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Interest-bearing notes receivable

The financial statement of Rachel Corporation presented the following information in the
2010 balance sheet:

June, 30
Balance Sheet: 2010
Current assets:
Other receivables $ 13,472,500

Noncurrent assets:
Notes receivable 39,317,500

Footnote information:

The fair market value of the notes was estimated by discounting the future cash flows
using current rates available to similar borrowers under similar circumstances.

All notes receivable bear interest at 5% to 12% and require future principal payments of
approximately $683,750 in 2011, $4,677,500 in 2012, $1,268,750 in 2013, $853,750 in
2014, $826,250 in 2015, and $31,691,250 thereafter. The current portion of these long-
term notes is included in other receivables in the consolidated balance sheets.

Required:
1. Estimate the average term of the notes and the interest rates at which these notes were
issued by customers of Rawlins.
2. Why would the interest rates vary so much?
3. Are the stated rate and the prevailing market rate of interest similar or quite different
at the date of issue?

Solution:
1. Most of the principal payments are due after 2015 suggesting that the average term is
at least six years (or perhaps longer).
2. Long-term notes are measured at the present value of remaining cash payments
(receipts), using the prevailing market rate of interest at the date of issuance. If the
sum of future principal payments is close to the net valuation of notes in the balance
sheet, then the stated and market rates of interest likely were similar at the date of
issuance. The stated interest rates vary between 5% and 12% which reflects the credit
risks associated with a wide range of customers and the variation in interest rates in
effect at the times the various notes were issued.

The sum of the principal payments for the period 2011 through 2015 and thereafter as listed
in the footnotes is $40,001,250. This amount is close to the amount disclosed for net long-
term notes receivable.

3. The principal amount due one year from the balance sheet date ($683,750) explains
the difference between the sum of the principal payments ($40,001,250) and the
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valuation of long term notes ($39,317,500). This difference suggests that the market
rates at issuance of the notes likely was the same as the stated rates.