The Vancouver Development Company (VDC) is planning to sell a$100 million, 10-year, 12%, semiannual payment bond issue. Provisions for a sinking fundto retire the issue over its life will be included in the indenture. Sinking fund payments willbe made at the end of each year, and each payment must be sufficient to retire 10% of theoriginal 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 bycalling 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 tocall bonds at par or (2) decides to buy bonds on the open market? For part (2), you canonly answer in words.b. What will happen to debt service requirements per year associated with this issue overits 10-year life?c. Now consider an alternative plan where VDC sets up its sinking fund so that equal annualamounts are paid into a sinking fund trust held by a bank, with the proceeds being used tobuy government bonds that are expected to pay 7% annual interest. The payments, plusaccumulated interest, must total $100 million at the end of 10 years, when the proceedswill be used to retire the issue. How large must the annual sinking fund payments be? Isthis 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 trusteeshiparrangement described in part c? (Note: Interest must be paid on Vancouver’soutstanding bonds but not on bonds that have been retired.) Assume level interestrates for purposes of answering this question.e. What would have to happen to interest rates to cause the company to buy bonds on theopen market rather than call them under the plan where some bonds are retired each year?
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? (Note: Interest must be paid on Vancouver’s
outstanding bonds but not on bonds that have been retired.) 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?
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