Question based on IMT CDL Assignment Solution and other course
Answer:
A debenture is a long term promissory note for raising loan capital. It may be either secured or unsecured. Debenture or Bond is a creditor ship security, with a fixed rate of interest and fixed maturityperiod. Debentures provide low risk capital to the company. Those who invest in debentures are called debenture holders. An alternative form of debenture is Bond in India. Public sector companies in India mostly issue bonds. The interest paid is a charge to the profit and loss account. Debentures are normally secured by a floating charge on the assets of the company. The bond is secured by specific assets of the company. In USA bonds are either secured or unsecured and debentures are unsecured bonds. As we know debentures are long term debts of a company which borrows money on a promise to pay at a later date with specified interest, the interest rate is usually fixed.
According to Indian Companies Act, Section 2(12) “Debenture includes debenture stock, bonds and any other securities of a company whether constituting a charge on the assets of a company or not”. As Tophan has defined “Debenture is a document given by a company as evidence of a debt to the holder usually arising out of a loan and most commonly secured by charge.”
C.W. Gerstenberg has defined “A corporate bond is a written promise under seal to pay a specified sum of money at a fixed time in future, usually more than ten years after the promise is made with interest at fixed rate, payable at specified interest dates.”
Public issue of debentures and private placement to mutual funds now require that the issue be rated by a credit rating agency like CRISIL (Credit Rating and Information Services of India Ltd.). The credit rating is given after evaluating factors like track record of the company, profitability, debt servicing capacity, credit worthiness and the perceived risk of lending.
Features of Debentures/Bonds
Maturity: Debentures are issued for a specific period of time and treated as source of long term finance. Generally, debentures are issued for a period of 7 to 10 years and are redeemed on the specific date.
- Fixed Interest Rate: The interest rate on debenture is fixed and does not change during the tenure of debenture, irrespective of the profit/loss of the company. Interest is calculated on the face value of the debenture. Interest is tax deductible and it is the income of the debenture holder and taxable in the hands of the debenture holders.
- Claim on Income: Interest payment is the obligation on the company even if the company incurs loss. Default in payment of interest empowers the debenture holder to move a petition in a court of law for the winding up of the company.
- Claim on Assets: At the time of liquidation, debenture holders are repaid their claim first before repayment is made to preference and equity shareholders. Debentures may have a specific charge or floating charge on the assets of the company. In the event, they are secured creditors. The sale proceeds of the assets pledged to them go towards repayment of principal and interest to them.
- Convertibility: The debentures having a conversion clause are known as convertible debentures. These debentures can be converted to equity shares after a certain period of time.
- Callable Feature: Call feature enables the company to redeem the debentures before the due date of redemption. Generally, the company can go for it when the interest rate payable is high then the current interest rate. In order to save costs, the company redeems the debentures before the due date. Normally, call price is higher than the issue price. It is noteworthy to mention that the company is gaining, hence, it is not an issue to share some gain with the debenture holders.
- Indenture or Trust Deed: It is a legal agreement between the company issuing the debentures on one hand and the trustees representing debenture holders on the other hand. The trust deed provides the specific terms in respect of the description of debentures, security available, rights of debenture holders and of the issuing company and responsibilities of the trustees. The responsibility of the trustees is to protect the rights of the debenture holders by enforcing the responsibilities of the company that has issued debentures. Normally, a financial institution or insurance company is appointed as a trustee.
- Controlling Power: A Debenture holder does not have any voting right; therefore, they do not enjoy the controlling power and can not participate in the management of the company. They have only prior claim in repayment over equity and preference shareholders.
Benefits of Debentures
- Less Costly: The debenture is less costly source of finance than preference and equity shares as the interest is tax deductible. From the perspective of investor, it is less risky investment and offers fixed rate of return.
- Absence of Dilution: Debenture holder do not enjoy any voting rights, hence, there is not any question of dilution of ownership or control.
- Fixed Interest Rate: The debenture holders are entitled for the fixed rate of interest as specified in the debenture. They do not have any claim on the extra share in the earnings of the company. So, cost to the company is fixed.
- Beneficial during Inflation: Real interest cost declines during the period of inflation.
- Easy to Raise Funds: At the time of depression or low sentiments in the market, the debenture as a source of finance is easy and comfortable. The investors appreciate the benefits of certainty of income, with low risk during those periods.
- Trading on Equity: In case the return on investment is higher than the cost of debt, it is advantageous to the company to raise fund through debentures as it can trade on equity and enhances the earnings to the equity holders.
- Flexibility: Debenture provides flexibility in the capital structure of the company as company can redeem debentures, as and when it has surplus funds and desires to do so. Generally, company reserves the right in the form of ‘call option’ at the time of issue to take advantage of the falling interest rates in the market.
Disadvantages of Debentures
- Obligatory Payment: The payment of interest is a legal obligation even in the case of company is incurring loss in any particular year. Redemption of debentures is to be made at the end of maturity. Default in payment may force the company to go into liquidation.
- Financial Risk: If a company is having fluctuating sales and earnings than it enhances the financial leverage and financial risk.
- Stamp Duty: The cost of stamp duty will increases the cost of financing.
- Not for All the Companies: Debenture interest is a fixed commitment. This should be noted that it not desirable for the companies which do not have stable earnings or who deal in products with elastic demand to issue debentures. The company that cannot offer assets as security cannot use this source of financing.
- Cash Outflows: As debentures are to be redeemed at the end of the maturity period. When it is redeemed, the cash outflow occurs. Even if a sinking fund is created to meet the redemption outflow, annual cash outflow occurs.
- Restrictive Covenants: The restrictive conditions are contained in the debenture indenture. As a condition can be incorporated in the indenture that the total borrowing by the company cannot exceed a specified limit. Hence, the restrictive covenants limit the operating flexibility of the company in future.
