Final answer:
If interest rates increase to 12%, you would not pay more than $964 for a $1,000 bond, reflecting the inverse relationship between bond prices and interest rates. The higher interest rates make new investments more attractive, which lowers the price of existing bonds. When purchasing bonds, there's also the risk that the issuing company may default and be unable to fully repay the bond's value.
Step-by-step explanation:
Given the change in interest rates to now 12%, and knowing that you could invest $964 in an alternative investment and receive $1,080 a year from now — That is $964(1 + 0.12) equals $1080 — you would not pay more than $964 for the original $1,000 bond. This is because the price of a bond is inversely related to the interest rate changes; as interest rates rise, the price of pre-existing bonds generally falls to yield the same rate of return to match current market rates. Furthermore, in the given example, a large company issuing bonds for $10 million with a promise of making interest payments at 8% annually represents a secure income stream, but there is always the risk that the firm may not have sufficient assets to pay off the bonds, in which case bondholders may only recoup a portion of what they loaned to the firm.