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What is Debenture ? | Definition, Types, Features, Advantage & Disadvantage


Contents :
  1. Meaning and Definition of Debenture.
  2. Procedure for Issue of Debentures.
  3. Types of Debentures.
  4. Characteristics of Debentures.
  5. Advantages and Disadvantages of Debenture.

What is Debenture ?

A company may final part of its capital needs by raising loans by issuing debentures. The short-term requirements are usually made by the company out of borrowing from commercial banks in the form of overdraft, cash credit and term loans. The long term finance required for supplementing the share capital is raised by issuing debentures, if the earnings of the company are constant and sufficient to meet interest liability and to make provision for repayment of the principal amount on maturity. Debenture capital is therefore, known as debt capital and is shown on the liability side of Balance Sheet.

Meaning of Debentures 

The word debenture is derived from the Latin word 'Lebere' meaning 'to owe'. In its simplest sense it means a document which either creates or acknowledges a debt. A company can raise finances by issuing debentures. A debenture may be defined as the acknowledgement of debt by a company. Debentures constitute the borrowed capital of the company and they are known as creditorship securities because debenture holders are regarded as the creditors of the company.


Definitions of Debenture 

General Definition :
"A debenture is a document issued by the company as an evidence of debt. It is the acknowledgement of the company's indebtedness to its holders."

Palmer :
"Any instrument under seal of the company, evidencing a deed, the essence of it being admission of indebtedness. "

Evelyn Thomas :
"It is a document under the company's seal which provide for the payment of a principal sum and interest thereon at regular intervals which is usually secured by a fixed or floating charge on the company's. property or undertaking and which acknowledges a loan to the company."


Procedure for Issue of Debentures 

1) First of all a Board meeting is convened at which the decision to issue debentures, the number and terms of issue and the rate of interest is taken by means of a resolution to that effect. However, where a company's shares are listed on the Stock Exchange, the listing agreement stipulates that shareholder's approval should be obtained for the offer of debentures to the public and therefore this approval is also to be obtained.

2) If the moneys to be borrowed, together with the moneys already borrowed by the company (apart from temporary loans) exceed the aggregate of the paid-up capital of the company and its free reserves, permission of the General Body is also obtained, by ordinary resolution, for the proposed issue (Sec. 293(1)(d)].

3) The guidelines regarding the issue of debentures prescribed by the Securities and Exchange Board of India (SEBI) must be duly complied with.

4) In case the debentures to be issued are bearer ones, it will be necessary to obtain permission from the Reserve Bank of India as well.

5) In case the debentures are issued under a Trust Deed, necessary consent of trustees is obtained and a draft of Trust Deed is prepared. A draft of prospectus and the Debenture Bond is also prepared.

6) Alter the completion of these formalities, the Board approves the drafts of prospectus, Trust Deed and Debenture Bonds and directs the secretary to arrange for their printing.

7) The Trust Deed is then executed with the trustees for debenture holders.

8) The particulars of the charges created on the issue are to be tiled with the Registrar of Companies within 30 days of the execution of the Trust Deed for registration and a Certificate of Registration is obtained. This Certificate is to be endorsed on every Debenture Certificate. All particulars are also entered in the "Register of Charges" maintained by the company at its registered office.

9) Where it is proposed to enlist the debentures in any stock exchange, approval of the concerned stock exchange is to be obtained.

10) A copy of the prospectus is then filed with the Registrar and the prospectus is issued to the public. In case the debentures are to be issued privately (without making a public officer) a statement in lieu of prospectus is to be filed with the Registrar at least three days before the first allotment of debentures.

11) After this, applications for .debentures are received and allotment of debentures is made by the Board by means of a resolution to that effect.

12) After the allotment, the particulars about each debenture holder are entered in the Register of Debenture holders and Debenture Certificates are prepared which are issued to the allottees in due course. With the introduction of the 'Depository System'," there is no need to issue debenture certificates for the debentures registered in the name of the 'depository'. Instead, the company is required to intimate the details of allotment of debentures to the depository immediately on allotment [New sub-section (4) of Section 113 inserted by the Depositories Act, 1996).

Classification / Types of Debentures 

Types of Debentures

1) On the Basis of Transferability :

a) Registered Debentures :
These debentures are recorded in the 'Register of Debenture holders'. Only those debenture holders whose names appear in this register are entitled to repayment of the principal amount (capital) and periodical payment of interest as agreed upon. Registered debentures are not negotiable by delivery as in the case with share warrants, etc. They are however, transferable as per the procedure prescribed in the Articles of Association of the company.

b) Bearer Debentures :
These are made out to bearer and hence negotiable by mere delivery of the document. There is no register of bearer debentures and there is no need to follow any procedure for their transfer. They can be passed on from hand to hand without notice.

2) On the Basis of Security Offered :

a) Secured or Mortgage Debentures :
These are the debentures which are secured by a charge on the assets or property of the company. These debenture holders have the right to recover their debt due from the bank out of its assets mortgaged in case the company fails abide by the terms of the debenture deed. A mortgage deed is executed by the company in favor of the debenture holder setting forth the terms of repayment, rate of interest, nature and value of security offered to cover the issue, the rights of debenture holders in respect of recovery with reference to the mortgaged assets in case of default by the company. The charge that may be created on the assets of the company may be fixed charge or floating charge.

b) Unsecured Debentures :
Holders of these debentures are one among the ordinary creditors of the company and are not endowed with any charge on the company's assets to support their debt against the company.

