Debentures – Types, Advantages and Disadvantages
Funds can be generated by a lot of sources in a business organization. The easiest method is the public issuance of securities. However, private companies cannot use this method as per legal obligation. The two widely used instruments to generate funds from the market are shares and debentures. In the case of Equity shares, ownership of the company is compromised. Hence, if the said company does not want to compromise the ownership, issuing debentures could be a better option. Such companies can then borrow the funds required by issuing debentures.
Meaning of Debenture:
A debenture can be described as a debt instrument issued by a company to the public in order to raise funds for medium or long-term usage. It is just like a bank loan, with debt obligation and liability for interest payment, but instead of borrowing from a bank, these are issued and traded in the capital market. A debenture is a legal document that states the amount invested or lent, interest due, and the repayment plan. At the conclusion of the term, the investor receives the principal and interest.
According to Section 2 (12) of the Indian Companies Act 1956, “a debenture is a document which either creates a debt or acknowledges it.”
Generally, debentures are issued with a fixed rate of interest, which is called the Coupon Rate. A debenture holder receives interest according to the coupon rate specified in the debenture certificate.
Types of Debentures:
Debentures can be categorized on the following basis:
A. On the basis of Security:
- Secured Debentures: Debentures that are issued against a security/collateral are called secured debentures. In other words, a charge is made against the assets of the issuing company.
- Unsecured Debentures: Debentures which are issued without any charge against the issuing company’s assets are called unsecured debentures.
B. On the basis of Tenure:
- Redeemable Debentures: Such debentures, which are due to be repaid at the end of a certain period, either in a lump sum or in installments, either at a premium or at face value, during the lifetime of the entity are called redeemable debentures.
- Irredeemable Debentures: Such debentures are not redeemed or repaid during the lifetime of the company. In the event of the winding-up of the company, such redemption may be possible.
C. On the basis of Convertibility:
- Convertible Debentures: Debentures that can be converted into either equity capital or any other security are called convertible debentures. This can be done at the will of the holders of the company.
- Non- Convertible Debentures: Debentures which cannot be converted into equity shares or any other form of security are called non-convertible debentures.
D. On the basis of Coupon Rate:
- Specific Coupon Rate Debentures: These debentures are issued at a specific rate of interest, called the coupon rate. This interest is payable to the holders periodically, regardless of whether the company made a profit that year or not.
- Zero-Coupon Rate Debentures: Such debentures do not carry any interest rate. To compensate the holders, these are usually issued at a discount so that the difference between the face value and the issue price can be treated as the interest income earned by the holder.
E. On the basis of Registration:
- Registered Debentures: Debentures against which all information about their holders, like names, addresses, etc. are kept in a special register at the company’s head office are called registered debentures. Such debentures cannot be transferred just by delivery, but require a transfer deed.
- Bearer Debentures: These debentures are transferred via simple delivery and no special record is kept in the company register for such documents.
Advantages of Debentures:
1. To Investors:
- Fixed Income for Investors: A company has to pay interest on the issued debentures, whether it earns profits in a financial year or not. So, the investors get a fixed income. This is not the case with equity shareholders, whose dividend depends solely on the profit earned.
- Secured Investment: Since debt securities are usually secured by way of a charge against the issuing company’s assets, the holders can sell off the asset in case of the company goes bankrupt or insolvent.
- Fixed Return even during Inflation: The rate of interest on debentures does not fluctuate with the changes in price levels, thereby ensuring a fixed level of income.
2. To the Company:
- No Dilution of Ownership: Since debenture holders do not have any voting rights or any participation in company meetings, the ownership of the company’s management remains intact, as opposed to companies issuing equity capital where control is diluted owing to voting rights to the holders.
- Cheaper Source: Flotation costs and listing costs for debentures are way lesser than those of equity capital, making them a cheaper source of funds for the company.
Disadvantages of Debentures:
1. To Investors:
- No Voting Rights: Debenture holders are not allowed to participate in company meetings and do not have voting rights. Thus they do not have any say in the company matters or policies.
2. To the Company:
- Rigidity as to Interest Payment: A company issuing equity capital can fix the dividend rate as per the profit earned, but the same is not possible for a company issuing debentures, where the rate of interest is fixed, and interest has to be paid whether there is profit or not.
- Less control over Mortgaged Assets: Assets against which charges are made cannot be employed freely for the company’s uses because they are under the control of the creditors. This leads to the underutilization of assets and resources.