Debentures

What is Debentures?

Definition: Debentures are a fixed-interest, fixed term investment. They are offered by finance and industrial companies which are referred to as issuers. They usually offer a higher return than is available from other fixed interest investments. Returns are based on a combination of official interest rates and loan rates depending on the issuer’s lending practices. They are not risk free investments.

Types of Debentures

Registered Debentures

These are the debentures that are registered with the company. The amount of such debentures is payable only to those debenture holders whose name appears in the register of the company.

Bearer Debentures

These are the debentures which are not recorded in a register of the company. Such debentures are transferable merely by delivery. Holder of bearer debentures is entitled to get the interest.

Secured or Mortgage Debentures

These are the debentures that are secured by a charge on the assets of the company. These are also called mortgage debentures. The holders of secured debentures have the right to recover their principal amount with the unpaid amount of interest on such debentures out of the assets mortgaged by the company.

Unsecured Debentures

Debentures which do not carry any security with regard to the principal amount or unpaid interest are unsecured debentures. These are also called simple debentures.

Redeemable Debentures

These are the debentures which are issued for a fixed period. The principal amount of such debentures is paid off to the holders on the expiry of such period. These debentures can be redeemed by annual drawings or by purchasing from the open market.

Non-redeemable Debentures

These are the debentures which are not redeemed in the lifetime of the company. Such debentures are paid back only when the company goes to liquidation.

Convertible Debentures

These are the debentures that can be converted into shares of the company on the expiry of pre-decided period. The terms and conditions of conversion are generally announced at the time of issue of debentures.

Non-convertible Debentures

The holders of such debentures cannot convert their debentures into the shares of the company.

---

Advantages of Debenture Financing

• Benefit of Tax: Issuing of debentures would attract interest expense for the company. As per normal tax laws, interest is a tax-deductible expense. On the contrary, the dividends paid to equity shareholders are not tax-free. They are paid out of divisible profits i.e. profits remaining after all the expenses and taxes well known as profit after tax (PAT).
  
  
• Cheaper Source of Finance: As discussed above, the interest cost incurred on debentures enjoys a tax shield which indirectly makes the cost of debenture low as compared to preference and equity shares. For example, effective cost of a 12% debenture with current tax rate of 30% is 8.4% {12% * (1-30%)}.
  
  
• Dilution of Ownership Control: Debentures don’t have any effect on the control of the existing shareholders of the company. If the same fund is raised using equity finance, the control of existing shareholders would dilute accordingly.
  
  
• No Dilution in Share of Profits: Opting for debentures over the equity as a source of finance saves the profit shares of existing shareholders. Debenture holders do not share profits of the company except that they are liable to receive the agreed amount of interest only.