INTEREST BEARING AND NONINTEREST-BEARING
Present Value of a Note is determined as follows
1. Find future cash flows. These are generally of 2 types
i. Face value of note, is the amount that the borrower will pay to the lender at the end of the loan period. It is a single sum. In a non-interest bearing note this is the ONLY cash flow.
ii. Cash interest payments, which are the cash payments made by the borrower to the lender over the life of the loan. Determine the cash payments by multiplying the stated interest rate by the stated or face value of the note. The cash payments are the same every year.
2. Discount the future cash flows by the effective interest rate (market rate when the note is issued).
The single sum from i. Above is discounted using table 2, present value of a single sum for the given number of periods at the effective interest rate.
The stream of interest payments from ii. above, are an ordinary annuity (annuity in arrears) and are discounted using the effective interest rate and the number of periods they will be received (Table 4 gives present value factors for an ordinary annuity).
NOTE: if the effective interest is equal to the stated interest the present value of the future income stream (principal and interest payments) will equal the face value of the note. If the stated interest is below the market rate the note will be issued at a discount and is said to be issued at an unrealistic interest rate. The lender will often give the borrower a low rate of interest in order to induce the borrower to buy goods or property. Unlike bonds there is little likelihood of a note being issued at a premium.