SINKING FUND The Vancouver Development Company (VDC) is planning to sell a $100 million, 10-year, 12%, semiannual payment bond issue. Provisions for a sinking fund to retire the issue over its life will be included in the indenture. Sinking fund payments will be made at the end of each year, and each payment must be sufficient to retire 10% of the original amount of the issue. The last sinking fund payment will retire the last of the bonds. The bonds to be retired each period can be purchased on the open market or obtained by calling up to 5% of the original issue at par, at VDC’s option.
a. How large must each sinking fund payment be if the company (1) uses the option to call bonds at par or (2) decides to buy bonds on the open market? For Part (2), you can only answer in words.
b. What will happen to debt service requirements per year associated with this issue over its 10-year life?
c. Now consider an alternative plan where VDC sets up its sinking fund so that equal annual amounts are paid into a sinking fund trust held by a bank, with the proceeds being used to buy government bonds that are expected to pay 7% annual interest. The payments, plus accumulated interest, must total $100 million at the end of 10 years, when the proceeds will be used to retire the issue. How large must the annual sinking fund payments be? Is this amount known with certainty, or might it be higher or lower?
d. What are the annual cash requirements for covering bond service costs under the trusteeship arrangement described in Part c? Assume level interest rates for purposes of answering this question.
e. What would have to happen to interest rates to cause the company to buy bonds on the open market rather than call them under the plan where some bonds are retired each year?