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 operating profit margin - performance ratios, Operating profit ...

Operating profit margin Operating profit margin    =   (PBIT / Turnover) x 100% This is the ratio of operating profit to turnover or sales. A high operating profit margin is

Compute the dividend policy and the value of the firm, Q. Compute the divid...

Q. Compute the dividend policy and the value of the firm? Rate of Return: (i) 15% (ii) 10% (iii)8% Cost of Capital (Ke) = 10% Earning per share (E) = Rs. 10 C

Financial analysis project, 1. Collect three years of recent, financial...

1. Collect three years of recent, financial data (2007 - current), including the Balance Sheet, Income Statement, and Statement of Cash Flow. a. REQUIRED - paper copies o

Describe puttable-convertible-foreign bonds and eurobonds, Describe the Put...

Describe the Puttable, Convertible, Foreign and Eurobonds. With puttable bonds the release date is under control of the holder (that is the opposed of the callable bond case)

Sensitivity analysis, A division of Saron plc is considering introducing a ...

A division of Saron plc is considering introducing a new product.  The product is the result of work undertaken by the division's research and development department - the expendit

Company capacity to continue trading, Company capacity to continue trading ...

Company capacity to continue trading Given the preceding discussion it is unlikely that the business can continue in its current form. The trading performance is clearly very

Investment decision and financing decision, The Investment Decision: - Inv...

The Investment Decision: - Investment decision as well known as 'Capital Budgeting' is related to the selection of long-term assets or else projects in which investments will be m

Derivatives, Derivatives - Financial instruments whose value varies with va...

Derivatives - Financial instruments whose value varies with value of an underlying asset (like a stock, BOND, commodity or currency) or index like interest rates. Financial instrum

Define a callable bond, What is a callable bond?  What is a putable bond?  ...

What is a callable bond?  What is a putable bond?  How do each of these features affect their respective market interest rates? A callable bond may be retired untimely at the dis

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