DISCOUNT NOTE Scenario Face value = $18,000 Interest rate = 8% 60 days

APPLICATION OF DISCOUNTING TREASURY BILLS Example: 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= $200 Cost = $10, $200 = $9,800 Effective rate = $200 = 8.16% $9,800 x When the government needs money, it sells Treasury bills. A Treasury bill is a loan to the federal government for 28 days (4 weeks), 91 days (13 weeks), or 1 year. Treasury bills can be bought over the phone or on the government website. The purchase price (or proceeds) of a Treasury bill is the value of the Treasury bill less the discount.

11-11 PRACTICE QUIZ 1- Warren Ford borrowed $12,000 on a non-interest-bearing, simple discount, 9.5% 60-day note. Assume ordinary interest. What are (a) the maturity value (b) the bank 'discount, (c) Warren's proceeds, and (d) the effective rate to the nearest hundredth percent? 2- Jane Long buys a $10,000, 13-week Treasury bill at 6%. What is her effective rate? Round to the nearest hundredth percent. For step by step solution watch the video for LU 11-1 ( Go to: McGraw-Hill’s Connect; Assignment # 3; Question 1; Click the eBook & resources options drop down menu; Click Structure of promissory notes; scroll down to LU11-1 and click

11-12 Manufacturers frequently deliver merchandise to retail companies and do not request payment for several months. If the manufacturer needs cash sooner, it can take one of its promissory notes to the bank. Assuming the maker of the note (retail company that signed the note) is reliable, the manufacturer can discounts the note to the bank and the bank will buy the note from the manufacturer. Now the manufacturer and has cash instead of waiting for several months. When the manufacturer discounts the promissory note to the bank, the company agrees to pay the note at maturity if the maker of the promissory note fails to pay the bank. The potential liability that may or may not result from discounting a note is called a contingent liability. Think of discounting a note as a three-party arrangement. the manufacturer realizes that the bank will charge for this service. The bank's charge is a bank discount. The actual amount the manufacturer receives is the proceeds of the note. The four steps below and the formulas in the example that follows will help you understand this discounting process.

11-13 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.

11-14 DISCOUNTING AN INTEREST-BEARING NOTE BEFORE MATURITY Roger Company 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 6% 5% August 9

11-15 DISCOUNTING AN INTEREST-BEARING NOTE BEFORE MATURITY What are Roger’s interest and maturity value? MV = $2,000 + $61.67 = $2, $2, x.05 x 31 = $ $2, – $8.80 = $2, Calculation on next slide What are the discount period and bank discount? What are the proceeds? I = $2,000 x.06 x 185 = $ Roger Company 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 6% 5% August 9

11-16 CALCULATION OF DAYS WITHOUT TABLE Manual Calculation March April30 May31 June30 July31 August days -- length of note days Roger held note 31 days bank waits Table Calculation August days March days Days passed before note is discounted154 Length of note Discount period 31

11-17 PRACTICE QUIZ From the above, calculate (a) interest and maturity value, (b) discount period, (c) bank discount, and (d)proceeds. Assume ordinary interest. Date of note Face value (principal) of note Length of noteInterest rate Bank discount rate Date of discount April 8$35, days11%9%June 8 For step by step solution watch the video for LU 11-2 ( Go to: McGraw-Hill’s Connect; Assignment # 3; Question 2; Click the eBook & resources options drop down menu; Click discounting interest bearing note ; scroll down to LU11-2 and click

11-18 DRILL PROBLEM 11-1 Solution: Complete the following table for this simple discount note. Use the ordinary interest method: LU 11-1(2) Amount Due Discount Bank at Maturity Rate Time Discount Proceeds $16,000 2 ¼ 190 days $211.11$15, $16,000 x.025 x 190 = $ $16, $ = $15,788.89

11-19 DRILL PROBLEM 11-3 Solution: Calculate the discount period for the bank to wait to receive its money: LU 11-2(1) Date of Length of Date Note Discount Note Note Discounted Period April days May = 25 May days Apr days

11-20 DRILL PROBLEM 11-5 Solution: Solve for maturity value, discount period, bank discount, and proceeds (assume a bank discount rate of 9%). LU 11-2(1, 2) Face Value Rate of Length Maturity Date Date note Discount Bank (principal) Interest of Note Value of Note Discounted Period DiscountProceeds $50,000 11% 95 days June 10 July 18 Discount period = = 57 July days June days $51, $733.18$50, $50,000 x.11 x 95 = $1, $50,000 = $51, MV 360 Bank discount = $51, x.09 x 57 = $ Proceeds = $51, = $50,718.21

11-21 DRILL PROBLEM 11-7 Solution: Calculate the effective rate of interest (to the nearest hundredth percent) of the following Treasury bill. Given: $10,000 Treasury bill, 4% for 13 weeks: LU 11-1(4) $10, $ = $9, Effective rate = $10,000 x.04 x 13 = $ Effective rate = $ $9,0000 x = 4.04%

11-22 MORE EXAMPLES