Financing of Business: Issue of Debentures: Merits and Limitations of Debentures, Types of Debentures (For CBSE, ICSE, IAS, NET, NRA 2022)

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Issue of Debentures

  • The companies can raise long term funds by issuing debentures that carry assured rate of return for investors in the form of a fixed rate of interest. It is known as debt capital or borrowed capital of the company. The debenture is a written acknowledgement of money borrowed. It specifies the terms and conditions, such as rate of interest, time of repayment, security offered, etc. These are offered to the public to subscribe in the same manner as is done in the case of shares.
  • The debenture holders are the creditors of the company and are entitled to get interest irrespective of profit earned by the company. They do not have any voting right. So, they do not interfere in the day-to-day management of the business. Ordinarily, debentures are fully secured. In case the company fails to pay interest on debentures or repay the principal amount, the debenture holders can recover it from sale of its assets.

Merits of Debentures

  • Debentures are secured loans. On winding up of the company, they are repayable before making any payment to the equity and preference shareholders.
  • The debenture holders get assured return irrespective of profit.
  • Issue of debentures enables the company to provide high return to equity shareholders when the earnings of the company are good. This is called Trading on Equity.
  • Debenture holders have no right either to vote or take part in the management of the company. So, by issuing debentures the company raises the additional capital without diluting the control over its management.
  • Interest paid on debentures is treated as an expense and is charged to the profits of the company. The company thus, saves income tax.

Limitations of Debentures

  • If the earnings of the company are uncertain and unpredictable, issue of debentures may pose serious problems due to fixed obligation to pay interest and repay the principal. So, when the company expects good and stable income, then only it should issue debentures.
  • The company, which issues debentures, creates a charge on its assets in favour of debenture holders. So, a company not having enough fixed assets cannot borrow money by issuing debentures.
  • The assets of the company once mortgaged cannot be used for further borrowing. So, issue of debentures reduces the borrowing capacity of the company. Trading on Equity

Trading on Equity refers to the use of high debt for ensuring higher returns for the equity shareholders. This is workable when the profitability is high and the rate of return on investment of funds is higher than the rate of interest to be paid on the borrowed money. Let us take an example. Suppose ₹ 5 crores are required to be invested on a project that may give 20 % return per annum. If the management decides to raise ₹ 2.50 crores by issuing equity shares of ₹ 10 each and ₹ 2.5 crores by issuing 10 % debentures, then the shareholders will get a return of 30 % on their funds. Let us the see the calculation.

  • Total earnings ₹ 1,00, 00,000
  • Interest on debenture@10 % ₹ 25,00, 000
  • Earning after paying interest ₹ 75,00, 000
  • Return on Equity Share Capital = 7500000/25000000 × 100 = 30 %

Now if the company decides to raise 80 % by debt and only 20 % by shares (₹ 4 crores by 10 % debentures and ₹ 1 crore by shares) , the return on equity share capital will be calculated as follows:

  • Total earnings ₹ 1,00, 00,000
  • Interest on debenture@10 % ₹ 40,00, 000
  • Earning after paying interest ₹ 60,00, 000
  • Return on Equity Share Capital = 6000000/10000000 × 100 = 60 %

We can see that with the use of higher proportion of debt the rate of return on equity capital has simply doubled. At the same time, it is also associated with high risk that, if the profitability declines to less than 10 % , we shall still have to pay 10 % on debentures. This will reduce the return on equity share capital to less than even 10 % .

Types of Debentures

Debentures may be classified as:

Types of Debentures

Redeemable and Irredeemable Debentures

The debentures which are repayable on a specified date, are called redeemable debentures. On the other hand, there is no fixed time by which the company is bound to pay back the money in case of irredeemable debentures. These debenture holders cannot demand to get back their money as long as the company does not make any default in payment of interest. So, these debentures are also called perpetual debentures.

Convertible and Non-Convertible Debentures

The holders of convertible debentures are given the option to convert their debentures into equity shares. But in case of non-convertible debentures the company does not give any such option.

Secured and Unsecured Debentures

Secured debentures are issued with a charge on the assets of the company as security. This charge may be fixed i.e.. , on specified asset, or it may be floating. Secured debentures are also known as mortgaged debentures. On the other hand, unsecured debentures are issued with merely a promise of payment without having any charge on any assets as security. So, these debentures are also known as naked or simple debentures. Now-a-days debentures are invariably issued as secured debentured.

Registered and Bearer Debentures

  • For registered debentures the issuing company maintains a record of the debenture holders. Any sale or transfer of such debentures must be registered with the company. On the other hand, bearer debentures are just like negotiable instruments and transferable by mere delivery. The company keeps no record of such debenture-holders. Interest coupons are attached to them and anybody can produce the coupon to get the interest.
  • After having some idea about shares and debentures let us find out the difference between them.

Difference between Shares and Debenture

Tabel of Difference between Shares and Debenture
StatusShareholders are the owners of the company. They provide ownership capital which is not refundable unless the company is liquidated.Debenture holders are the creditors of the company. They provide loans generally for a fixed period, which are to be paid back.
Nature of return on investmentShareholders get dividends. Its amount is not fixed as it depends on the profit of the company.Interest is paid on debentures at a fixed rate. Interest is payable even if the company is running at a loss.
Rightsshareholders are the real owners of the company. They have the right to vote and determine the policies of the company.Debenture holders do not have the right to attend meetings of the company. So, they have no say in the management of the company.
SecurityNo security is required to issue shares.Generally, debentures are secured. So, sufficient fixed assets are required when debentures are to be issued.
Order of repaymentShare capital is paid back only after paying the debenture holders and creditors.Debenture holders have the priority of repayment over shareholders.
RiskRisk is high due to uncertainty of returns.Little risk due to certainty of return.

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