- Debentures are a type of long-term debt instrument used by companies to raise capital.
- They are similar to bonds in that they pay a fixed rate of interest and have a fixed maturity date. Here are some notes on debentures as a source of finance:
- Debentures are a type of long-term debt financing used by companies.
- They are issued to investors in exchange for cash, with the promise to pay back the principal plus interest over a set period of time.
- Debentures can be either secured or unsecured, with secured debentures being backed by the company’s assets and unsecured debentures relying solely on the company’s creditworthiness.
Features of debentures:
- Fixed interest rate: Debentures pay a fixed rate of interest, which is determined at the time of issuance.
- Long-term maturity: Debentures typically have a maturity date of 5 to 30 years.
- Secured or unsecured: Debentures can be secured by company assets, or unsecured, relying solely on the company’s creditworthiness.
- Tradable: Debentures can be bought and sold on secondary markets, providing investors with liquidity.
- No ownership dilution: Unlike equity financing, debenture financing does not dilute ownership in the company.
- There are different types of debentures, each with its own unique characteristics.
- Convertible debentures: Convertible debentures allow the holder to convert the debenture into shares of the issuing company after a specified period of time. This type of debenture provides investors with the potential for capital gains if the value of the company’s shares increases.
- Non-convertible debentures: Non-convertible debentures cannot be converted into shares of the issuing company. They typically pay a fixed rate of interest and have a fixed maturity period.
- Secured debentures: Secured debentures are backed by specific assets of the issuing company, such as land or buildings. In case of default, the holders of secured debentures have a claim on the underlying assets.
- Unsecured debentures: Unsecured debentures are not backed by any specific assets of the issuing company. In case of default, the holders of unsecured debentures have a claim on the company’s assets along with other unsecured creditors.
- Registered debentures: Registered debentures are issued in the name of the holder, and the issuer maintains a register of debenture holders. This type of debenture provides greater security to the holder, as the issuer can track the ownership and payment of interest.
- Bearer debentures: Bearer debentures are not registered in the name of the holder, and they are transferable by delivery. This type of debenture provides greater anonymity to the holder, but it also increases the risk of loss or theft.
- Redeemable debentures: Redeemable debentures are issued for a fixed period of time, after which they must be redeemed by the issuer. This type of debenture provides greater certainty to the holder, as they know when they will receive their principal investment back.
- Irredeemable debentures: Irredeemable debentures are issued without a fixed maturity date. The issuer may choose to redeem the debentures at any time, but they are not obligated to do so. This type of debenture provides greater flexibility to the issuer, but it also increases the uncertainty for the holder.
- Naked Debentures: Naked debentures are unsecured and do not have any specific assets as collateral. They are solely backed by the issuer’s creditworthiness and reputation.
- Fixed Debentures: Fixed debentures have a fixed rate of interest that is paid to the holder throughout the life of the debenture. The interest rate remains the same regardless of changes in the market.
- Floating Debentures: Floating debentures have a variable interest rate that is linked to a benchmark rate, such as LIBOR or the prime rate. The interest paid to the holder changes with the benchmark rate.
- Mortgage Debentures: Mortgage debentures are secured by specific assets of the issuer, such as land, buildings, or equipment. If the issuer defaults, the holder has a claim on the underlying assets.
- Debentures can have multiple features, and different types of debentures can be combined to create hybrid debentures. For example, a debenture can be both convertible and secured, providing the holder with the option to convert the debenture into shares of the issuer while also having specific assets as collateral.
Ideal uses of debentures:
- Long-term investments: Debentures are ideal for long-term investments in companies with stable cash flows.
- Large-scale projects: Debentures can be used to finance large-scale projects, such as infrastructure or real estate development.
- Expansion: Debentures can be used to finance a company’s expansion plans.
Benefits of debentures:
- Fixed interest rate: The fixed interest rate on debentures provides a predictable stream of income for investors.
- No ownership dilution: Debenture financing does not dilute ownership in the company, allowing existing shareholders to maintain control.
- Flexibility: Debentures can be customized to meet the specific financing needs of the company.
- Tax-deductible interest: Interest payments on debentures are tax-deductible for the company.
- No collateral required: Unsecured debentures do not require collateral, making them an attractive option for companies without significant assets.
Drawbacks of debentures:
- Interest payments: Companies must make interest payments on debentures, regardless of their financial performance.
- Limited flexibility: Once issued, debentures cannot be easily modified or cancelled.
- Default risk: If a company is unable to make interest or principal payments on its debentures, it may default on its debt.
- Higher cost of capital: Debentures generally have a higher cost of capital than other forms of debt financing, due to their longer-term and fixed interest rate.
