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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?

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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
Publisher: Cengage Learning
ISBN: 9781337395250
BuyFind

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
Publisher: Cengage Learning
ISBN: 9781337395250

Solutions

Chapter
Section
Chapter 7, Problem 1Q
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?

Expert Solution
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.

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Chapter 7 Solutions

Fundamentals of Financial Management (MindTap Course List)
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Ch. 7 - A sinking fund can be set up in one of two ways:...Ch. 7 - Can the following equation be used to find the...Ch. 7 - The values of outstanding bonds change whenever...Ch. 7 - If interest rates rise after a bond issue, what...Ch. 7 - Discuss the following statement: A bonds yield to...Ch. 7 - If you buy a callable bond and interest rates...Ch. 7 - Assume that you have a short investment horizon...Ch. 7 - Indicate whether each of the following actions...Ch. 7 - Why is a call provision advantageous to a bond...Ch. 7 - Are securities that provide for a sinking fund...Ch. 7 - Whats the difference between a call for sinking...Ch. 7 - Why are convertibles and bonds with warrants...Ch. 7 - Explain whether the following statement is true or...Ch. 7 - Would the yield spread on a corporate bond over a...Ch. 7 - A bonds expected return is sometimes estimated by...Ch. 7 - Which of the following bonds has the most price...Ch. 7 - Which of the bonds has the most reinvestment risk?...Ch. 7 - BOND VALUATION Madsen Motorss bonds have 23 years...Ch. 7 - YIELD TO MATURITY AND FUTURE PRICE A bond has a...Ch. 7 - BOND VALUATION Nesmith Corporations outstanding...Ch. 7 - YIELD TO MATURITY A firms bonds have a maturity of...Ch. 7 - BOND VALUATION An investor has two bonds in his...Ch. 7 - BOND VALUATION An investor has two bonds in her...Ch. 7 - INTEREST RATE SENSITIVITY .An investor purchased...Ch. 7 - YIELD TO CALL Seven years ago the Templeton...Ch. 7 - YIELD TO MATURITY Harrimon Industries bonds have 6...Ch. 7 - CURRENT YIELD, CAPITAL GAINS YIELD, AND YIELD TO...Ch. 7 - BOND YIELDS Last year Carson Industries issued a...Ch. 7 - YIELD TO CALL It is now January 1, 2018, and you...Ch. 7 - PRICE AND YIELD A 7% semiannual coupon bond...Ch. 7 - EXPECTED INTEREST RATE Lourdes Corporations 12%...Ch. 7 - BOND VALUATION Bond X is noncallable and has 20...Ch. 7 - BOND VALUATION You are considering a 10-year,...Ch. 7 - BOND RETURNS Last year Janet purchased a 1,000...Ch. 7 - YIELD TO MATURITY AND YIELD TO CALL Kempton...Ch. 7 - BOND VALUATION Clifford Clark is a recent retiree...Ch. 7 - BOND VALUATION Robert Black and Carol Alvarez are...

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