Question

earned income

1. When a company exchanges a long-term, non-interest-bearing note for cash and no interest rate is stated, how does it determine the effective interest?

Answer 1

Long term Non-interest bearing note does not charge any interest on the outstanding debt. Instead they are issued at a price lower than their face value. This difference between the face value and the issue value is commonly referred to as 'discount on notes payable' is the accumulation of present values of the interest payable across the life of the notes payable.

The effective rate of interest can be computed on such a notes as follows:

PV = FV / (1 + i%)ⁿ

^{where PV = The cash received against the notes (issue value)}

FV = Face Value of the notes payable at the end of the term

n = The period of Notes payable

I = effective interest thereon, we need to compute this.

Other way we can say: I% = { ⁿ√(PV/FV) } - 1

Thus we compute the effective interest.