Debenture is used to issue the loan by government and companies. The loan is issued at the fixed interest depending upon the reputation of the companies. When companies need to borrow some money to expand themselves they take the help of debentures. There are four different types of debentures. Let us learn the Debenture, features of debentures, advantages, and disadvantages of debentures in detail.
The word ‘debenture’ itself is a derivation of the Latin word ‘debere’ which means to borrow or loan. Debentures are written instruments of debt that companies issue under their common seal. They are similar to a loan certificate.
Debentures are issued to the public as a contract of repayment of money borrowed from them. These debentures are for a fixed period and a fixed interest rate that can be payable yearly or half-yearly. Debentures are also offered to the public at large, like equity shares. Debentures are actually the most common way for large companies to borrow money.
Let us look at some important features of debentures that make them unique,
- Debentures are instruments of debt, which means that debenture holders become creditors of the company
- They are a certificate of debt, with the date of redemption and amount of repayment mentioned on it. This certificate is issued under the company seal and is known as a Debenture Deed
- Debentures have a fixed rate of interest, and such interest amount is payable yearly or half-yearly
- Debenture holders do not get any voting rights. This is because they are not instruments of equity, so debenture holders are not owners of the company, only creditors
- The interest payable to these debenture holders is a charge against the profits of the company. So these payments have to be made even in case of a loss.
Advantages of Debentures
- One of the biggest advantages of debentures is that the company can get its required funds without diluting equity. Since debentures are a form of debt, the equity of the company remains unchanged.
- Interest to be paid on debentures is a charge against profit for the company. But this also means it is a tax-deductible expense and is useful while tax planning
- Debentures encourage long-term planning and funding. And compared to other forms of lending debentures tend to be cheaper.
- Debenture holders bear very little risk since the loan is secured and the interest is payable even in the case of a loss to the company
- At times of inflation, debentures are the preferred instrument to raise funds since they have a fixed rate of interest
Browse more Topics under Issue And Redemption Of Debentures
Disadvantages of Debentures
- The interest payable to debenture holders is a financial burden for the company. It is payable even in the event of a loss
- While issuing debentures help a company trade on equity, it also makes it to dependent on debt. A skewed Debt-Equity Ratio is not good for the financial health of a company
- Redemption of debentures is a significant cash outflow for the company which can imbalance its liquidity
- During a depression, when profits are declining, debentures can prove to be very expensive due to their fixed interest rate
Types of Debentures
There are various types of debentures that a company can issue, based on security, tenure, convertibility etc. Let us take a look at some of these types of debentures.
- Secured Debentures: These are debentures that are secured against an asset/assets of the company. This means a charge is created on such an asset in case of default in repayment of such debentures. So in case, the company does not have enough funds to repay such debentures, the said asset will be sold to pay such a loan. The charge may be fixed, i.e. against a specific assets/assets or floating, i.e. against all assets of the firm.
- Unsecured Debentures: These are not secured by any charge against the assets of the company, neither fixed nor floating. Normally such kinds of debentures are not issued by companies in India.
- Redeemable Debentures: These debentures are payable at the expiry of their term. Which means at the end of a specified period they are payable, either in the lump sum or in installments over a time period. Such debentures can be redeemable at par, premium or at a discount.
- Irredeemable Debentures: Such debentures are perpetual in nature. There is no fixed date at which they become payable. They are redeemable when the company goes into the liquidation process. Or they can be redeemable after an unspecified long time interval.
- Fully Convertible Debentures: These shares can be converted to equity shares at the option of the debenture holder. So if he wishes then after a specified time interval all his shares will be converted to equity shares and he will become a shareholder.
- Partly Convertible Debentures: Here the holders of such debentures are given the option to partially convert their debentures to shares. If he opts for the conversion, he will be both a creditor and a shareholder of the company.
- Non-Convertible Debentures: As the name suggests such debentures do not have an option to be converted to shares or any kind of equity. These debentures will remain so till their maturity, no conversion will take place. These are the most common type of debentures.
Solved Example for You
Q: Tax-rate is relevant and important for calculation of specific cost of capital of ________.
- Equity Share
- Preferential Share
- None of the above
Ans: The correct answer is C. In the case of debentures the interest payable is a cost of capital. Such an interest is tax deductible and charged to the profit and loss account as an expense. Hence it will reduce the tax liability of a company.