Question

Examine the pros and cons of a sinking fund from the viewpoint of both a firm and its bondholders. Determine the fundamental manner in which this knowledge could be helpful to a financial manager. Provide a rationale for your response

Answer 1

Pros & cons of sinking fund:

Pros:

It helps the companies to address their debt in advance. Rather than waiting for the issued bonds to mature, they can set aside certain amount of money into the sinking fund each year. They can use the money in the fund to purchase some bonds in advance.

The investors will be happy to know that the company will be able to meet its debt requirements. This can give assurance to the investors that the company will not go on bankruptcy very soon. When the company lets its debt go out of control, it won’t be considered as an attractive zone for investment.

Sinking fund can also increase the goodwill of the company as a result of timely payment of its debt & helps retaining the faith of investors.

Cons:

The investor can lose the interest if the company uses the sinking fund to buy the bonds before maturity.

At times companies wait for the interest rates to go down for the value of the bonds to increase as a result of which they would purchase several bonds which would be less than what they will have to pay in the market.

This can be a loss to the investor because had he sold the bonds in the secondary market before being purchased by the company, they could have made profits. There can’t be lot of uncertainty for the investors as we won’t be aware when the company will purchase back the bonds.

How useful for the financial manager?

It helps the financial managers to plan periodically the amount to be set aside in the sinking fund & the interest to be paid to the bondholders. Those bonds whose maturity is earlier must be purchased first so that the new bondholders can enjoy some interest payments.