What are the Advanatages and disadvantages of sinking fund method of depreciation?

Sinking Fund Advantages and Disadvantages

On paper, sinking funds appear to be a great program for both businesses and their investors. However, there are advantages and disadvantages to using this type of fund.

Investor Advantage: Piece of Mind

For investors, these accounts represent peace of mind. Investors with securities backed by these funds know that the company is less likely to be unable to pay dividends. Additionally, corporate debentures supported by specialized funds are more likely to receive the principle payment upon maturity.

Corporation Advantage: Long-Term Debt Management

Sinking funds are created so companies can address their debt in advance. As such, businesses have the comfort of having established long-term solutions for handling their debt and repaying their investors. In addition, these accounts give businesses the opportunity to plan for the cost of purchasing new assets such as upgraded machinery, construction work, and new technology.

Example

Technicolor NationwideTechnologies (TNT) establishes a sinking fund at the beginning of its establishment in 1985. 10% of the overall profits are then invested into this account. In addition to these payments, the trust company invests the fund's assets into long-term low risk stocks and bonds to grow capitol. As computers and information technology changes, TNT is able to purchase new electronic equipment using the resources from the fund.

Investor Disadvantage: Repurchasing of Bonds

Corporations with sinking funds periodically repurchase securities and debentures before their maturity. As such, these bonds are repurchased without consent directly from stockholders and bondholders. Businesses can choose to "call" bonds at any time, and no choice is given to the investor about whether or not to part with their holding. Any investor whose bond is purchased will have to forfeit their interest payments. This creates an atmosphere of uncertainty for investors, as they have no knowledge of when a company will choose to purchase back bonds.

Example

Thomas and Jack have both purchased bonds from Harriet's Corporate Housing (HCH). Jack decides to sell his bonds but Thomas wants to hold onto his. However, HCH suddenly "calls" the bonds and purchases them from some investors, including Jack and Thomas. Jack doesn't mind, because he had already decided to sell his off his bonds. Unfortunately, Thomas is upset by his inability to choose to keep his investment, and by the unexpected loss of his interest payments.

Investor Disadvantage: Repurchasing of Bonds at Lower Prices

Not only do corporations repurchase bonds regularly, they do so at a lower price than the bond's initial value. This par value is usually less than what the bond is worth within the actual marketplace. Some companies will also wait for interest rates on bonds to go down before purchasing back securities. As a result, bondholders stand to lose substantial amounts of money when their bonds are repurchased by companies at a lower price than their initial investment.

While sinking funds can represent a more secure investment, they also present the risk of a sudden loss at anytime. This lack of control should be carefully considered if you choose to invest in sinking fund backed stocks and securities.