The Vancouver Development Company has just sold a $100 million, 10-year, 12 perc

Question

The Vancouver Development Company has just sold a $100 million, 10-year, 12 percent bond issue. A sinking fund will retire over its life. Sinking fund payments are of equal amounts and will be made semiannually and the proceeds will be used to retire bonds as the payments are made. Bonds can be called at par for sinking fund purposes or the fund paid into the sinking fund can be used to buy bonds on the open market.

a. How large must each semiannual sinking fund payement be made?

b. What will happen, under the conditions of the problem stated to this point, to the company's debt service requirements(interest and sinking fund payments) per year for this issue over time.

c. Now suppose that Vancouver Development sets up its sinking fund so that, at the end of each year, equal annual payments are paid into a sinking fund trust held by a bank, with the proceeds being used to buy government bonds that pay 9 percent interest. What is the amount of the payment that must be made to the sinking fund each year and what are the annual cash requirements for covering bond service costs under this trusteeship arragement?(Note: Interest must be paid on Vancouver's outstanding bonds but not on bonds that have been retired?

d. what would have to happen to bond prices to cause the company to buy bonds on the open market rather than call them under the original sinking fund plan?

Explanation / Answer

a. PMT = PMT (12%/2, 10*2, $100, $0)

Each semi-annual sinking fund payment will be $8.72 million

b. Company will continue to pay 12% interest rate on the outstanding debt with semi-annual compounding. However, the total outstanding amount of debt will continuously decline with every six months when the payment is made.

c. Unfortunately, I do not understand the question completely. The company is paying 12% (with semi-annual compounding so effectively more than 12% on annualized basis) on its outstanding debt on one side. On the other side, it wants to invest in government bonds at 9% annualized compounding. The objective of this fund isn't clear to me.

d. The bonds can be called at par. So if the par value is above $1000, the bonds can be called at par value of $1000. But if the price of the bond was less than $1000, the company might buy bonds on the open market at a cheaper price rather than pay the par value of $1000.

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