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09class_12 - Introduction to Valuation Valuing a Bond...

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1 Introduction to Valuation --- Valuing a Bond Consider valuing a 3-year bond with principal equal to $1,000 and $120 interest rate payable at the end of each year. Thus the coupon rate is 12 percent. Also assume that the appropriate discount rate to apply is 10 percent. Thus 10 percent is the effective market interest rate.
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2 Continuing with the example V = 120(1.1) -1 +120(1.1) -2 +1,120(1.1) -3 . Thus the value for the price of the bond is 1,049.7. It makes sense that V is higher than 1,000 because the coupon rate is higher than the effective market interest rate.
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3 The general formula for discounted cash flow (page 881) is V = C 1 (1+r) -1 +C 2 (1+r) -2 +…+C N (1+r) -N Where C i is the Cash flow i periods in the future, r is the appropriate discount factor to use, and N is the forecast horizon.
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4 Thus in applying discounted cash flow analysis there are 3 issues. 1. What discount factor to use. 2. What definition of cash flow to use. 3. How to handle the situation where N is very large or infinite.
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5 The book page (858) has a list of 6 issues
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