Examples of Sinking Fund
Let’s consider an example, a manufacturing company ABC Industries which issues $150 million in long-term bonds with a maturity period of 7 years to fund the expansion of its production facilities. The bonds carry an annual interest rate of 5%, and interest payments are made semi-annually. Instead of facing the challenge of repaying the entire $150 million at the end of the 7-year maturity period, ABC Industries decides to establish a sinking fund to systematically set aside funds for debt repayment. ABC Industries can follow the following strategies in such cases,
1. Issuance of Bonds: ABC Industries successfully issued $150 million in long-term bonds, specifically designated for the development of its industrial facilities.
2. Sinking Fund Contribution: The company sets up a sinking fund and agrees to contribute $15 million annually to the fund at the end of each financial year. These contributions will continue for the entire 7-year period.
3. Accumulated Fund: The sinking fund has accumulated a sum of $60 million ($15 million x 4 years) at the end of the 4th year.
4. Debt Repayment: ABC Industries decides to use the accumulated sinking fund to repay a part of the outstanding bonds. The company opts to repurchase $60 million worth of bonds in the open market.
5. Reduced Debt and Interest Payments: The use of the sinking fund has led to a reduction in the company’s outstanding debt to $90 million ($150 million and $60 million). Consequently, this results in reduced interest payments for the remaining years.
6. Market Conditions: ABC Industries may deliberately repurchase bonds at discounts if market circumstances allow. The corporation may also repurchase bonds at face value if market prices rise.
Comparison of Strategies when ABC Industries decides to operate without a Sinking Fund
If ABC Industries had not opted to set up a sinking fund, the company would have faced the challenge of repaying the entire $150 million at the end of the 7-year maturity period and the company might have had to allocate a substantial portion of its profits or cash reserves to meet the lump-sum debt payment. Without the sinking fund, the risk of default would have been higher, especially if economic conditions or market factors affected the company’s ability to generate sufficient funds. In summary, the sinking fund strategy adopted by ABC Industries illustrates how systematic contributions over time can be utilized to strategically manage debt, reduce interest expenses, and enhance financial flexibility for the company.
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