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A sinking fund is a fund established by an economic entity by setting aside revenue over a period of time đồ sộ fund a future capital expense, or repayment of a long-term debt.

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In North America and elsewhere where it is common for public and private corporations đồ sộ raise funds through the issue of bonds, the term is normally used in this context. However, in the United Kingdom^[1] and elsewhere^[2] where the issue of bonds (other than vãn government bonds) is unusual, and where long-term leasehold tenancies are common, the term is only normally used in the context of replacement or renewal of capital assets, particularly the common parts of buildings.

Borrowing money by issuing a bond is referred đồ sộ as floating a bond. Sinking is its opposite, repaying debt or acquiring capital assets without debt.

Historical context[edit]

The sinking fund was first used in Great Britain in the 18th century đồ sộ reduce national debt. While used by Robert Walpole in 1716 and effectively in the 1720s and early 1730s, it originated in the commercial tax syndicates of the Italian peninsula of the 14th century, where its function was đồ sộ retire redeemable public debt of those cities.

The fund received whatever surplus occurred in the national Budget each year. However, the problem was that the fund was rarely given any priority in Government strategy. The result of this was that the funds were often raided by the Treasury when they needed funds quickly.

In 1772, the nonconformist minister Richard Price published a pamphlet on methods of reducing the national debt. The pamphlet caught the interest of William Pitt the Younger, who drafted a proposal đồ sộ reform the Sinking Fund in 1786. Lord North recommended "the Creation of a Fund, đồ sộ be appropriated, and invariably applied, under proper Direction, in the gradual Diminution of the Debt". Pitt's way of securing "proper Direction" was đồ sộ introduce legislation that prevented ministers from raiding the fund in crises. He also increased taxes đồ sộ ensure that a £1 million surplus could be used đồ sộ reduce the national debt. The legislation also placed administration of the fund in the hands of "Commissioners for the Reduction of the National Debt".

The scheme worked well between 1786 and 1793 with the Commissioners receiving £8 million and reinvesting it đồ sộ reduce the debt by more than vãn £10 million. However, the outbreak of war with France in 1793 "destroyed the rationale of the Sinking Fund" (Eric Evans).^{[citation needed]} The fund was abandoned by Lord Liverpool's government only in the 1820s.

Sinking funds were also seen commonly in investment in the 19th century in the United States, especially with highly invested markets lượt thích railroads. An example would be the Central Pacific Railroad Company, which challenged the constitutionality of mandatory sinking funds for companies in the case In re Sinking Funds Cases in 1878.^[3]

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Modern context – bond repayment[edit]

In modern finance, a sinking fund is, generally, a method by which an organization sets aside money over time đồ sộ retire its indebtedness. More specifically, it is a fund into which money can be deposited, sánh that over time preferred stock, debentures or stocks can be retired. See also "sinking fund provision" under Bond (finance)#Features.

In some US states, Michigan for example, school districts may ask the voters đồ sộ approve a taxation for the purpose of establishing a sinking fund. The State Treasury Department has strict guidelines for expenditure of fund dollars with the penalty for misuse being an eternal ban on ever seeking the tax levy again.

Types[edit]

A sinking fund may operate in one or more of the following ways:

1. The firm may repurchase a fraction of the outstanding bonds in the open market each year.
2. The firm may repurchase a fraction of outstanding bonds at a special đường dây nóng price associated with the sinking fund provision (they are callable bonds).
3. The firm has the option đồ sộ repurchase the bonds at either the market price or the sinking fund price, whichever is lower. To allocate the burden of the sinking fund đường dây nóng fairly among bondholders, the bonds chosen for the đường dây nóng are selected at random based on serial number. The firm can only repurchase a limited fraction of the bond issue at the sinking fund price. At best some indentures allow firms đồ sộ use a doubling option, which allows repurchase of double the required number of bonds at the sinking fund price.
4. A less common provision is đồ sộ đường dây nóng for periodic payments đồ sộ a trustee, with the payments invested sánh that the accumulated sum can be used for retirement of the entire issue at maturity: instead of the debt amortizing over the life, the debt remains outstanding and a matching asset accrues. In this way a fund is built up with the intention of paying off the debt in full at a specified future date instead of directly paying the debt down over time. This method was popular in the 1980s-90's in the UK household mortgage market.

Benefits and drawbacks[edit]

For the organization retiring debt, it has the benefit that the principal of the debt or at least part of it, will be available when due, sánh that the organization does not need đồ sộ pay a large amount of money when due, and thus a heavy disruption đồ sộ the financial position of the organization can be avoided. For the creditors, the fund reduces the risk the organization will mặc định due đồ sộ financial hardship caused by the large payment, when the principal is due: it reduces credit risk.

However, if the bonds are callable, this comes at a cost đồ sộ creditors, because the organization has an option on the bonds:

• The firm will choose đồ sộ buy back discount bonds (selling below par) at their market price,
• while exercising its option đồ sộ buy back premium bonds (selling above par) at par.

Therefore, if interest rates fall and bond prices rise, a firm will benefit from the sinking fund provision that enables it đồ sộ repurchase its bonds at below-market prices. In this case, the firm's gain is the bondholder's loss – thus callable bonds will typically be issued at a higher coupon rate, reflecting the value of the option.

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Modern context – capital expenditure[edit]

Sinking funds can also be used đồ sộ phối aside money for purposes of replacing capital equipment as it becomes obsolete, or major maintenance or renewal of elements of a fixed asset, typically a building. Such a fund is also commonly called a reserve fund, however the distinguishing feature of a sinking fund is that the payments into it are calculated đồ sộ amortize a forecast future expenditure whereas a reserve fund is intended đồ sộ equalise expenditure in respect of regularly recurring service items đồ sộ avoid fluctuations in the amount of service charge payable each year.^[4]

External links[edit]

• Online annual sinking fund calculator

References[edit]

• Bodie, Kane and Marcus. 2007. Essentials of Investments. Sixth International Edition. Singapore: McGraw Hill.