A sinking fund is a type of fund created by an organization to set aside money to repay its debt or replace an asset. In the case of debentures, a sinking fund is created to redeem the debentures at maturity.



To calculate the provision needed to be made out of profits for redeeming debentures worth Rs 5 lakhs at the end of 25 years, the following formula can be used:

P = (A / ((1 + r)^n - 1)) x (1 + r)

Where,
P = Annual provision to be made
A = Amount of debentures to be redeemed (Rs 5 lakhs)
r = Interest rate earned on sinking fund investments (4%)
n = Maturity period of debentures (25 years)

Plugging in the values, we get:

P = (500000 / ((1 + 0.04)^25 - 1)) x (1 + 0.04)
P = Rs 12,289.23 (approx.)

Therefore, an annual provision of Rs 12,289.23 needs to be made out of profits to redeem the debentures at maturity.



The sinking fund calculation is based on the concept of compound interest. The amount to be redeemed at maturity (Rs 5 lakhs) is divided by the present value of an annuity factor, which is calculated using the formula ((1 + r)^n - 1) / r. The result is then multiplied by (1 + r) to account for the interest earned on the sinking fund investments.

In the given example, the sinking fund investments are assumed to earn interest at 4% per annum. This means that the annual provision made out of profits will earn interest at the same rate, thereby accumulating a sufficient amount to redeem the debentures at maturity.



A sinking fund is a useful tool for organizations to manage their debt obligations and ensure timely repayment. By calculating the annual provision needed to be made out of profits, organizations can set aside a fixed amount each year towards redeeming their debentures at maturity. This not only helps in avoiding financial distress but also improves the organization's creditworthiness in the market.

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