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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.

Language:
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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

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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