Valuation of Promissory Notes: Not as Simple as It Seems

Debt instrument values must incorporate the timing and amount of all future payments, as well as an in-depth analysis of the conditions and terms, any required collateral, and all factors that have an impact on the risk profile of the debt instrument.

A promissory note is not something that an appraiser is often required to value. However, when the situation does arise, the calculation seems fairly simple. The standard formula should be simple, calculating the interest accrued added to the outstanding principal amount.

Although it seems simple, it's not usually that easy. A simple debt instrument's value equals the future cash flow's value, discounted with a rate that incorporates the underlying risk to get back to present value. In most cases, the debt's value is only equal to the unpaid principal amount if the interest rate of stated coupon equals the discount rate.

Collateral and Valuation

If a promissory note has the backing of an asset, an appraiser must value that asset separately. Any underlying collateral impacts a promissory note's overall value. Using collateral with a promissory note can help mitigate the risk of default, so it can help a secured note to have a lower yield price than a debt security that doesn't have any collateral behind it.

The collateral's value can also represent the note's floor value if either of the following terms applies:

  • The terms of repayment require a large balloon payment at maturity and interest-only payments throughout the term of the loan.
  • The note is in default status.

Something that may be surprising to those unfamiliar with promissory notes is that the sum of the accrued interest plus the unpaid principal may be a higher value in some circumstances. In these situations, a well-authenticated and thorough analysis of valuation must support a fair market value that is lower than the note's carrying value. At a minimum, this type of analysis should incorporate any underlying collateral and include a determination of a discount rate that is appropriate and fair.

When including a discount rate in the valuation, the appraiser must support it with a thorough analysis of any pertinent market data that compares market metrics to the subject debt instrument.

Discount Rate Analysis

Figuring out a reasonable discount rate is an important part of the promissory note valuation process. Since a large portion of debt is publicly traded, appraisers can find a lot of information and use it to estimate an appropriate discount rate for the promissory note. Taking this approach evaluates the risk profile of the borrower, comparing it to the pricing and attributes of public debt, as well as the credit rating criteria as proxies for the discount rate, also referred to as the required return rate.

When creating a discount rate, the appraiser must adjust the market proxy to account for any applicable subject debt attributes. This process involves analyzing:

  • The lack of protective covenants.
  • Debt subordination.
  • The lack of collateral or security.
  • Any repayment risk that is specific to the note.
  • A lack of marketability.
  • The financial condition of the borrower.

When looking at these factors, this analysis is called a synthetic debt rating. It utilizes the financial metrics of the borrower, comparing them to any financial rations utilized to rate or price public debt. From there, the estimated discount rate will be applied to the future cash flows projected to determine the fair market value of the note

Gift and Estate Tax Implications

Regulations imposed by the U.S. Treasury use a standard for determining the fair market value of a promissory note that is outlined in §§ 20.2031-4. These sections state that the fair market value of both secured and unsecured promissory notes is presumed to be the unpaid principal amount and any interest accrued, unless the donor, or executor, states that the notes are worthless or the value is lower.

The IRS does not provide any safe harbor guidelines in relation to appropriate methodology, discounts, or market interest rates. The only exception to this is Revenue Ruling 67-276, which precludes market surveys as evidence of the conclusive fair market value of a promissory note. Market surveys can be used to support fundamental analysis, but they cannot be used alone.

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