To understand what a sinking fund factor is, we must first understand what is a sinking fund? Once we knock that out of the park, we can investigate the internal workings of the sinking fund factor.
What Is a Sinking Fund?
A sinking fund is a fund that contains funds set aside or used to repay debts or bonds. The company that issued the debt will need to repay the debt in the future. The sinking funds will help alleviate the difficulties of huge expenditure. The concept of sinking fund was established so that the company can set aside some money to the fund in the years before the bond expires.
Sinking Fund Explanation
Sinking funds can help companies that issue debt in the form of bonds to gradually save money and avoid paying large sums at the time of maturity. Some bonds are issued with a sinking fund option. The prospectus for such bonds will determine the date the issuer can choose to use the sunk fund to redeem the bond in advance. Although this can help companies ensure that they have enough funds to pay off debts, in some cases they can also use these funds to repurchase preferred shares or buy back outstanding bonds.
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Reduce the risk of default
The sinking fund adds security to investors ’corporate bond issuance. Since there will be enough funds to repay the bonds that are due, there is less possibility of default on the arrears due. In other words, if a sinking fund is established, the arrears at maturity will be greatly reduced. Therefore, if the company goes bankrupt or defaults, the fund can help investors get some protection. Sinking funds can also help companies mitigate concerns about default risk, thereby attracting more investors to issue bonds.
Since this type of fund increase security and reduce default risk, bond interest rates are usually low. As a result, the company is generally considered to be in good standing, which may result in a positive credit rating for its bond. A good credit rating will increase investor demand for corporate bonds, which is particularly useful when the company needs to issue more debt or bonds in the future.
Due to lower interest rates and lower debt repayment costs, cash flow and profitability can be improved over the years. If the company performs well, investors are more likely to invest in its bonds, which leads to increased demand and the possibility that the company can raise more funds when needed.
If the bonds issued are callable bonds, it means that the company can use the sinking fund to refund or repay some bonds in advance when it is financially feasible. Bonds are embedded with call options, giving the issuer the right to “call” or repurchase the bond. The bond issuance prospectus can provide detailed information on the callable option, including the time of callable bonds, specific price levels, and the number of such callable bonds. Generally, only a portion of the bonds issued are callable bonds, and these bonds are randomly selected using their serial numbers.
Callable bonds are usually invoked with an amount slightly higher than the face value, and bonds that were redeemed earlier have a higher call value. For example, if a callable bond is at $ 105, then the investor receives $ 1050 for each $ 1000 in face value. But regulations may stipulate that the price will drop to $ 104 a year later.
If the interest rate falls after the bond is issued, the company can issue new bonds at a lower rate of interest than that os a callable bonds. The company uses the sales proceeds of the second issue to redeem bonds by exercising redemption rights. As a result, the company repaid its debt by closing off high-yield bonds with newly issued bonds at a lower interest rate.
Similarly, if the interest rate falls (which will cause the bond price to rise), the face value will go below the current market price. In this case, the bonds can be redeemed by the company, which redeems the bonds from investors at face value. Investors will lose part of their interest, resulting in a reduction in long-term income.
Other types of sinking funds
The sinking funds can be used to buy back preferred shares. Preferred stocks usually pay more attractive dividends than ordinary stocks. The company can set aside funds as cash deposits and use it to close preferred shares. In some cases, stocks can be accompanied by call options, which means that the company has all the rights to buy back that stock at a predetermined price.
Sinking funds are usually listed as long-term assets in the company’s balance sheet, and are often included in the list of long-term investments or other investments.
Capital-intensive companies usually issue long-term bonds to finance the purchase of new factories and equipment. Oil and gas companies need a lot of capital because they need a lot of capital or funds to finance long-term operations such as drilling rigs and drilling equipment.
Sinking Fund Factor:
Sinking Fund Factor is an equal periodic payment, which must be paid at a periodic interest rate I, at the end of each cycle of n cycles, so that the payment will be compounded to 1 USD at the end of the last cycle.
Sinking Fund Factor is usually used to determine how much each period must be set aside to meet future monetary obligations.
Sinking Fund Factor can be considered the “opposite” of the FW $ 1 / P factor. Mathematically, the SFF and FW $ 1 / P factors are reciprocals:
The table below shows how the annual sinking fund payment of 0.228591 increased to $ 1 at the end of 4 years. The payment is made at the end of each year, so the opening balance of the first year is 0.