484 Chapter 13 | Bonds and Sinking Funds

3. A $5000 bond with a coupon rate of 6.25% and redeemable in two years was purchased when the yield rate was
7.75% compounded semi-annually. Construct the bond schedule showing the accumulation of discount.
4. A $20,000, 4.85% government bond that was due to mature in two years was purchased when the yield rate was
5.65% compounded semi-annually. Construct the bond schedule showing the accumulation of discount.
5. For Problem 7 in Exercise 13.2, construct the bond schedule showing the amortization of the premium.
6. For Problem 8 in Exercise 13.2, construct the bond schedule showing the amortization of the premium.
7. For Problem 9 in Exercise 13.2, construct the bond schedule showing the accumulation of discount.
8. For Problem 10 in Exercise 13.2, construct the bond schedule showing the accumulation of discount.

13.5 | Sinking Funds

A sinking fund is an interest earning fund that is set up by a corporation or government to periodically
A sinking fund is an
interest-earning fund deposit money into, so that the accumulated funds will be available at a future date to repay the principal
that is established of a large debt at the time of its maturity. These funds are generally set up to assure investors, (who have
to make periodic
deposits for the purchased bonds or debentures from the corporation or government) that provisions have been made to
purpose of retiring ensure repayment of their principal amount at the time of maturity of their bonds or debentures.
debts.
For example, if a business receives $1 million by issuing ten-year bonds to the public, on the date of
maturity of the bonds, it would have to repay the entire principal to the holders of the bonds.

As the principal amount is large, the business may establish a sinking fund to deposit money into
Sinking funds can also
be used to prematurely periodically, until it accumulates $1 million by the maturity date of the bonds. This amount can then
clear a portion of the be used to repay the principal amount to the bond holders.
debt.

Sinking Fund Calculations and

Constructing a Sinking Fund Schedule
As a sinking fund is generally a series of equal deposits made at regular intervals for a fixed period of
time, it is treated as an annuity. Payments into the fund can be made at the end of the period (ordinary
annuity) or at the beginning of the period (annuity due).

A sinking fund schedule provides details of the payment number, periodic payment into the fund, interest
earned during the period, increase in the fund, the fund balance, and the book value of the fund.

Steps to construct a sinking fund schedule

Book Value = Principal - Fund Balance

Interest Earned = Fund Balance i
Previous Period
Increase in the Fund = PMT + Interest Earned
Fund Balance = Fund Balance + Increase in the Fund
Previous Period
Final Payment = Book Value - Interest Earned
Previous Period Final Period
Computing the totals
Total Increase in the Fund = Original Loan Amount (Principal)
Total Payment = Sum of the Payments = (n - 1) PMT + Final Payment
Total Interest Earned = Total Increase in the Fund - Total Payments
 Chapter 13 | Bonds and Sinking Funds 485

Example 13.5(a) Ordinary Simple Annuity Sinking Fund Calculations and

Constructing a Sinking Fund Schedule
Acapac Industries established a sinking fund in order to accumulate $10,000 by depositing equal amounts
of money at the end of every 6 months for 2 years. If the fund was earning interest at 4% compounded
semi-annually, calculate the following and construct a sinking fund schedule to illustrate details of the fund:
(i) Size of the periodic sinking fund deposit.
(ii) Sinking fund balance at the end of the 2nd payment period.
(iii) Interest earned in the 3rd payment period.
(iv) Amount by which the sinking fund increased in the 3rd payment period.

Solution (i) Calculating the size of the periodic sinking fund deposit
This sinking fund is an ordinary simple annuity.
j 0.04
FV = $10,000, t = 2 years, i = = = 0.02
m 2
n = 2 deposits per year # 2 years = 4 semi-annual deposits

FV = PMT ;
^1 + ihn - 1 E
Using Formula 10.2(a),
i

^1 + 0.02h4 - 1 G
10,000 = PMT= = PMT [4.121608...]
0.02
PMT = 2426.237527...
= $2426.24
Therefore, the periodic sinking fund deposit was $2426.24.
(ii) Calculating the sinking fund balance at the end of the 2nd payment period
The sinking fund balance at the end of any given period is the future value of the periodic deposits
made until the end of that period.
At the end of the 2nd payment period, n = 2. Let the Future Value at the end of the 2nd period be FV2.

