Question

A sinking fund can be set up in one of two ways. Discuss the advantages and disadvantages of each procedure from the viewpoint of both the firm and its bondholders. Must be an original answer. Please and thank you.

Answer 1

A Sinking Fund can be set up in one of the below two ways:

(1) The corporation makes annual payments to the trustee, who invests the proceeds in securities (frequently government bonds) and uses the accumulated total to retire the bond issue at maturity.

(2) The trustee uses the annual payments to retire a portion of the issue each year, either calling a given percentage of the issue by a lottery and paying a specified price per bond or buying bonds on the open market, whichever is cheaper.

From the viewpoint of firm, one significant feature in setting up a sinking fund is that normally the bonds of the firm have a superior yield in comparison to government bonds. As a result, high interest is saved by the firm by taking the decision of calling of their bonds instead of the firm might earn by purchasing government bonds.

Investors also have a inclination towards the yearly retirement process if they predict that in future interest rates would increase, but on the other hand if they predict that rates would fall, then in that case they errand the government bond purchases agenda.

Bondholders identify that, under the bond purchase plan of government, every bondholder would get only the specific amount from the insolvency of the sinking fund at the situation of default of the firm. On the other side, under the annual retirement plan, few holders would get the cash advantage whereas some would get only indirectly benefit.

On balance, investors have slight motive for selecting one method over the other, while the method of annual retirement is evidently highly advantageous for the issuing company.