Capital Sources for Business: Debentures

A debenture is a document issued by a company as an evidence of a debt due from the company with or without a charge on the assets of the company. It is an acknowledgement of the company’s indebtedness to its debenture-holders. Debentures are financial instruments for raising long term debt capital. Debenture holders are the creditors of the company.

In India, according to the Companies Act, 1956, the term debenture includes “debenture stock, bonds and any other securities of a company whether constituting a charge on the assets of the company or not.”

Debenture-holders are entitled to periodical payment of interest at an agreed rate. They are also entitled to redemption of their capital as per the agreed terms. No voting rights are given to debenture-holders. Under section 117 of the Companies Act, 1956, debentures with voting rights cannot be issued. Usually debentures are secured by charge on or mortgage of the assets of the company.

Types of Debentures

  1. Registered debentures : Registered debentures are recorded in a register of debenture-holders with full details about the number, value and types of debentures held by the debenture-holders. The payment of interest and repayment of capital is made to the debenture-holders whose names are entered duly in the register of debenture-holders. Registered debentures are not negotiable. Transfer of ownership of these type of debentures cannot be valid unless the regular instrument of transfer is sanctioned by the Directors. Registered debentures are not transferable by mere delivery.
  2. Bearer or Unregistered debentures: The debentures which are payable to the bearer are called bearer debentures. The names of the debenture-holders are not recorded in the register of debenture-holders. Bearer debentures are negotiable. They are transferable by mere delivery and registration of transfer is not necessary.
  3. Secured debentures: The debentures which are secured by a mortgage or change on the whole or a part of the assets of the company are called secured debentures.
  4. Unsecured debentures: Unsecured debentures are those which do not came to charge on the assets of the company. These are, also, known as ‘naked’ debentures.
  5. Redeemable debentures: The debentures which are repayable after a certain period are called redeemable debentures. Redeemable debentures may be bullet-repayment debentures (i.e. one time be payment) or periodic repayment debentures.
  6. Irredeemable debentures: The debentures which are not repayable during the life time of the company are called irredeemable debentures. They are also known as perpetual debentures. Irredeemable debentures can be redeemed only in the event of the company’s winding up.
  7. Fully convertible debentures: Convertible debentures can be converted into equity shares of the company as per the terms of their issue. Convertible debenture-holders get an opportunity to become shareholders and to take part in the company management at a later stage. Convertibility adds a ‘sweetener’ to the debentures and enhance their appeal to risk seeking investors.
  8. Non-Convertible debentures: Non-convertible debentures are not convertible. They remain as debt capital instruments.
  9. Partly convertible  debentures: Partly convertible debentures appeal to investors who want the benefits of convertibility and non-convertibility in one instrument.
  10. Equitable debentures: Equitable debentures are those which are secured by deposit of title deeds of the property with a memorandum in writing to create a charge.
  11. Legal debentures: Legal debentures are those in which the legal ownership of property of the corporation is transferred by a deed to the debenture holders, security for the loans.
  12. Preferred debentures: Preferred debentures are those which are paid first in the event of winding up of the company. The debentures have priority over other debentures.
  13. Fixed rate debentures : Fixed rate debentures carry a fixed rate of interest. Now-a-days this class is not desired by both investors and issuing institutions.
  14. Floating rate debentures : Floating rate debentures carry floating interest rate coupons. The rates float over some bench mark rates like bank rate, LIBOR etc.
  15. Zero-coupon debentures: Zero-coupon debentures do not carry periodic interest coupons. Interest on these is paid on maturity. Hence, these are also called as deep-discount debentures.
  16. Foreign Currency convertible debentures: Foreign currency convertible debentures are issued in overseas market in the currency of the country where the floatation takes place. Later these are converted into equity, either GDR, ADR or plain equity.

Merits of debentures

  • Debentures provide funds to the company for a long period without diluting its control, since debenture holders are not entitled to vote.
  • Interest paid to debenture-holders is a charge on income of the company and is deductible from computable income for income tax purpose whereas dividends paid on shares are regarded as income and are liable to corporate income tax. The post-tax cost of debt is thus lowered.
  • Debentures provide funds to the company for a specific period. Hence, the company can appropriately adjust its financial plan to suit its requirements.
  • Since debentures are generally issued on redeemable basis, the company can avoid over-capitalization by refunding the debt when the financial needs are no longer felt.
  • In a period of rising prices, debenture issue is advantageous. The burden of servicing debentures, which entail a fixed monetary commitment for interest and principal repayment, decreases in real terms as the price level increases.
  • Debentures enable the company to take advantage of trading on equity and thus pay to the equity shareholders dividend at a rate higher than overall return on investment.
  • Debentures are suitable to the investors who are cautious and conservative and who particularly prefer a stable rate of return with minimum or no risk. Even institutional investors prefer debentures for this reason.

Demerits of Debentures

  • Debenture interest and capital repayment are obligatory payments. Failure to meet these payment jeopardizes the solvency of the firm.
  • In the case of debentures, interest has to be paid to the debenture holders irrespective of the fact whether the company earns profit or not. It becomes a great burden on the finances of the company.
  • Debenture financing enhances the financial risk associated with the firm. This may increase the cost of equity capital.
  • When assets of the company get tagged to the debenture holders the result is that the credit rating of the company in the market comes down and financial institutions and banks refuse loans to that company.
  • Debentures are particularly not suitable for companies whose earnings fluctuate considerably. In case of such company raising funds through debentures may lead to considerable fluctuations in the rate of dividend payable to the equity shareholders.

Credit: Financial Management Concepts-MGU

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