FV = PMT ;
^1 + ihn - 1 E
Using Formula 10.2(a),
i
^1 + 0.02h2 - 1 G
FV2 = 2426.24= = 2426.24 [2.02] = $4901.00
0.02
Therefore, the sinking fund balance at the end of the 2nd payment period was $4901.00.
(iii) Calculating the interest earned in the 3rd payment period
Interest that is earned in any period is on the amount that is available in the fund at the beginning
of that period, which is the same as the amount that is available at the end of the previous period.
To calculate the interest earned in the 3rd period, we need to determine the fund balance at the
end of the 2nd period.
From (iv), we know that the fund balance at the end of the 2nd period = FV2 = $4901.00
Interest on this amount is = i # FV2 = 0.02 # 4901.00 = $98.02
Therefore, $98.02 was the interest earned by the fund in the 3rd payment period.
(iv) Calculating the amount by which the sinking fund increased in the 3rd payment period
The amount by which the sinking fund increased in a period is the interest earned during that
period plus the deposit made in that period.

( Amount by which the Sinking Fund

rd
Increased in the 3 Period ) = ( inInterest
the 3 Period )
Earned
rd + PMT

= (4901.00 # 0.02) + 2426.24 = $2524.26

Therefore, the amount by which the sinking fund increased in the 3rd payment period is $2524.26.
486 Chapter 13 | Bonds and Sinking Funds

Solution Constructing the sinking fund schedule

continued
Payment Payment Interest Increase in the Fund
Book Value
Period (PMT) Earned Fund Balance
0 - - - $0.00 $10,000 (a)
1 $2426.24 $0.00 (b) $2426.24 (c) 2426.24 (d) 7573.76 (e)
2 2426.24 48.52 2474.76 4901.00 5099.00
The final payment will 3 2426.24 98.02 2524.26 7425.26 2574.74
be of a different size as
the periodic payments 4 2426.23 (i) 148.51 (h) 2574.74 (g) 10,000.00 (f) 0
are rounded to the
nearest cent. Total $9704.95 $295.05 $10,000.00

(a) Book Value0 = Principal = $10,000.00

(b) Interest Earned1 = Fund Balance0 i = 0.00 0.02 = $0.00
(c) Increase in the Fund1 = PMT + Interest Earned1 = 2426.24 + 0.00 = $2426.24
(d) Fund Balance1 = Fund Balance0 + Increase in the Fund1 = 0.00 + 2426.24 = $2426.24
(e) Book Value1 = Principal - Fund Balance1 = 10,000.00 - 2426.24 = $7573.76
(f) Final Fund Balance = Principal = $10,000.00
(g) Final Increase in the Fund = Book Value = $2574.74
3
(h) Final Interest Earned = Fund Balance3 i = 7425.26 0.02 = $148.51
(i) Final Payment = Book Value3 - Interest Earned4 = 2574.74 - 148.51 = $2426.23

Example 13.5(b) Simple Annuity Due Sinking Fund Calculations and

Constructing a Sinking Fund Schedule
Refer to Example 13.5(a) and answer all parts of the problem assuming that Acapac Industries made
deposits at the beginning of every six months instead of at the end of each period.