3) On the Basis of Redeemability :

a) Redeemable Debentures :
These debentures are issued on redeemable basis i.e. those debentures which are repayable after a predetermined or specified period are known as 'Redeemable Debentures. These debentures can be redeemed by the company on a fixed date or on demand by the debenture holders or by periodical drawings or at the discretion of the company which may give notice of redemption. They can, however, be reissued after usual formalities.

b) Irredeemable Debentures :
They are also known as perpetual debentures. These are the debentures which are not repayable during the life time of the company. Such debt becomes due for redemption only when the company goes into liquidation or when interest is not regularly paid as and when accrued.

4) Convertible Debentures :

Holders of these debentures are given the choice to convert their debenture-holdings into equity shares of the company at stated rates after a specified period. Thus, these debenture holders get an opportunity to become shareholders and to take part in the company management.

Characteristics of Debentures 

Debentures are another kind of security traded in the capital market. A debenture is an acknowledgement of a debt by a company, usually issued under a common seal, and unsecured or secured by a fixed or floating charge on the assets of the company. The terms and conditions under which they are issued are endorsed on the back of the security. Characteristics of debentures are as follows:

1) Maturity Period :
Debentures consist of long-term fixed maturity period. Normally, debentures consist of 10-20 years maturity period and are repayable with the principle investment at the end of the maturity period.

2) Residual Claims in Income :
Debenture holders are eligible to get fixed rate of interest at every end of the accounting period. Debenture holders have priority of claim in income of the company over equity and preference shareholders.

3) Residual Claims on Asset :
Debenture holders have priority of claims on Assets of the company over equity and preference shareholders. The Debenture holders may have either specific change on the Assets or floating change of the assets of the company. Specific change of Debenture holders are treated as secured creditors and floating change of Debenture holders are treated as unsecured creditors.

4) No Voting Rights :
Debenture holders are considered as creditors of the company. Hence they have no voting rights. Debenture holders cannot have the control over the performance of the business concern.

5) Fixed Rate of Interest :
Debentures yield fixed rate of interest till the maturity period. Hence the business will not affect the yield of the debenture.

Advantages of Debentures 

a) Advantages to Company :

1) Lower Rate of Interest :
The rate of interest payable on debentures is not only fixed but is also usually lower than the rate of dividend paid on shares.

2) Trading on Equity :
By issuing debentures, company is enabled to trade on -equity as because the rate of interest on debentures is usually lower than the rate of earnings and thus the company can declare a higher rate of dividend on equity shares.

3) Freedom in Management :
Debenture holders are not given any voting right to control the affairs of the company and thus the company can raise the finance without surrendering control to the debenture holders.

4) Tax Benefits :
The payment of interest on debentures is charged against profits of the company as per income tax rules whereas the payment of dividend is an appropriation of profit hence not a charge against profit hence not a charge against profits. The profits of the company are reduced by the amount of interest paid to debenture holders which results in reducing the tax liability.

5) Certainty of Finance :
Debentures are issued for a fairly long period. According to the new guidelines issued by the government the secured debentures shall not be redeemable before a period of seven years. Hence, there is a certainty of finance for that specific period and the company may adjust its financial plans accordingly.

6) Capital From Moderate Investors :
Company can collect the finance from such investors who prefer fixed income with minimum risk rather than an uncertain high rate of dividend on capital. Security of capital is more important for them.

7) Boon During Depression :
During depression, a company can easily collect the finance through the issue of debentures because the psychology of investors is affected by the trends of the stock market. As there is a slump in the market, a company is not expected to earn high profits, therefore, investors are not willing to invest their funds in share capital of company.

8) Controlling over- capitalization :
The state of over-capitalization can very easily be controlled by redeeming the redeemable debentures. In this way, it provides flexibility in the capital structure.

9) Consolidation of Debt :
A company may consolidate its several debts of short duration by issuing debentures and thus, may reduce its capital.

b) Advantages to Investors :

1) Fixed and Stable Income :
Debentures carry a fixed rate of interest. An investor can estimate his income well in advance. Thus, debentures provide a fixed, regular and stable source of income to debenture holders.

2) Safety Investment :
Debenture holders have specific or general charge on the assets of the company, so their investment is quite safe.

3) Liquidity :
Debentures are more liquid investment and have more ready market because they are safe and can be used as collateral security by the investors in raising loan from any financial institution.

4) Conversion of Loan :
Debenture holders can convert their holding in shares at appropriate time in case of convertible debentures.

Disadvantages of Debenture 

a) Disadvantages to Companies :

1) Fixed charge on Assets :
Debentures carry a fixed charge on all assets of the company hence the company cannot raise loan on such assets again, if needed.

2) Fixed Burden :
Interest payable on debentures is a charge on the profits of the company. It will be paid even if there is not profit. Thus, it is a burden on the company especially when there are no profits or inadequate profits.

3) Risk of Winding Up :
The debenture holders have a right to claim winding up or the company, in case, the interest on debentures is and paid by the Company. So debenture issue is risky in lean period.

b) Disadvantages to Investors :

1) No Control :
Debenture holders are creditors and not the owners of company and hence get no controlling authority over the affairs of the company.

2) No Extra Profits :
Debenture holders get a fixed income as interest irrespective of the quantum of profits earned by the company. They cannot share the profits even if company earns huge amount as profits.

3) Uncertainty :
In case of redeemable debentures payable within a specified period, investors have uncertainty in their minds as so their redemption.

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