Final answer:
When the market rate of interest increases, the present value of a stream of cash flows decreases. This happens because the cash flows are discounted at a higher rate, leading to a lower present value even when the actual cash payments remain the same.
Step-by-step explanation:
If the current market rate of interest is %, then the present value (PV) of this stream of cash flows is closest to decreasing. The scenario you provided illustrates how the present value of a stream of cash flows changes when the interest rate changes.
When the interest rate increases, the present value of those cash flows decreases, even if the actual dollar payments remain unchanged.
The reason for this relationship between interest rates and present value lies in the way present value is calculated. The present value of future cash flows is determined by discounting them at the market interest rate.
If the interest rate increases, as in the example from 8% to 11%, the discount rate is higher, and the present value of the same cash flows is lower.
Investors considering the sale of an investment like a bond would find that the value has fallen if interest rates in the market have risen, reflecting the lower present value of the expected future payments.
This is a fundamental principle in finance, where the price of a bond is always considered as the present value of a stream of future expected payments, which is influenced by the prevailing market interest rate and the perceived riskiness of the bond.