Solution (i) Calculating the size of the periodic sinking fund deposit
This sinking fund is a simple annuity due.
j 0.04
FV = $10,000, t = 2 years, i= = = 0.02
m 2
n = 2 deposits per year # 2 years = 4 semi-annual deposits

Using Formula 10.4(a), FVDue = PMT ;

^1 + ihn - 1 E
(1+i)
i
^1 + 0.02h4 - 1 G
10,000 = PMT = (1+0.02)
0.02
10,000 = PMT [4.121608...] # 1.02 = PMT [4.204040...]
PMT = 2378.664242... = $2378.66
Therefore, the periodic sinking fund deposit was $2378.66.
(ii) Calculating the sinking fund balance at the end of the 2nd payment period
Sinking fund balance at the end of any given period is the future value of the periodic deposits
made until the end of that period.
At the end of the 2nd payment period, n = 2. Let the Future Value at the end of the 2nd period be FV2

Using Formula 10.4(a), FV = PMT ;

^1 + ihn - 1 E
(1+i)
i
^1 + 0.02h2 - 1 G
FV2 = 2378.66 = (1+0.02)
0.02
= 2378.66 [2.0604] = $4900.99
Therefore, the sinking fund balance at the end of the 2nd payment period was $4900.99.
 Chapter 13 | Bonds and Sinking Funds 487

Solution (iii) Calculating the interest earned in the 3rd payment period
continued
The interest for a period is not only calculated on the fund balance of the previous period, but
also on the periodic deposit, as the deposit is made at the beginning of the period.

Therefore, ( Interest
3 Payment Period )
rd
Earned for the
=i#(
2 Period nd

Fund Balance
+ PMT)

From (iv), we know that the fund balance at the end of the 2nd period = $4900.99

( Interest
3 Payment Period )
rd
Earned for the
= 0.02(4900.99 + 2378.66) = $145.59

Therefore, $145.59 is the interest earned by the fund in the 3rd payment period.
(iv) Calculating the amount by which the sinking fund increased in the 3rd payment period:
The amount by which the sinking fund increased in a period is the interest earned during that
period plus the deposit made in that period.

( Amount by which the sinking fund

rd
increased in the 3 period )=( Interest
3 Payment Period )
rd
Earned for the
+ PMT

= 145.59 + 2378.66 = $2524.25

Therefore, the amount by which the sinking fund increased in the 3rd payment period was $2524.25.
Constructing the sinking fund schedule

Payment Payment Interest Increase in Fund Book

Period (PMT) Earned the Fund Balance Value

PMT is made at the 0 - - - $0.00 $10,000 (a)

beginning of the 1 $2378.66 $47.57 (b) $2426.23 (c) 2426.23 (d) 7573.77 (e)
interval.
Interest Earned, 2 2378.66 96.10 2474.76 4900.99 5099.01
Increase in the Fund, 3 2378.66 145.59 2524.25 7425.24 2574.76
and Fund Balance
are at the end of the 4 2378.68 (i) 196.08 (h) 2574.76 (g) 10,000.00 (f) 0
interval. Total $9514.66 $485.34 $10,000.00

(a) Book Value0 = Principal = $10,000.00

In annuity due (b) Interest Earned1 = (Fund Balance0 + PMT) i = (0.00 + 2378.66) 0.02 = $47.57
sinking funds, as
payments are made (c) Increase in the Fund1 = PMT + Interest Earned1 = 2378.66 + 47.57 = $2426.23
at the beginning
of the period, (d) Fund Balance1 = Fund Balance0 + Increase in the Fund1 = 0.00 + 2426.23 = $2426.23
Interest Earned is (e) Book Value1 = Principal - Fund Balance1 = 10,000.00 - 2426.23 = $7573.77
calculated not only
on the previous fund (f) Final Fund Balance = Principal = $10,000.00
balance but also on
the payment that is (g) Final Increase in the Fund = Book Value3 = $2574.76
deposited into the (h) Final Interest Earned = (Fund Balance3 + PMT) i = (7425.24 + 2378.66) 0.02 = $196.08
fund.
(i) Final Payment = Book Value3 - Interest Earned4 = 2574.76 - 196.08 = $2378.68

