Pure Discount Loans

The pure discount loan is the simplest form of loan. With such a loan, the borrower receives money today and repays a single lump sum at some time in the future. A one-year, 10 percent pure discount loan, for example, would require the borrower to repay $1.10 in one year for every dollar borrowed today.

Because a pure discount loan is so simple, we already know how to value one. Suppose a borrower was able to repay $25,000 in five years. If we, acting as the lender, wanted a 12 percent interest rate on the loan, how much would we be willing to lend? Put another way, what value would we assign today to that $25,000 to be repaid in five years? Based on our work in Chapter 5, we know the answer is just the present value of $25,000 at 12 percent for five years:

Present value = $25,000/1.125 = $25,000/1.7623 = $14,186

Pure discount loans are very common when the loan term is short, say, a year or less. In recent years, they have become increasingly common for much longer periods.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

III. Valuation of Future Cash Flows

6. Discounted Cash Flow Valuation

© The McGraw-Hill Companies, 2002

PART THREE Valuation of Future Cash Flows

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