Debentures- A Creditorship To The Company

Sometimes when the Company needs investment without diluting its equity state, the Company opts for Debentures Issue. A debenture is an instrument of debt executed by the corporation acknowledging its obligation to repay the amount at a specified rate and also carrying a fixed interest. It is one of the methods of raising loan capital for the company. 

A debenture is just like a certificate of loan evidencing that the company is liable to pay a specified amount with interest and although the fund raised by the debentures becomes a part of the company’s capital structure, it does not become the share capital of the company.

Debenture under the Companies Act, 2013:

Section 2(30) of the companies Act, 2013 provides that “debenture” includes debenture stock, bonds, or any other instrument of a company evidencing a debt, whether constituting a charge on the assets of the company or not.

Provided that the following shall not be treated as debenture

(a) the instruments referred to in Chapter III-D of the Reserve Bank of India Act, 1934; 

(b) such other instruments, as may be prescribed by the Central Government in consultation with the Reserve Bank of India, issued by a company.

ADVANTAGES FOR ISSUE OF DEBENTURE:

Debentures offer several benefits both to the company as well as investors.

Advantages to the Company:

The company has the following main benefits for issuing debentures as a source of finance:

(i) Debentures provide long-term finance to a company.

(ii) The rate of interest payable on debentures is, normally, lower than the rate of dividend paid on shares.

(iii) The interest paid on debentures is a tax-deductible expense and therefore the effective cost of debentures is lower as compared to the share capital of the company, where a dividend is not a tax-deductible expense.

(iv) Debt financing does not affect dilution of control because debenture-holders do not have any voting rights.

(v) A company can trade on equity by combining debentures in its capital structure and thereby increasing its earnings per share.

(vi) Companies prefer the issue of debentures because of the fixed rate of interest attached to them irrespective of the changes in price levels of the debenture.

(vii) Debentures offer flexibility in the capital structure of a company as the same can be redeemed as and when the company has surplus funds and desires to do so.

(viii) Even during the depression of the market, a company may be able to raise funds through the issue of debentures because of the certainty of income and low risk to investors.

Advantages to Investors:

It is not only the company but also the investors who are enjoying several benefits by investing in debentures.

(i) Debentures offer a fixed and regular source of income to their investors.

(ii) It is comparatively a safer investment because the company has created either a specific/fixed charge or a floating charge on all the property of the company and enjoys the status of a superior creditor in the event of winding up of the company.

(iii) Many investors choose debentures because they have a definite maturity period.

(iv) A debenture is a more liquid investment and an investor can sell or mortgage his debenture instrument to obtain loans from financial institutions.

(v) The interest of debenture-holders is safeguarded by various provisions of the debenture trust deed and the guidelines enacted by the SEBI in this regard.

DISADVANTAGES FOR ISSUE OF DEBENTURE: 

Despite many advantages of debenture, debenture financing suffers from certain limitations.

Disadvantages to the company:

(i) The fixed rate of interest and repayment of the principal amount on maturity are legal obligations of the company. These have to be paid even when there are no profits for the company. Hence, it is a constant burden on the company. Default in these payments adversely affects the creditworthiness of the corporation and may even lead to the liquidation of the company.

(ii) Charge on the property of the company and other protective measures provided to debenture holders by the issue of debentures usually restrict a company from using this source of finance. A company cannot raise further loans against the security of property already mortgaged to debenture-holders.

(iii) The use of debt financing normally increases the risk perception of investors in the company, hence financial risk increases the cost of equity capital.

(iv) Cost of raising funds through debentures is also high because of high stamp duty.

(v) A company whose expected future earnings are not fixed or who deals in products with highly elastic demand or who does not have enough fixed assets to offer as security to debenture-holders cannot use this source of raising investment to its benefit.

Disadvantage to Investors:

Many investors do not consider debentures as an attractive investment because of the following:

(i) Debentures do not carry any voting rights and hence debenture holders do not have any controlling power over the affairs of the company.

(ii) Debenture-holders are only creditors of the company and not the owners of the company. They do not have to claim any claim on the surplus assets and profit of the company beyond the fixed interest and their principal amount.

(iii) Interest on debentures is fully taxable in the hands of holders while shareholders may avoid tax by way of bonus shares in place of a cash dividend.

(iv) The prices of debentures in the market fluctuate with the changes in the interest rates.

(v) Uncertainty about redemption also restricts certain investors from investing in debenture or bonds.

How is the share of the company different from the debenture of the company?

While shares and debentures both are types of financial instruments issued by a company, there are some similarities between the two. Both are methods of raising capital for the company. Both shares and debentures are issued to the public and can be tradeable on the stock exchange.

Comparison between shares and debenture

PREREQUISITE FOR ISSUE OF DEBENTURES

1. Ensure that the AOA of the company empowers the issue of the debenture.
2. Check whether the Company issues debentures within the borrowing limit prescribed under section 180(1)(c) of the Act.
3. In case of the issue of secured debenture, the date of its redemption shall not exceed ten years from the date of issue:

However, the following classes of Companies may issue secured debentures for a period exceeding ten years but not exceeding thirty years,

• Companies engaged in setting up infrastructure projects
• Infrastructure Finance Companies
• Non-Banking Financial Companies
• Companies are allowed by a Ministry of the Central Government or by RBI or by the National Housing Bank or any other statutory authority.

1. The issue shall be secured by way of charge on assets of the company or subsidiaries company or holding company or associates’ companies, having a value which is sufficient for the due repayment of debentures and interest thereon.
2. A debenture trustee has to be appointed before the issue of a letter of offer for subscription of debentures and not later than sixty days after the allotment of the debentures and execute a debenture trust deed to safeguard the interest of the debenture holders.
3. Creation of charge on asset of the company in favor of Debenture Trustee.

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