Calculating the Periodic Cost and

Constructing a Partial Sinking Fund Schedule
When a company issues a bond and sets up a sinking fund, it makes the following two periodic
payments until the maturity of the bond:
Periodic interest payments to the bond holder
Periodic deposits made into the sinking fund
The periodic cost of this debt for any period is the sum of the above two payments for that period.
488 Chapter 13 | Bonds and Sinking Funds

Example 13.5(c) Calculating the Periodic Cost, Book Value of the Debt, and
Constructing a Partial Sinking Fund Schedule
A social networking company wanted to raise $100,000 and issued twenty, $5000 bonds paying a
10% coupon rate payable semi-annually for five years. It set up a sinking fund to repay the debt at the
end of five years and made deposits at the end of every six months into the fund. The sinking fund was
earning 6.5% compounded semi-annually.
(i) Calculate the periodic cost of the debt.
(ii) Calculate the book value of the debt after three years.
(iii) Construct a partial sinking fund schedule showing details of the first two and last two
payments and the totals of the schedule.

Solution
(i) Calculate the periodic cost of the debt

( Periodic
of the Debt ) ( Payment of the Bond ) ( the Sinking Fund )
Cost = Periodic Interest + Periodic Deposit into

= PMTInterest Payment on the Bond + PMTSinking Fund

Calculating periodic interest payment of the bond

j 0.10
FV = $100,000, b = = = 0.05
m 2
Using Formula 13.2(b), PMTInterest Payment on the Bond = FV # b = 100,000.00 # 0.05 = $5000.00
Calculating sinking fund periodic deposit
This sinking fund is an ordinary simple annuity.
FV = $100,000, t = 5 years
n = 2 deposits per year # 5 years = 10 semi-annual deposits
j 0.065
i= = = 0.0325
m 2
Using Formula 10.2(a),
FV = PMT ;
^1 + ihn - 1 E

i
^1 + 0.0325h10 - 1 G
100,000 = PMT =
0.0325
100,000 = PMT [11.596747...]
PMT = 8623.107239 = $8623.11
Sinking Fund
The periodic cost of the debt = PMT + PMTSinking Fund
Interest Payment on the Bond

= 5000.00 + 8623.11 = $13,623.11

Therefore, the periodic cost of the debt was $13,623.11.
(ii) Calculate the book value of the debt after three years

( Debt after 3 years ) = (

Book Value of the Principal Amount
of the Debt ) - ( Sinking Fund Balance at
the End of 3 years )
The sinking fund balance at the end of 3 years is the future value of the sinking fund at the end of 3 years.
t = 3 years, n = 2 deposits per year # 3 years = 6 semi-annual deposits, i = 0.0325

Using Formula 10.2(a), FV = PMT ;

^1 + ihn - 1 E ^1 + 0.0325h6 - 1 G
= 8623.11 = = 56,129.08759...
i 0.0325

( Debt after 3 years )

Book Value of the
= 100,000 - 56,129.09 = $43,870.91

Therefore, the book value of the debt after 3 years was $43,870.91.
 Chapter 13 | Bonds and Sinking Funds 489

Solution (iii) Constructing the partial sinking fund schedule

continued
Payment Payment Interest Increase in
Fund Balance Book Value
Period (PMT) Earned the Fund
0 - - - $0.00 $100,000.00
1 $8623.11 $0.00 $8623.11 8623.11 91,376.89
2 8623.11 280.25 8903.36 17,526.47 82,473.53
- - - - - -
8 - - - 77,363.24* 22,636.76
9 8623.11 2514.31 11,137.42 88,500.66 11,499.34
10 8623.07 2876.27 11,499.34 100,000.00 0
Total $86,231.06 $13,768.94 $100,000.00

*Fund balance = Future Value

8 8 Payments

Using Formula 10.2(a),

FV = PMT ;
^1 + ihn - 1 E
i

^1 + 0.0325h8 - 1 G
= 8623.11 =
0.0325
= 77,363.2357...
= $77,363.24

13.5 | Exercises Answers to the odd-numbered problems are available at the end of the textbook
In the following problems, express the answers rounded to two decimal places, wherever applicable.

