Determining the value at a node or backward induction, Financial Management

Assignment Help:

The value of node is determined using a methodology called backward induction. The value at any node depends on the future cash flows; therefore, we need to start from the last year in the tree and work backwards to get the required solution. For example, if we want to find the value at node T, we need to first calculate the value at node TH and TL and to find the value of bond at node TH; also, we need to first calculate the value of the bond at nodes THH and THL which is nothing but the future cash flows. The future cash flows depend on two factors. First, the coupon payment one year from now; and second, the bonds value one year from now. We have already seen that at every node there are two options and the node can take a higher or lower value. Therefore, the cash flow at a node can either be the bond value if the 1-year rate is higher rate plus the coupon payment or the bond value if the 1-year rate is lower rate plus the coupon payments. Coming back to our example, the cash flow at T will either be bond rate at THH plus coupon rate or the bond rate at THL plus coupon payment.

We need to calculate the present value of the expected cash flow to get the bond value at a node. We get two present values in each case, one is the present value if the 1-year rate is higher and the other if it is lower. As we have two options with equal probability, an average of the two present values is computed.

VH     =       Higher 1-year rate value of the bond.

VL       =       Lower 1-year rate of the bond.

P       =       Coupon payment.

r*      =       1-year rate at the node where the valuation is sought.

Therefore, the cash flow at a node is

VH + P for the higher 1-year rate (or)

VL+ P for the lower 1-year rate.

Present value of the cash flows using the 1-year rate at the node, is calculated as follows:

Present value for the higher rate = 256_determining value at node.png

Present value for the lower rate = 2381_determining value at node1.png

The value of the bond at the node is 2234_determining value at node2.png


Related Discussions:- Determining the value at a node or backward induction

Explain the reconstruction and effect on share price, Reconstruction and ef...

Reconstruction and effect on share price A listed company facing reconstruction (divestment, demerger, MBO etc) will have informed the stock market in advance and the share pri

Types of equity securities , Types of equaty Securities Equity securiti...

Types of equaty Securities Equity securities, traditionally, are classified into two types when they are issued. They are: Common Stock, and Preferred Stock.     Common Stoc

Cost of equity from new common stock, Weaver Chocolate Co. expects to gain ...

Weaver Chocolate Co. expects to gain $3.50 per share during the present year, its expected dividend payout ratio is 65%, its expected constant dividend growth rate is 6.0%, and its

How are financing costs capital budgeting analysis process, How are financi...

How are financing costs generally incorporated into the capital budgeting analysis process? Financing costs are typically captured in the discount or hurdle rate when doing IRR

Determine the analytical procedures of auditors, Analytical procedures of a...

Analytical procedures of auditors Auditors must apply analytical procedures at the planning and overall review stage of audit. Analytical procedures include the considerati

Constructing index numbers - weighted aggregates index, Weighted Aggregates...

Weighted Aggregates Index   In a weighted aggregates index, weights are assigned according to their significance and consequently the weighted index improves the accuracy of the

What are the main elements of capital budgeting decisions, What are the mai...

What are the main elements of capital budgeting decisions There are three elements of capital budgeting decisions (i) long-term assets and their composition (ii) business

Types of capital budgeting, Types of Capital Budgeting Decisions: A bu...

Types of Capital Budgeting Decisions: A business organization has to quite normal face the problem of capital investment decisions. Capital investment defines as the investmen

Calculate the interest rate on the investment, Jessica is given the opportu...

Jessica is given the opportunity to invest $5,000 now and receive $5,700 at the end of one year. However, she could only invest $1,000 of her own money and would need to borrow the

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd