Final answer:
The correct statement concerning sinking funds is that they may be used to purchase bonds in the open market. Sinking funds are set aside by bond issuers to ensure the principal amount is repaid before maturity, benefitting both issuers and bondholders, and providing flexibility in managing debt obligations.
Step-by-step explanation:
In evaluating the correct statement about sinking funds, it is essential to understand their role in the context of corporate finance. Given the scenarios presented, the statement that sinking funds may be used to purchase bonds in the open market is correct. Sinking funds are established by an issuer of bonds to repay the principal amount of debt before its maturity. This financial mechanism benefits both the bond issuer and the bondholders by mitigating risk of default at the maturity date.
Many believe that a sinking fund must be funded at the time the bonds are issued or should include at least one "balloon payment," but these are not universally mandatory conditions. It is also not accurate that a sinking fund must be funded annually starting on the issue date. Sinking funds provide flexibility in how and when the issuer can set aside funds for the eventual repayment of the bond principal. On the other hand, using sinking funds solely to call bonds is a restrictive view that dismisses other potential uses, such as purchasing bonds in the open market when they are trading below their par value, which can lead to significant savings for the issuing company and is an effective way to manage debt obligations.
For example, if a firm issued a $50 million bond at an 8% interest rate, it might use a sinking fund to manage future debt repayment risks. If interest rates decline, existing bonds with higher rates become more valuable. The company might take advantage of the situation by buying back bonds at favorable prices in the market through its sinking fund, which can be more cost-effective than calling them, depending on market conditions.