1. A $10,000 bond was cleared in four years by setting up a sinking fund that was earning 5.5% compounded semi-
annually. If deposits were made to the fund at the end of every six months, calculate the size of the periodic
payments deposited.

2. Rasheed Furnishings issued bonds worth $500,000 to expand its factory. It established a sinking fund to retire this debt
in three years and made deposits into it at the end of every six months. If the fund was earning 7% compounded semi-
annually, calculate the size of the periodic payment deposited into the fund.

3. For Problem 1, construct a sinking fund schedule illustrating the details of the fund for four years.

4. For Problem 2, construct a sinking fund schedule illustrating the details of the fund for three years.

5. Victoria Appliances sold bonds for $500,000 that were redeemable in five years. It established a sinking fund that
was earning 8% compounded semi-annually to pay back the principal of the bonds on maturity. Deposits were
being made to the fund at the end of every six months.
a. Calculate the size of the periodic sinking fund deposit.
b. Calculate the sinking fund balance at the end of the 6th payment period.
c. Calculate the interest earned in the 7th payment period.
d. Calculate the amount by which the sinking fund increased in the 7th payment period.
e. Construct a partial sinking fund schedule to illustrate details of the last two payments.
490 Chapter 13 | Bonds and Sinking Funds

6. A company issued bonds for $850,000 and established a sinking fund to retire the debt in 15 years. It made deposits
at the end of every 6 months into the fund and the fund was earning 3.55% compounded semi-annually.
a. Calculate the size of the periodic sinking fund deposit.
b. Calculate the sinking fund balance at the end of the 11th payment period.
c. Calculate the interest earned in the 12th payment period.
d. Calculate the amount by which the sinking fund increased in the 12th payment period.
e. Construct a partial sinking fund schedule to illustrate details of the last two payments.

7. A company sold $100,000 bonds and set up a sinking fund that was earning 8% compounded semi-annually to retire
the bonds in four years. If it made equal deposits into the fund at the beginning of every six months, calculate the
size of the periodic payments deposited.
8. Williams Software borrowed $1,250,000 through a bond issued to purchase new servers. It established a sinking
fund to retire this debt in three years and made deposits into it at the beginning of every six months. The fund
earned 9.5% compounded semi-annually during the period. Calculate the size of the periodic payments deposited
into the fund.
9. In Problem 7, construct a sinking fund schedule illustrating the details of the fund.
10. In Problem 8, construct a sinking fund schedule illustrating the details of the fund.
11. A bank in Toronto issued bonds for $750,000 that were redeemable in ten years. It established a sinking fund
that was earning 3.5% compounded semi-annually to retire this debt on maturity and made equal deposits at the
beginning of every six months into the fund.
a. Calculate the size of the periodic deposits.
b. Calculate the fund balance at the end of the 19th payment period.
c. Calculate the interest earned in the 20th payment period.
d. Calculate the amount by which the sinking fund increased in the 20th payment period .
e. Construct a partial sinking fund schedule to illustrate details of the first two payments.
12. A company borrowed $280,000 and set up a sinking fund to retire the debt in six years. It made equal deposits at
the beginning of every six months into the fund and the fund was earning 8.55% compounded semi-annually.
a. Calculate the size of the deposits made into the fund.
b. Calculate the sinking fund balance at the end of the 4th payment period.
c. Calculate the interest earned in the 5th payment period.
d. Calculate the amount by which the sinking fund increased in the 5th payment period.
e. Construct a partial sinking fund schedule to illustrate details of the first two payments.
13. To raise $5,000,000 to expand into new markets, a very successful laptop manufacturer issued bonds in the market with
a coupon rate of 7%, paying interest semi-annually, and redeemable in 20 years. It established a sinking fund to retire
this debt on maturity and made equal deposits into the fund at the end of every 6 months. If the fund was earning 4%
compounded semi-annually, calculate the periodic cost of the debt and the book value of the debt after 10 years.
14. Wynter Tires Inc. issued $300,000 worth of 5% bonds to purchase new equipment for its showroom. It planned to
retire this debt in 10 years on maturity by setting up a sinking fund and making equal deposits into it at the end of
every six months. If the fund was earning 4% compounded semi-annually, calculate the periodic cost of the debt
and the book value of the debt after five years.
15. For Problem 13, construct a partial amortization schedule illustrating the first three payments, last three payments,
and totals of the schedule.
16. For Problem 14, construct a partial amortization schedule illustrating the first two payments, last two payments,
and totals of the schedule.
 Chapter 13 | Bonds and Sinking Funds 491

