ACCA Advanced Financial Management (AFM) Practice Exam

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What is the purpose of a sinking fund?

To retire debt before maturity
To finance new acquisitions
To invest in short-term securities
To generate capital gains

The correct answer is: To retire debt before maturity

The purpose of a sinking fund is primarily to retire debt before its maturity. A sinking fund is established by a company to set aside money over time for the purpose of repaying a specific debt obligation, such as a bond or loan. This mechanism helps in managing large liabilities more effectively and ensures that the company will be able to pay off its debt when it comes due. By systematically allocating funds towards this goal, companies can reduce the risk of default and mitigate the impact of large, lump-sum repayments. It assures creditors that the company is taking proactive steps to honor its commitments, which can enhance its creditworthiness and potentially lead to lower borrowing costs in the future. In contrast, the other options focus on different financial strategies. Financing new acquisitions relates to capital investment decisions rather than debt management. Investing in short-term securities typically aims for liquidity and immediate returns rather than addressing long-term debt. Generating capital gains is an investment strategy focused on increasing asset value over time, which does not directly relate to the obligations tied to a sinking fund.