Question

Write down the usefulness of Amortization and sinking fund in financial sector.
(this question is related to actuarial science)

Answer 1

Sinking Fund-

Sinking funds carry some risk, because failure to fulfill sinking fund requirements puts the bond issue into default, which might lead to bankruptcy. Hence, sinking funds might cause cash shortages. Nevertheless, an issuer may accept sinking fund provisions for the following reasons:

1. If the creditworthiness of the issuer is in question, lenders may not grant credit witho ut a sinking fund since it provides a measure of protection for the creditor. The opportunity costs of the sinking fund requirement may be the inability to secure long-term debt needed to purchase highly profitable equipment.
2. The accumulation of funds in a special account also provides the issuer with security against future business conditions that may be detrimental to its ability to retire the debt.
3. The insurance provided by a sinking fund decreases the interest rates, therefore, the interest expenses. This results in increased cash flow.
4. When the purchase of productive assets requires a sinking fund, the sinking fund mirrors the depreciation schedule of those assets. The issuer benefits in two ways. Depreciation allows the issuer to recover the costs while simultaneously retiring the debt of equipment going out of service.
5. The issuer can book capital gains on debt retirement if it purchases bonds in the open market below book value.
6. A sinking fund enhances the tax benefits of financial leverage. First, interest expense and depreciation are tax deductible. The issuer can use the tax savings to fund part of the annual sinking fund payment. Second, the sinking fund could earn compounded interest, helping to reduce the cost of borrowing. Finally, the interest expense decreases proportionately to the amount of bonds outstanding. If the sinking fund accumulates and compounds, the earnings grow geometrically. At some point the issuer will benefit from a positive after-tax cash flow.

Amortization-

• When used in the context of a home purchase, amortization is the process by which loan principal decreases over the life of a loan, typically an amortizing loan. As each mortgage payment is made, part of the payment is applied as interest on the loan, and the remainder of the payment is applied towards reducing the principal. An amortization schedule, a table detailing each periodic payment on a loan, shows the amounts of principal and interest and demonstrates how a loan's principal amount decreases over time. An amortization schedule can be generated by an amortization calculator. Negative amortization is an amortization schedule where the loan amount actually increases through not paying the full interest.
• In business, amortization allocates a lump sum amount to different time periods, particularly for loans and other forms of finance, including related interest or other finance charges. Amortization is also applied to capital expenditures of certain assets under accounting rules, particularly intangible assets, in a manner analogous to depreciation.
• In tax law in the United States, amortization refers to the cost recovery system for intangible property.
• In computer science, amortized analysis is a method of analyzing the execution cost of algorithms over a sequence of operations.^[3]
• In the context of zoning regulations, amortization refers to the time period a non-conforming property has to conform to a new zoning classification before the non-conforming use becomes prohibited. For example, if the city rezones property from industrial to residential and sets an amortization period of one year, all property within the rezoned boundary must move from industrial use to residential use within one year.
• In the context of Securitization the Joshua Curve relates to a unique amortization profile that results in the innovative "horseshoe Shape" or "J Shape" weighted average life ("WAL") distribution. In other words, if the base case results in a WAL of 10.0 years, the stress case and performance case would both result in reduced WALs that are both less than 10.0 years due to accelerated amortization.