Sinking Fund Applied To A Leasehold Property

2. A leasehold property may be purchased for £1000, and the unexpired leasehold period may consist of sixty years. At the end of that time the property reverts absolutely to the ownership of the freeholder or his assigns, and unless an adequate sinking fund has been maintained, the loss of capital to the leaseholder is final. Proceeding in the same way as before, an annual sum of £6 2s. 8d. appropriated from the income will provide the restoration of the purchase-money. In such a case it should also be remembered that the freeholder is entitled to require that the ultimate lessee should relinquish the premises in a reasonable condition of repair, which, where the buildings are old, involves a considerable expenditure, notwithstanding the repairs which have been necessary from time to time. The mode of meeting this concluding cost is furnished by a sinking fund.

Sinking Fund Applied To "Wasting" Securities

3. In all instances of what are termed "wasting" securities - securities which simply grow exhausted as time proceeds and leave at the end no capital value behind - such as, for example, besides leaseholds, securities which endure for a specific period and then finally cease, like terminable annuities and annuities upon lives - a sufficient sinking fund constitutes an essential element of a prudent purchase. In the case of life annuities which may be bought, the annual premium for an assurance on the nominee's life for the purchase money forms the sinking fund required. In the instances cited the holder may, at some time, dispose of his investment and no longer need the protection of the sinking fund he has created. No loss, however, will be occasioned; when he sells the bond or leasehold, the price he will obtain will be inferior to that which he paid, since the security will be nearer to the point when the premium will disappear or the leasehold terminate; but this diminution of price, if the transaction has been prudently managed, will be fully compensated by the accumulated amount to which the sinking fund has then attained.

Sinking Fond Applied To Provision For Making A Specific Payment At A Future Date

4. It might have been mentioned that a person may have engaged to make a specific payment at a definite future date. It might entail considerable inconvenience and strain if the means for discharging that obligation had to be raised in one sum when the obligation became enforceable, and this difficulty would be averted by the construction of a sinking fund. In forming a sinking fund accordingly the following considerations must be borne in mind -

The Fund Should He Invested In Stable Securities

1. The annual (or other periodic) instalments which constitute the fund should be invested in securities which may be reasonably considered to be fairly stable in their values (judged from previous records of prices over an adequate time), with variations on the whole of minor extent.

Not In Securities At A Premium

2. It is obvious that no investment of the successive instalments should be made in securities at a premium, since if this rule were not observed we should require a sinking fund within a sinking fund. Nor, again, for the same reason must "wasting" securities be selected.

At A Low Rate Of Interest

3. The rate of interest at which the fund is created should be a low one, say, at present, 3 to 3¼ per cent, and if, for example, the rate of 3¼ be chosen, the rate actually realised throughout the duration of the term - if we regard income tax at 1s. alone without contemplation of possible depreciations or losses - should be £3 8s. 5d. per cent. Hence 3 per cent net over a lengthened period appears to be the highest suitable rate. Ordinary shares in companies are not, as a rule, appropriate as investments on account of the fluctuations in the dividends due to trading vicissitudes and speculation. Securities bearing a fixed rate of interest form the preferable choice.

The Interest Received On The Investments Must He Immediately Reinvested

4. The interest, as it is periodically received upon the several investments, must at once (or as promptly as possible) be similarly re-invested at the same rate, so that compound interest - which is of the essence of the process - may be secured. Now in most instances some delay will occur in these re-investments, and this consideration confirms the condition that the rate on which the fund is based should be low, so that any higher rate obtained at any time may compensate for loss of interest while fresh investments are being arranged.

The Sinking Fund Must Never Be Invested In The Business It Is Intended To Protect

5. It is a most important caution to enforce that the sinking fund should never be invested in the business which it is intended to protect. In commercial and financial institutions the reserve fund (which corresponds in its functions to a sinking fund) should never be accumulated by being employed in the transactions of the business they conduct. For, obviously, the fund will then be subjected to the vicissitudes to which that business is liable, and the very object of the fund - the restoration of losses which may be experienced in the management of the institutions - may thus be wholly or largely defeated. This proposition is fundamental.