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Finance: What is a sinking fund? 8 Views
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Description:
What is a sinking fund? Companies that issue bonds pay the interest coupon amount each year and are required to redeem all of the principal at maturity. In order to better manage the sudden cash crunch of a large loan repayment in a single year, some bonds are structured with sinking funds, which are set aside pools of cash from each year’s operations that are used to buy back bonds in the open market and retire them. This reduces the amount of outstanding bonds that have to be paid off at maturity, as well as reduces annual interest payment obligations. A bond with a sinking fund often gets a ratings bump up from a comparable issue from the same company due to the reduced chance of default.
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Transcript
- 00:00
And finance allah shmoop what is ah sinking fund oh
- 00:06
that oil rig she's sinking we'll meet nessie lovely pink
- 00:13
rig who has been working nicely for eight years now
- 00:16
she pumps ten thousand barrels of oil from five thousand
- 00:19
feet underwater without complaining a lick The experts believe that
Full Transcript
- 00:23
there are literally millions of barrels below where she drills
- 00:26
and they know that sadly nessie won't be alive long
- 00:30
enough to pump all of them out from you know
- 00:33
below the ocean well she'll live twenty years and that's
- 00:35
it then she'll kill over like your favorite dog one
- 00:38
day and die and the company knows that they'll have
- 00:41
to spend a billion dollars that day toe by nesi
- 00:45
to the to z Well with that eventual sad day
- 00:48
in mind mega glop corporation crown danish oyster which owns
- 00:53
nessie has expected the billion dollar bill to come to
- 00:56
them at that time And thus far each year for
- 01:00
eight years they have socked away money in what is
- 01:03
called a sinking fund and you know it took us
- 01:05
a while to get there too so sorry so that
- 01:07
twelve years from now when the billion dollar bill comes
- 01:10
due it's not a big shock to the company They
- 01:13
will already have saved their pennies Lots of them so
- 01:16
that the billion box will be on hand Just sitting
- 01:19
in their bank of america account our bank of wherever
- 01:21
account ready teo Wire into riggs Are us to deliver
- 01:26
a brand spanking new nessie too When nesic one has
- 01:30
you know sucked her last oil So here's the mao
- 01:33
A billion dollar bill is coming due in twenty years
- 01:36
We have tons of advanced notice and sock away money
- 01:39
to pay for it on a straight line basis while
- 01:41
we sock away fifty million bucks a year They put
- 01:44
it in a mattress in you know bank of america
- 01:47
totally ready to go When you know her time comes
- 01:50
in real life The company would have lots of other
- 01:52
options Like buying the nessie too With leverage they could
- 01:56
put a fraction of the total amount of purchase her
- 01:59
down and maybe that's a third or less in total
- 02:01
price Then they could borrow the remainder amount of money
- 02:04
and buy the rig on credit Well they could also
- 02:07
just lease it from the manufacturer but then leasing it
- 02:10
Means that someone else owns nessie too and they maintain
- 02:13
it There's a lot more risk in managing it and
- 02:16
fixing it should nessie to ever need a trip to
- 02:19
the shop And things can get ugly Yeah like that
- 02:22
Okay Option three sinking fund buy with cash on hand
- 02:25
Well so why would the company have struggled so much
- 02:27
to put away fifty million year for two decades Well
- 02:30
when it comes time to negotiate with vendors about buying
- 02:33
a rig when the buyer is loaded and ready with
- 02:35
ash well then it can command much better deal terms
- 02:39
and probably a better price right it khun goto many
- 02:42
ven doors of rigs and say i got cash You've
- 02:45
got the rig A vendor who needs to borrow money
- 02:48
from a bank first teo then pay another vendor And
- 02:52
at worst it would have to you know borrow money
- 02:55
from the vendor selling the rig and they charge a
- 02:58
super high interest rate Ever buy a car Yeah You
- 03:01
don't wanna have to borrow money from a car salesman
- 03:04
Ever Well sinking funds essentially sink the liability of an
- 03:08
eventual big fat harry bill that's coming D'oh Yeah different 00:03:11.968 --> [endTime] Bill what
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