Issue of Debentures: Meaning, Characteristics, Purpose of Issuing Debentures and Example

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.

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.

Characteristics of Debentures:

1. Fixed Interest: Debentures typically pay a fixed rate of interest to their holders, which is agreed upon at the time of issue. The interest rate on debentures is usually lower than that on bonds, as the debenture holder does not have any ownership rights in the issuing company.

2. Long-term: Debentures are typically issued for a period of several years, ranging from 5 to 20 years or more.

3. Unsecured: Debentures are generally unsecured, meaning they are not backed by any collateral or assets. This makes them a riskier investment than bonds or other secured debt instruments.

4. Transferable: Debentures are generally transferable, meaning they can be bought and sold in the open market. This allows investors to buy and sell their debentures as they see fit, providing greater liquidity compared to other forms of long-term debt.

5. Redeemable: Most debentures are redeemable, meaning that they can be redeemed or repaid by the issuing company at the end of the term. Some debentures are perpetual, meaning they do not have a set maturity date and do not need to be redeemed.

Example:

Suppose a company, XYZ Ltd., wants to raise capital for expanding its operations. It decides to issue debentures to the public. The company issues 10,000 debentures at a face value of ₹100 each, with a fixed interest rate of 5% per annum. The debentures have a term of 10 years and are redeemable at the end of the term.

In this example, the company has raised ₹1,000,000 from the issuance of debentures (10,000 debentures x ₹100 face value each). The debenture holders will receive a fixed rate of interest of 5% per annum on their investment, which they will receive annually over the 10-year term of the debentures. At the end of the 10-year term, the company will redeem the debentures and repay the face value of ₹100 to each debenture holder.

Purpose of Issuing Debentures:

Debentures are a type of debt security issued by a company to raise capital. The purpose of issuing debentures can vary, but some common reasons include:

1. Financing Business Operations: Companies may issue debentures as a means of financing their day-to-day operations, such as paying salaries, buying inventory, and investing in research and development.

2. Funding Capital Expenditures: Companies may also issue debentures to fund capital expenditures, such as building new facilities, acquiring other companies, or investing in new equipment.

3. Refinancing Existing Debt: Companies may choose to issue debentures to refinance existing debt, such as loans or bonds, in order to take advantage of lower interest rates or to extend the maturity of their debt.

4. Diversifying funding sources: Companies may also issue debentures as a way to diversify their funding sources, as opposed to relying solely on equity financing or bank loans.

Example: 

A manufacturing company wants to expand its operations by building a new factory. The company has limited cash on hand and is unable to obtain a bank loan, so it decides to issue debentures to raise the capital it needs. The company offers investors the opportunity to lend it money by purchasing debentures, which will be repaid with interest over a set period of time. This allows the company to raise the funds it needs to build the new factory and grow its business, while also giving investors the opportunity to earn a return on their investment.

It’s important to note that issuing debentures carries a certain level of risk for both the issuer and the investor. For the issuer, there is the risk of default, meaning that they may not be able to repay the debentures as promised. For the investor, there is the risk of not receiving the promised return or losing their investment entirely. As such, it’s important to carefully consider the purpose of the debentures and the creditworthiness of the issuer before making an investment.

Other Articles from the Chapter Issue of Debentures:

• Debentures – Types, Advantages and Disadvantages
• Types of Debentures
• Difference between Shares and Debentures