What are Debentures?
A debenture is a document issued by a company as evidence of debt due from the company with or without a charge on the assets of the company. It is an acknowledgment of the company‘s indebtedness to its debenture holders. Debentures are instruments for raising long-term debt capital.
Debenture holders are the creditors of the company. In India, according to the Companies Act, of 1956, the term debenture includes debenture stock, bonds, and any other securities of a company whether constituting a charge on the assets of the company or not.
Debenture-holders are entitled to periodical payment of interest at an agreed rate. They are also entitled to the redemption of their capital as per the agreed terms. No voting rights are given to debenture-holders. Under section 117 of the Companies Act, of 1956, debentures with voting rights cannot be issued. Usually, debentures are secured by a charge on or mortgage of the company.
Advantages of Debentures
The following are the advantages of debentures:
- Debentures provide funds to the company for a long period without diluting its control, since debenture-holders are not entitled to vote.
- Interest paid to debenture-holders is charged on the income of the company and is deductible from computable income for income tax purposes whereas dividends paid on shares are regarded as income and are liable to corporate income tax. The post-tax cost of debt is thus lowered.
- Debentures provide funds to the company for a specific period. Hence, the company can appropriately adjust its financial plan to suit its requirements.
- Since debentures are generally issued on a redeemable basis, the company can avoid over-capitalization by refunding the debt when the financial needs are no longer felt.
- In a period of rising prices, debenture issued is advantageous. The burden of servicing debentures, which entails a fixed monetary commitment for interest and principal repayment, decreases in real terms as the price level increases.
- Debentures enable the company to take advantage of trading on equity and thus pay the equity shareholders’ dividend at a rate higher than the overall return on investment.
- Debentures are suitable for investors who are cautious and conservative and who particularly prefer a stable rate of return with minimum or no risk. Even institutional investors prefer debentures for this reason.
Disadvantages of Debentures
The following are the disadvantages of debentures:
- Debenture interest and capital repayment are obligatory payments. Failure to meet these payments jeopardizes the solvency of the firm.
- In the case of debentures, interest has to be paid to the debenture-holders irrespective of the fact whether the company earns a profit or not. It becomes a great burden on the finances of the company.
- Debentures financing enhances the financial risk associated with the firm. This may increase the cost of equity capital.
- When assets of the company get tagged to the debenture-holders the result is that the credit rating of the company in the market comes down and financial institutions and banks refuse loans to that company.
- Debentures are particularly not suitable for companies whose earnings fluctuate considerably. Such a company raising funds through debentures may lead to considerable fluctuations in the rate of dividends payable to the equity shareholders.