Final answer:
To calculate the present value of bonds, apply the present value formula to its future payments discounted at the current interest rate. A bond's present value decreases when the discount rate exceeds the bond's coupon rate.
Step-by-step explanation:
The question involves calculating the present value of a bond using different discount rates. A two-year bond issued for $3,000 with an interest rate of 8% pays $240 in interest each year. To calculate the present value, we use the present value formula for both the interest payments and the principal repayment.
With a discount rate of 8%, the present value of the interest payments and the principal amount is equal to the face value of the bond, because the discount rate matches the interest rate. When the discount rate increases to 11%, the present value will be less than the face value due to the higher cost of borrowing.
In the scenario where the local water company issued a $10,000 ten-year bond at 6%, and you consider buying it one year before maturity when interest rates are at 9%, you would expect to pay less than $10,000 for the bond. To calculate the present value, we discount the final year's interest payment and the principal repayment at the new interest rate of 9%.