Final answer:
The valuation of bonds is influenced by the market interest rate compared to the bond's interest rate. A bond paying $1,080 in one year should not cost more than $964 if the market rate is 12%. For any bond, future cash flows should be discounted back to the present value at the current market rate.
Step-by-step explanation:
When considering the valuation of bonds, it's essential to understand how market conditions affect their price. In the case of a bond expected to pay $1,080 in one year, if the market interest rate is 12%, an equivalent alternative investment would also result in $1,080 if $964 were invested at that rate. Therefore, the bond should not be purchased for more than $964 if it is to be a competitive investment. This concept is known as present discounted value, where future payments are discounted back to their present value at the current market interest rate.
Similarly, if a $10,000 bond issued at 6% is being considered for purchase one year before maturity, and market interest rates have risen to 9%, one would expect to pay less than $10,000 due to the bond's lower interest rate compared to the market. This concept applies across various scenarios, whether analyzing a simple two-year bond at an 8% interest rate and recalculating its present value should the discount rate increase to 11%, or any other bond with stipulated cash flows and prevailing market rates.