May 29, 2022

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Debentures As a Source of Finance

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Debentures As a Source of Finance

A Debenture is a document or certificate issued by the company under its seal acknowledging a debt. Deentures are long-term source of finance.

Types of Debentures

Debentures is divided into the following major types:

1. Unsecured debentures:

  It is also called simple or naked debentures. Unsecured debentures do not have any security on assets of the company. Att the winding up of the company, the unsecured debenture holder do not have any claim on any asset of the company.

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2. Secured debentures:

It is also called as mortgaged debentures. Secured debentures are given security on assets of the company.  They are called mortgaged because these debentures are given against any mortgage of the assets of the company. At winding up, the holder of secured debenture has claim on a particular assets or group of assets that has been mortgaged to him.

3. Redeemable debentures:

These debentures are to be redeemed on the expiry of a certain period. The interest is paid periodically and the initial investment is returned after the fixed maturity period. Redeemable debentures can be secured or unsecured.

4. Irredeemable debentures:

These kind of debentures cannot be redeemable during the life time of the business concern. It can be prepaid at the winding up of a company.

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5. Convertible debentures:

Convertible debentures are the debentures whose holders have the option to converted them wholly or partly into shares. These debentures are usually converted into equity shares. Conversion of the debentures may be:
Non-convertible debentures, Fully convertible debentures or partly convertible debentures

6.Other types:

Debentures can be classified into the following types.

1. Gaurantee Debenture

2. Collateral Debenture

3. Zero Coupon Bond

4. Zero Interest Bond/Debenture

5. First Debenture

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Features of Debentures

1. Maturity period:

Debentures are long-term source of finance. Debentures have 10–20 years maturity period and are repayable with the principle investment at the end of the maturity period together with the interest.

2.No voting rights:

 Debenture holders are creditors of the company and not owners. Therefore, lack voting rights.

3.Fixed rate of interest:

Fixed rate of interest are paid to debentures holders till the maturity period. The interest paid are finance cost and therefore help to reduce tax paid by the company.

4. 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. Also, when a company liquidate, debenture holders are redeemed first before preference and equity shares.

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5. Residual claims on asset:

Debenture holders have claims on Assets of the company first before equity and preference shareholders.

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Advantages of Debenture

1. Long-term sources:

Debenture is a long-term sources of finance to the company.

2. Income tax deduction:

Interest payable to debentures can be deducted from the total profit of the company. So it helps to reduce the tax burden of the company.

3.Trade on equity:

 A company can trade on equity by mixing debentures in its capital structure and thereby increase its earning per share. When the company apply the trade on equity concept, cost of capital will reduce and value of the company will increase.

4. Fixed rate of interest:

Fixed rate of interest is payable to debenture holders. Generally, the rate of interest is lower than the other sources of long-term finance.

Disadvantages of Debenture

1.Fixed rate of interest:

 Debentures as a source of finance is not good for companies that do not make profits. Debenture consists of fixed rate of interest payable to securities. Even though the company is unable to earn profit, they have to pay the fixed rate of interest to debenture holders.

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2.No voting rights:

Debenture holders do not have any voting rights. Hence, they do not have rights to control the decisions made by the management of the company.

3. High risk:

Every additional issue of debentures becomes more risky and costly on account of higher expectation of debenture holders. This enhanced financial risk, increases the cost of equity capital and the cost of raising finance through debentures which is also high because of high stamp duty. Also, if the company fails to pay debenture in a particular year, the debenture holders can sue for the liquidation of the company.

4. Creditors of the company:

Debenture holders are merely creditors and not the owners of the company and therefore, have no claim in the surplus profits of the company.

5. Restrictions of further issues:

The company cannot raise further finance through debentures as the debentures are under the part of security of the assets already mortgaged to debenture holders.

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