What is a debenture? How to raise fund by issuing debentures?

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Definition and Explanation

Debenture is an instrument issued by the company acknowledging its debts to the holder under its seal. Debentures carry interest at certain percent. As it is loan taken by the company, it is repaid after a certain specified period or at the option of the company as per the terms of their issue. There are no legal restrictions on the price for which debentures are issued. Debentures may be issued at par, at discount or at premium like shares.

Debentureholders are the creditors of the company. They are paid interest on their debentures regularly at fixed rate. It is usual practice to prefix the rate before debentures, i.e., 12% debentures. Debentureholders have priority as to their interest and of their loan in case of dissolution of the company over shareholders. Debentureholders are not concerned with the management of the company. They are not involved in the administration and control of the company.

A debenture is a loan certificate issued by the company to its holders. The company instead of borrowing entire funds from an individual divides the funds into certain small denomination or parts. These parts are known as debentures.

Example


Suppose the Company wants to borrow $10,00,000 as loan by issuing debentures, it may issue debentures of $100 each and thus 10,000 debentures will be issued. In case of $1,000 debenture, only 1,000 debentures will be required for the loan of $10,00,000.

Kinds of Debentures

Debentures may be classified as under:

1. Redeemable debentures

The amount of the debentures are to be repaid within certain specified period as per the terms of their issue.

2. Irredeemable debentures

These are perpetual debentures. The company has no right to make the payment of the principal of these debentures during its lifetime. These debentures are repaid in case of winding of the company.

3. Bearer debentures

These debentures are transferable by mere delivery. The name of the holder is not registered with the company.

4. Registered debentures

These debentures are not transferable by mere delivery. The names of the debentureholders are registered with the company.

5. Naked debentures

These debentures are not mortgaged and they are issued without any charge on company’s assets. The issue of these debentures is not popular the company.

6. Secured or Mortgaged Debentures

These debentures are secured by a charge on company’s assets. This charge may be fixed or floating.

7. Collateral Debentures

Debentures may also be issued to banks and financial institutions as an additional or subsidiary security in addition to certain principal security. Lending institutions can exercise their right as debentureholders, if the company does not pay loan interest thereon and the principal security falls short.

Difference between Shareholders and Debentureholders

The main difference between shareholders and debenture holders are given below:

 

Point of differenceShareholdersDebentureholders
MeaningThe subscribers to the shares are shareholders. Shares are the parts of share capital.Debentureholders are the subscribers to debentures. Debentures are parts of loan.
StatusThey are owners of the company.They are the creditors of the company.
ReturnShareholders are paid dividend on their holdings.Debentureholders are paid interest on debentures held by them.
Regularity returnDividends are paid when there is sufficient profit. The rate of dividend is not fixed. Dividends are not a regular source of income.Interest on debenture is paid at fixed rate regularly.
SecurityShares are not secured.Debentures are ordinarily secured.
Right to attend meetingShareholders are invited to attend the annual general meeting of the company.Debentureholders are not invited, unless any decision affecting their interest is being taken.
RepaymentShare capital is not returned, except in case of redeemable preference shares.Debentures being loan is repaid by the company.
Priority of refundIn case of dissolution of the company shareholders’ funds are refunded after every claim is settled.Debentureholders have a priority of the refund of their loan prior to shareholders.
Restriction on issueThere are certain restrictions on issue of shares at discount.There are no restrictions as to issue of debentures at discount.
ControlShareholders control the affairs of the company. It is managed, the Board of Directors, the elected representatives of the shareholders.They are not involved in the management and control of the company.

Evaluation of Funds Raising through Debentures/Loans

Advantages/Merits of Funds raising through Debentures/Loans

(i) Availability of necessary funds. The company can raise funds by the issue of debentures, if funds are not available by the issue of shares.

(ii) No interference in the management. Debentureholders do not have voting rights, so they cannot participate in the management.

(iii) Fixed rate of interest. The company has to pay interest at fixed rate, even if its rate of earning and dividend is comparatively higher.

(iv) Facility to return loan. The company can return funds to debentureholders as per agreement and relieve itself from the burden of loan.

(v) Regular source of income. The investors get fixed and regular interest at the agreed rate of interest, whether the company earns profit or suffers loss.

(vi) Safe and secured investment. Debentures are issued against the security of assets. Debentureholders have charge of the assets of the company. In this way, their investment is safe and secured, because if the company is disolved, funds may be realized by disposal of assets pledged.

Disadvantages/Demerits of Funds raising through Debentures/Loans

Issue of debentures is disadvantageous in the following ways:

1. Disadvantageous to financially unsound company. The company will be required to pay interest regularly at fixed rate, even if it has been suffering loss.

2. Pledging assets. Funds are available after pledging assets as security, which would have been available without mortgaging assets by issue of shares.

3. No participation in management. Debentureholders do not have voting right. They cannot participate in the management, even if they have supplied funds to the company.

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