Debentures are company debt. These are medium-long term debt or loans taken by a company to raise capital. These securities are repayable after a fixed-period. Debentures pay the holders a fixed rate of interest (this interest rate is usually lower than OD and bank loans). Debenture interest is paid before paying out dividends.
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Debentures have a lower interest rate than bank overdrafts and bank loans.
Debentures are usually repayable at a far off date in the future.
Banks require borrowers to use the funds for specific purposes. There is no such restriction on debentures.
For debenture holders, debentures are a safe investment. There will be no capital erosion.
Debenture holders earn a fixed interest.
Debenture holders have no ownership rights. They are treated as creditors.
Interest rate on debentures may be fixed or floating.
Debentures can be purchased through brokers and stock exchanges.
Debentures mature after a specific period of time. Hence, debentures are to be repaid on maturity as stipulated in the issue.
Companies may issue debentures with a call feature. This entitles the company to redeem debentures at a certain price before maturity. The call price of the debentures is usually more than the issue price.
Depending on the objectives and needs, a company can issue various types of debentures. The major types of debentures are:
Registered debentures are registered with the company. These debentures can be transferred only by a transfer deed. Debenture interest is paid only to those names appearing in the register of the company.
Bearer Debentures are not recorded in the register of a company. As the name suggests, Bearer Debentures are transferable by delivery and don’t require a transfer deed. The holder or the bearers of these Debentures are entitled to get the interest.
Secured Debentures are secured by a charge on the company assets. They give the holders a right to recover principal amount along with any unpaid debenture interest out of the assets mortgaged by the company.
Unsecured Debentures are not secured. They do not have any charge on the company assets. Therefore, they have no claim on company assets with respect to the principal amount or unpaid interest.
Redeemable Debentures are issued for a fixed period. On the expiry of the fixed period, the debenture holders are paid the principal amount.
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Non-redeemable Debentures cannot be redeemed in a Company’s lifetime. Non-redeemable Debentures are only paid back on company’s liquidation.
Convertible Debentures can be converted into shares of the company on completion of a pre-decided period. The terms and conditions of the conversion are announced at the time of issue of the debentures.
Non-convertible Debentures can’t be converted into the shares of the company.
First Debentures are repaid before other debentures.
Second Debentures are redeemed after first debentures.
Companies raise capital through the issue of shares. This means that every time they issue shares, they are diluting the ownership of the company. Contrastingly, debentures are a company's debt. Debentures don’t give holders any ownership rights. Depending on the company’s objectives, debentures can have advantages over shares in the following ways:
1. Avoid ownership dilution: To run a Company, fund raising is inevitable. But, issuing more shares means diluting the ownership of the company. Say a shareholder owns 10,000 shares out of 1 Lakh equity shares. Their stakes are 10% in the company, thus they own 10% of the company. Say the company issues 1,00,000 more equity shares. Now, the 10% share will shrink to 5%. This will impact the Earnings Per Share (EPS).
Had the company issued debt securities like debentures, there wouldn’t have been a dilution. Though EPS will be impacted even now, the impact is fixed and measured as the debentures have a fixed rate of interest.
2. Maintain the ownership structure: As shareholders are the owners of a company, they have a say in the company’s ownership structure. If new shares are issued, and these are bought by new shareholders and not the current ones, the new shareholders can change the ownership structure. On the other hand, debentures will not affect the ownership structure.
3. Temporary financing: When it comes to the company, shares are permanent securities. Once shares are issued, the company cannot redeem them. But debentures can be redeemed easily. Debentures can be issued when there is a need for funds and can be paid back when there are surplus funds. The company can also call for the redemption of the debentures before maturity, if it can find cheaper financing elsewhere.
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