Textbook Problem

A sinking fund can be set up in one of two ways:

• 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.
• The trustee uses the annual payments to retire a portion of the issue each year, 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.

What are the advantages and disadvantages of each procedure from the viewpoint of the firm and the bondholders?

Summary Introduction

To identify: The advantages and disadvantages of given procedures from the firm’s point of view and the bondholders.

Introduction:

Sinking Fund: Sinking fund refers to the investment made by the issuer of the debt instrument annually, which is used to redeem bonds at maturity.

Answer to Problem 1Q

First way:

• Advantages to firm: Investment in government bonds will provide risk free return to the firm.
• Disadvantages to firm: Investment in government bonds will provide lower return to the firm as compared to market return.
• Advantages to bondholder: Bondholders will get continuous return from the firm and there is no interest rate risk.
• Disadvantages to bondholder: Bondholders loose the opportunity to receive the premium on redemption of their bonds.

Second way:

• Advantages to firm: Retiring of bonds through calling or open market purchase, whichever is low will reduce the cost of the firm for current debt.
• Disadvantages to firm: It will increase the interest rate which increases the cost of the firm for any additional debts.
• Advantages to bondholder: Bondholders will get risk free return and their funds will be secured.
• Disadvantages to bondholder: Bondholders will get lower return if firm uses open market operation.

Explanation of Solution

• From the viewpoint of firm and bondholder both the ways are somewhat advantageous and disadvantageous.
• First way provide risk free return but lower return than market return to the bondholder.
• Second way leads to retiring of bonds at par value or market value whichever is less, therefore the return to bondholder is again less but return is assured.

Conclusion

Hence, both the ways have some advantages and disadvantages for firm and bondholders.