04 L45 - Lesson 4: Overview When you complete Lesson 4, you...

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Lesson 4: Overview When you complete Lesson 4, you will be able to understand valuation methods for direct claim securities - stocks and bonds Introduction to Bond and Stock Valuation Firms and investment bankers have created an almost limitless variety of securities with new ones being created every day. You could spend your entire career developing variations of the basic equation. However, in this lesson, we will deal with the following securities: Securities 1. Bonds 2. Common Stock 3. Preferred Stock Direct claim securities have a direct claim on the cash flows of the firm. The next topic is Valuation Process Valuation Process This general valuation model can be applied to businesses, projects, debt,
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preferred stock, and common stock. The four step process for Discounted Cash Flow (DCF): 1. estimate future cash flows 2. estimate riskiness of future cash flows 3. incorporate the risk into the analysis of future cash flows 4. discount the future cash flows to present value. Bonds and Stocks are valued based on DCF principles, whereas options are based on option pricing models discussed in chapter 5. Derivatives like options have a value derived from underlying securities values. The variations on a theme are unlimited except by the imagination of the financial innovator. We will cover the important forms of this process to set benchmarks. The next topic is Bonds.
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Bonds Bonds are debt and represent an investment of principal for a defined series of future cash payments. Key Features of Bonds: 1. Face Amount 2. Coupon Rate 3. Term The valuation of bonds is derived by applying the DCF method. Question What is the value of a 1 year, 12% annual coupon bond if k d = 12%? Answer Question Find the value of a 10 year 12% annual coupon bond. Answer
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Question What would be the value of a 1 year bond if k d = 9% Answer Question What would be the value of a 10 year bond if k d = 9% Answer When k d falls below the coupon rate, the bonds values rise above par, so they sell at a premium. The longer the maturity, the larger the premium
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The following graphic shows the value of a 12% coupon bond over time. If kd remains constant:
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04 L45 - Lesson 4: Overview When you complete Lesson 4, you...

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