CHAPTER 14
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Key Points
Chapter 14 is the
second of two chapters
that explore the
process of raising the
capital necessary to
run the business and
enable it to invest in
long-term projects and
human capital.
Chapter 14 investigates
debt (creditor)
financing. We explore
the types of
promissory notes used
by businesses to raise
long-term capital and
how each of these
notes works. In
addition, Chapter 14
examines the cash flow
implications of the
various types of notes
and the impact of these
notes on the budgeted
financial statements.
There are three basic types of notes:
 Periodic payment notes a.k.a. installment notes
 Lump-sum payment notes a.k.a. noninterest-bearing
notes
 Periodic payment and lump-sum notes a.k.a.
interest-bearing notes.
When the market rate of interest is different than the face
rate of interest, notes are issued at a:
 Discount, or
 Premium
With an installment note, the payment of principal and
interest remains the same over time (statement of cash
flows) although the composition (principal versus interest)
changes. The interest expense decreases over time (income
statement) and the carrying value of the liability (balance
sheet) decreases over time.
With a noninterest-bearing note, there is no periodic cash
payment. The interest expense increases over time (income
statement) and the carrying value of the liability (balance
sheet) increases over time.
With a bond issued at a discount, the cash payment for
interest remains constant over time (statement of cash
flows), the interest expense increases over time (income
statement) and the carrying value of the debt (balance sheet)
increases over time.
With a bond issued at a premium, the cash payment for
interest remains constant over time (statement of cash
flows), the interest expense decreases over time (income
statement, and the carrying value of the debt (balance sheet)
decreases over time.
There are many different types of bonds, including:
 Registered versus bearer
 Callable versus convertible
 Secured versus unsecured
 Subordinated
DISCUSSION OUTLINE
Chapter 14’s discussion should focus on the inner workings of the three basic types of notes.
Students must understand the components of these notes (PV, FV, r, n, c, and ANN) and the
difference between cash payments and interest charges. If you accomplish these objectives now,
the recording of debt events in Chapter 15 is much easier.
Debt Financing Terms
 Maker of Note =
 Holder of Note =
 Face Value of Note =
 Face Rate of Note =
 Effective Interest Rate =
 Proceeds of Note =
What are the three basic types of notes and how does each work?

Periodic payment note (installment note)—

Lump-sum payment note (noninterest-bearing note)—

Periodic and lump-sum payment note (interest-bearing note)—
How would issuing each of the three basic types of notes impact the company’s pro forma
(budgeted) financial statements (ignoring income taxes)?

Installment note

Noninterest-bearing note

Interest-bearing note (market rate greater than face rate)

Interest-bearing note (market rate less than face rate)

Interest-bearing note (market rate is equal to the face rate)
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What are the most common sources of debt financing?

Private borrowing—

Leasing—

Issuing bonds—
What are the types of bonds most commonly issued?






Registered—
Callable—
Convertible—
Serial—
Secured—
Subordinated—
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Lecture Examples
1.
Your company needs $20,000. It signs a periodic payment note for 2 years agreeing to
make monthly payments at 12 percent annual interest. What is the amount of each payment?
What are the amounts shown on the pro forma income statement, statement of cash flows, and
balance sheet for the first two months of this note?
Answer:
PV = 20,000, FV = 0, r = 12, c = 12, n = 24, ANN = $941.47
Month One:
Income statement—interest expense = $20,000 * .12/12 = $200
Statement of cash flows—cash inflow = $20,000; cash outflow = $941.47
Balance sheet—carrying value of note = $20,000 – ($941.47 - $200) = $19,258.53
Month Two:
Income statement—interest expense = $19,258.53 * .12/12 = $192.59
Statement of cash flows—cash outflow = $941.47
Balance sheet—carrying value of note = $19,258.53 – ($941.47 - $192.59) = $18,509.65
2.
Your company needs $20,000. It signs a lump-sum payment note for 2 years when the
market rate of interest is 12 percent compounded quarterly. What is the amount your company is
required to repay? What are the amounts shown on the pro forma income statement, statement
of cash flows, and balance sheet for the first two quarters of this note?
Answer:
PV = 20,000, ANN = 0, r = 12, c = 4, n = 8, FV = $25,335.40
Quarter One:
Income statement—interest expense = $20,000 * .12/4 = $600
Statement of cash flows—cash inflow = $20,000; cash outflow = $0
Balance sheet—carrying value of note = $20,000 + $600 = $20,600
Quarter Two:
Income statement—interest expense = $20,600 *.12/4 = $618
Statement of cash flows—cash outflow = $0
Balance sheet—carrying value of note = $20,600 + $618 = $21,218
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3.
Your company issues a $20,000 interest-bearing note. You agree to make semiannual
payments at a 12 percent annual rate for 2 years. The market rate of interest is 10 percent. What
is the amount your company will receive? What are the amounts shown on the pro forma
income statement, statement of cash flows, and balance sheet for the first two semiannual periods
of this note?
ANN = $20,000 * .12/2 = $1,200, FV = $20,000, r = 10, c = 2, n = 4,
PV = $20,709.19
Semiannual Period One:
Income statement—interest expense = $20,709.19 * .1/2 = $1,035.46
Statement of cash flows—cash inflow = $20,709.19; cash outflow = $1,200
Balance sheet—carrying value of note = $20,709.19 – ($1,200 - 1.035.46) = $20,544.65
Semiannual Period Two:
Income statement—interest expense = $20,544.65 * .1/2 = $1,027.23
Statement of cash flows—cash outflow = $1,200
Balance sheet—carrying value of note = $20,544.65 – ($1,200 - $1,027.23) =
$20,371.88
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