Question

Juicy Energy Industries develops and produces biomass, an alternative energy source. The company has an outstanding $10,000,000, 30-year, 10% bond issue dated July 1, 2007. The bond issue is due June 30, 2037. Some bond indentures require the corporation issuing the bonds to transfer cash to a special cash fund, called a sinking fund, over the life of the bond. Such funds help assure investors that there will be adequate cash to pay the bonds at their maturity date.

The bond indenture requires a bond sinking fund, which has a balance of $1,200,000 as of July 1, 2012. The company is currently experiencing a shortage of funds due to a recent acquisition. Dillip Fogel, the company's treasurer, is considering using the funds from the bond sinking fund to cover payroll and other bills that are coming due at the end of the month. Dillip's brother-in-law, a trustee in a sinking fund, has indicated willingness to allow Dillip to use the funds from the sinking fund to temporarily meet the company's cash needs.

Discuss whether Dillip's proposal is appropriate. Support your opinion.

Answer 1

Dillip's proposal is inappropriate because the use of sinking funds to pay payroll or other bills would defeat the purpose of establishing the sinking fund.  

Sinking funds are setup to assure the investors that the firm has adequate funds to pay the investors when the bonds mature . Investors confidence would be lost if sinking funds are diverted for purposes other than what they are meant for. Also the company faces a high risk of defaulting when the bonds mature as they may not have enough funds to pay the investors.