Question: A sinking fund can be set up in one of two ways: (1) The corporation makes annual payments to the trustee, who invests the proceeds

A sinking fund can be set up in one of two ways:

(1) The corporation makes annual payments to the trustee, who invests the proceeds in securities (frequently government bonds) and uses the accumulated total to retire the bond issue at maturity.

(2) The trustee uses the annual payments to retire a portion of the issue each year, either calling a given percentage of the issue by a lottery and paying a specified price per bond or buying bonds on the open market, whichever is cheaper.

Discuss the advantages and disadvantages of each procedure from the viewpoint of both the firm and its bondholders.

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