Final answer:
When interest rates rise, existing bonds with lower interest rates become less valuable and may be sold at a discount. Assessing the present value of a bond's future payments is vital when the market interest rate changes, as it directly influences the bond's current market price.
Step-by-step explanation:
When considering purchasing a bond, an important factor to consider is the interest rate at which the bond was issued versus the current market interest rate. If a local water company issued a $10,000 ten-year bond at an interest rate of 6%, and you are considering buying this bond one year before maturity, but interest rates are now 9%, the bond's price will likely be affected. Since the bond pays less interest compared to the new market rate, it may be sold at a discount to attract buyers. On the other hand, if the current market rates were lower than the bond's rate, the bond would be worth more and could be sold at a premium.
Analyze present value calculations to determine the impact of changing interest rates on a bond's value. For example, a two-year bond issued for $3,000 at an interest rate of 8% pays $240 interest annually. To determine the bond's present value with an 8% discount rate, you would use the formula for present value. If the discount rate increases to 11%, the present value of future payments decreases, making the bond less valuable.