Appraisal and Valuation Concepts – Understanding Note Discounting

What Is The Discounted Market Value of a Promissory Note?

What is a Discount Rate?
A discount rate is a yield adjustment tool used by an investor who is purchasing an existing promissory note. Since the interest rate stated on the note cannot be changed, the amount being paid for the remaining balance on the note is reduced. By reducing the amount paid for the note-“discounting it”–the investor receives a higher yield. The borrower on the note is paying the exact amount specified on the face of the note while the investor who purchased the note, at a discount, is receiving a higher yield.

To further define this rate, it can be described as the rate of return required by an investor to accept the risks of a certain note investment. The determination of these rates is very subjective. When dealing with private party notes, the size of the discount is normally “in the eye of the beholder”. It is a “gut feeling” of the investor based on the investor’s l opinion of the quality of the promissory note.

What is the Purpose of Discounting a Promissory Note?
A higher rate will be used for a riskier promissory note, and a lower rate for a less risky note. The problem with any discount rate calculation process is how to select an appropriate discount rate. It becomes an art rather than a science.

The prudent note investor requires a “premium” interest rate, a higher yield, over and above a “safe” base rate which is risk-free. This “premium” interest rate is called the “risk premium” and is added to the base “safe” rate to arrive at the appropriate combined rate applicable to the subject note. This process is usually done informally, in the mind of the investor. A high-risk note requires a high yield to attract an investor.

Is there a Mathematic Formula Used to Calculate the Discount Rate?
Analysts and academics have produced an astounding number of formulas, proofs, and mathematical expressions used to calculate discount rates. In most cases, the expressions and formulas are correct on the grounds of mathematical consistency. But, the numbers required in the equations usually do not represent understandable or generally available market data relating to promissory notes. Because of the shortage of reliable market data relating to private party promissory notes, determining the risk-adjusted discount rate is never accurate because it is not supported by “real world’ data. The old computer warning applies here: “Garbage in, garbage out”.

How is the Discount Calculated in Actual Situations?
This means that the valuation expert must use a variety of ways to estimate the return that an investor might require from a specific note investment. The note appraiser must relay on personal experience, current market conditions, and an objective determination of the risks associated with the specific note being considered. Since no two notes are exactly alike, the note Discount calculator appraiser must be guided by common sense and sound judgment.

In addition to the appraiser’s judgment, the discount rate required for a more risky note will change, depending on an individual investor’s appetite for risk at the time, and the individual investor’s capital availability, at the time. A discount rate must be matched to the character of the cash flow that is being discounted at a certain point in time; and, it must be discounted to reflect the individual investors’ circumstances.

Summary
The discount rate on any specific note is determined by the appraiser’s or the investor’s opinion of value. A key component of the value of a note is the amount of risk it contains. The appraiser’s valuation of the note and its risk must be based on current market factors, the quality of the specific promissory note, and the investor’s specific circumstances.

Discount rates, and risk adjusted discount rates, offer a way to adjust the value of future annual free cash flows-interest income-to the present, taking into account the time value of money and various risk factors. As with most valuation issues, the key to determining the discount rate is to get “close enough” and to make reasonable assumptions about future free cash flows.