17. $100,000 bonds were issued at a coupon rate of 5% payable semi-annually and redeemable in three years. To retire these bonds,
a sinking fund was established, where equal deposits were made at the beginning of every six months. The fund was earning
4.5% compounded semi-annually. What was the periodic cost of the debt and the book value of the debt after two years?
18. Demarco Electronics took a loan of $345,500 from a bank to purchase testing equipment to improve the quality of its
electric meters. It set up a sinking fund to retire the debt in four years and made equal payments at the beginning of every
six months to this fund. If the loan was received at 6% compounded semi-annually and the sinking fund was earning 5%
compounded semi-annually, calculate the periodic cost of the debt and the book value of the debt in three years.
19. For Problem 17, construct a sinking fund schedule illustrating details.
20. For Problem 18, construct a sinking fund schedule illustrating details.

13

| Review Exercises
Answers to the odd-numbered problems are available at the end of the textbook

In the following problems, assume that the coupon rates are compounded semi-annually, the coupons are paid every
six months, and bonds are redeemed at par (for their face value) on maturity, unless otherwise stated.
Express the answers rounded to two decimal places, wherever applicable.

1. Edgar purchased a $5000 bond that had a coupon
rate of 5.5% payable semi-annually and was
redeemable in seven years. What was his purchase
price for the bond if the yield to maturity at the time
of purchase was 6.25% compounded semi-annually?
What was the discount or premium on the bond?
2. A company invested $150,000 in bonds that were
issued by another company. The bonds were paying
a coupon rate of 11% and were redeemable in ten
years. Five years after purchasing the bonds, it needed
money urgently so it sold them in the market when
the yield was 9.5% compounded semi-annually. How
much did the company sell the bonds for and what
was the discount or premium on the bonds at the time
of sale?
5. Anna and her husband invested their savings of
$50,000 in bonds that were paying a 10% coupon rate
and were redeemable in 10 years. The yield at the time
of their purchase was 9% compounded semi-annually.
They held the bonds for four years and sold them
when the yield was 10% compounded semi-annually.
Calculate their gain or loss on this investment.
6. The Province of Ontario issued $5000 bonds with
a 9% coupon rate. An investor purchased ten of
these bonds when the yield was 8.5% compounded
semi-annually and there were six years left to
maturity. However, after four years, the investor
sold all the bonds in the market when the yield was
7% compounded semi-annually. How much did the
investor gain or lose on this investment?

3. What was the purchase price, and the discount or
premium, on a $1000 bond with a coupon rate of
8.5% payable semi-annually if the yield at the time
of issue was 8% compounded quarterly and the
bond was redeemable in five years?
7. A $25,000 bond paying a 12.5% coupon rate was
redeemable on August 01, 2015. What was its
purchase price, and its premium or discount, on
October 18, 2011 when the yield was 8% compounded
semi-annually?

4. Heather purchased a $10,000 bond that had 4%
coupons and ten years to maturity. If the yield at
the time of purchase was 5% compounded monthly
calculate the purchase price of the bond and the
discount or premium at the time of purchase.
8. Calculate the discount or premium on a $5000 bond with
a 4% coupon rate if it was redeemable on December 31,
2020 and was purchased on February 23, 2018 when the
yield was 5% compounded semi-annually.