Question

The purpose of a bond sinking fund is to:

1) accumulate funds needed to pay the tax liability on the bond proceeds.
2) accumulate funds to pay the regular interest payments.
3) hold the bond proceeds until the funds need disbursed.
4) repay bonds early either through purchases or calls.
5) repay bondholders from a trust fund if the issuer defaults.

Answer 1

A bond sinking fund is set up by a company to repay its bond obligations early, by either purchasing the bonds back or calling them before maturity, ensuring that the company can manage its debt repayments effectively over time.

Step-by-step explanation:

The purpose of a bond sinking fund is to accumulate funds to repay bonds early either through purchases or calls. This method is used instead of accumulating funds to pay the regular interest payments, holding bond proceeds until they need to be disbursed, paying tax liabilities, or repaying bondholders in case of issuer default.

When a company issues bonds, such as a $10 million issuance with an 8% annual interest rate, it needs to ensure it can fulfill the promise to return the borrowed capital at the end of the bond term. A sinking fund helps the firm to systematically put aside money, reducing the risk of a large one-time payment burden and potentially defaulting on the obligation to bondholders.