This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
It may be of interest to readers in connection with the preceding review of sinking fund methods, and as showing how the principles that have been stated are applied in practice, to review briefly a somewhat novel proposal for the redemption of a bond issue which was presented to the writer some years ago. The proposal may be regarded as typical of a number of ingenious plans which on analysis are generally found to be unsound.
The essential points of the proposal may be stated as follows:
A manufacturing concern, a corporation, wishes to increase its working capital by $400,000. It has at present about $300,000 worth of paper in the banks and desires to make this a permanent loan in order to be able to take care of future increase of business by additional bank credit if it should be necessary. The plan under consideration is the issue of $400,000 of 50-year 6% debenture bonds without any mortgage, secured by a general charge against the property.
A redemption fund is to be provided by the corporation's procuring a trust company to act as trustee for a fund of $72,000. This is to be invested at the trust company's discretion, so that it will yield 4% per annum, and the above amount at this rate, compounded semiannually, in fifty years will amount to $520,000, or $120,000 more than sufficient to pay the bonds at maturity.
The borrowing corporation would therefore receive from this issue $328,000 and at the expiration of the 50-year term $120,000 additional.
The trust company's remuneration is to come from whatever it can make above 4% on this $72,000.
Will you give me your opinion as to whether you would consider this good business on the part of the corporation and what you would think of the bonds aside from the question of the credit of the borrowing company.
In putting this matter before a trust company to act as trustee, for the redemption fund, what objections, if any, would likely be made? Do you know of any bond issues of this kind?
The reply to this inquiry was as follows:
Your plan for providing for the ultimate redemption of a bond issue, is unusual. We do not know of any bonds issued under similar conditions. For the reasons presented below, the plan seems to us wasteful and objectionable.
First, and most important of all, it would seem to us very unwise to turn over $72,000 to any individual or institution to be invested at the discretion of the trustee, with the provision that the trustee is to retain as profits whatever income is secured above 4%. Under this arrangement the trustee is given every inducement to secure just as large an income as possible, even if the principal be risked. In other words, the trustee is left free to speculate with other people's money.
It may be claimed, on the other side, that a highly reputable conservative trust company would be chosen as trustee and that this trust company would be responsible for the original sum with interest compounded at 4%. But you must remember that 50 years is a long time and that no man can foresee what changes in ownership and management may take place before the end of the period.
Moreover, 4% is about all that can be secured on thoroughly safe investment bonds at the present time. The proposed plan, therefore, would make it imperative on the trustee to invest in more or less doubtful securities. Under these conditions, we doubt very much if any first-class trust company would consent to act as trustee.
The rate of return on sinking funds invested in outside securities is always uncertain, and, as experience has shown, almost always disappointing. The best modern practice in handling sinking funds, therefore, is to invest them in the very bonds which the sinking fund is designed to protect. These bonds may be secured either by purchase in the open market or by providing at the beginning that they may be called and redeemed at a good price, usually considerably above par. As bonds backed by sinking funds usually bear comparatively high rates of interest, this method of investment is not only safe, from the corporation's standpoint, and the returns certain, but also results in a much larger saving than is possible by conservative investment in outside securities. In the present case, for instance, a sinking fund so invested would yield a return of 6% instead of 4%.
Another criticism of this bond issue is that the life of the bond is too long. Scarcely any industrial corporation is so firmly established that its bonds can safely be bought when they run over a 50-year period - not, at least, unless some of the bonds, as with the United States Steel issue, are bought up and put into the sinking fund each year. For this reason alone we do not believe that the bonds under the proposed plan would find a ready market.
Another objection is that the proposed plan is expensive. The corporation, assuming that the bonds are sold at par, will secure $400,000, $72,000 of which will go into the redemption fund, leaving only $328,000 for the company. The $72,000 will draw only 4%; yet the company must pay 6% on the whole $400,000.
The net expense to the corporation consists of the yearly interest payment less the annuity which, if set aside each year and invested at 4%, would equal $120,000 at the end of 50 years. This annuity is $786.02. The net expense to the corporation, therefore, is $24,000 less $786.02, which equals $23,213.98, equivalent to 7.08% on the $328,000 actually received.
If, instead of the redemption fund, the ordinary sinking fund invested in outside securities at 4% were used, the yearly expense would be as follows:
6% on $328,000..............
Plus sinking fund yearly payment which accumulating at 4% would equal $328,000 at the end of 50 years.............
This latter sum is 6.65% on $328,000.
If the sinking fund, as suggested above, were invested in the corporation's own bonds, there would be a still greater saving. The exact amount of this saving would depend on the price at which the bonds were redeemed or bought in the open market, and cannot, therefore, be calculated precisely in advance - not at least unless the rate of redemption is fixed at the time the bonds are issued.