What is a Debenture?

A debenture is an instrument issued by a company that acknowledges its debts to the holder under its seal.

A debenture is a loan certificate issued by the company to its holders. Instead of borrowing entire funds from an individual, a company can divide the funds into certain small denominations or parts (i.e., debentures).

Debentures carry interest at a certain percent (e.g., 8%). As it is a loan taken by a company, it is repaid after a specified period or at the option of the company as per the terms of the issue.

There are no legal restrictions on the price for which debentures are issued. Debentures may be issued at par, at discount, or at premium, as in the case of shares.

Debenture holders are a company’s creditors. They regularly receive interest on their debentures at a fixed rate. It is usual practice to prefix the rate before debentures (i.e., 12% debentures).

In the event of the dissolution of the company, debenture holders have priority over shareholders as to their interest, as well as of their loan.

Debenture holders are not concerned with the management of the company. Also, they are not involved in the administration and control of the company.

Example

Suppose that a company is seeking to borrow $1,000,000 as a loan by issuing debentures. To do so, it can issue debentures of $100 each (i.e., 10,000 debentures will be issued). For $1,000 debentures, only 1,000 debentures will be required for the loan of $1,000,000.

Types of Debentures

Debentures are classified as:

1. Redeemable Debentures

The amount of the debentures is to be repaid within the period specified in the terms of their issue.

2. Irredeemable Debentures

These are perpetual debentures. The company has no right to make the payment of the principal of these debentures during its lifetime. These debentures are repaid in case of the company’s closure.

3. Bearer Debentures

These debentures are transferable by mere delivery. The name of the holder is not registered with the company.

4. Registered Debentures

These debentures are not transferable by mere delivery. The names of the debenture holders are registered with the company.

5. Naked Debentures

These debentures are not mortgaged and they are issued without any charge on the company’s assets. The issue of these debentures is not popular with companies.

6. Secured or Mortgaged Debentures

These debentures are secured by a charge on the company’s assets. This charge may be fixed or floating.

7. Collateral Debentures

Debentures may also be issued to banks and financial institutions as an additional or subsidiary security, in addition to certain principal security.

If the company does not pay loan interest and the principal security falls short, lending institutions can exercise their right as debenture holders.

Difference Between Shareholders and Debenture Holders

The main differences between shareholders and debenture holders are summarized in the table below.

Point of difference Shareholders Debenture holders
Meaning The subscribers to the shares are shareholders. Shares are the parts of share capital. Debenture holders are the subscribers to debentures. Debentures are parts of a loan.
Status Owners of the company. Creditors of the company.
Return Shareholders are paid dividends on their holdings. Debenture holders are paid interest on the debentures they hold.
Regularity of return Dividends are paid when there is sufficient profit. The dividend rate is not fixed. Dividends are not a regular source of income. Interest on debentures is paid at a fixed rate regularly.
Security Shares are not secured. Debentures are ordinarily secured.
Right to attend meetings Shareholders are invited to attend the annual general meeting of the company. Debenture holders are not invited to attend the annual general meeting of the company unless a decision affecting their interest is being made.
Repayment Share capital is not returned except in the case of redeemable preference shares. Debentures are the loan repaid by the company.
Priority of refunds In the event of the dissolution of the company, shareholder funds are refunded after every claim is settled. Debenture holders have a priority of the refund of their loan prior to shareholders.
Restriction on issue There are certain restrictions on the issue of shares at discount. There are no restrictions as to the issue of debentures at discount.
Control Shareholders control the affairs of the company. It is managed by the board of directors, which consists of the elected representatives of the shareholders. They are not involved in the management and control of the company.

Evaluation of Funds Raising Through Debentures/Loans

Advantages/Merits of Fundraising Through Debentures/Loans

1. Availability of necessary funds: The company can raise funds by the issue of debentures if funds are not available by the issue of shares.
2. No interference in management: Debenture holders do not have voting rights, which means they cannot participate in the management of the company.
3. Fixed rate of interest: The company has to pay interest at a fixed rate even if its rate of earnings and dividends is comparatively higher.
4. Ability to return loan: The company can return funds to debenture holders as per agreement and relieve itself from the burden of the loan.
5. Regular source of income: Investors receive fixed and regular interest at the agreed rate, irrespective of whether the company earns a profit or suffers a loss.
6. Safe and secured investment: Debentures are issued against assets as security, meaning holders have charge of the firm’s assets. Hence, the investment is safe because if the company is dissolved, funds may be realized by the disposal of assets pledged.

Disadvantages/Demerits of Fundraising Through Debentures/Loans

Debentures may be disadvantageous for the following reasons:
1. Disadvantageous for financially unsound companies: The company will be required to pay interest regularly at a fixed rate, even if it has been suffering losses.
2. Pledging assets: Funds are available, after pledging assets as security, which would have been available without mortgaging assets by issuing shares.
3. No participation in management: Debenture holders do not have voting rights. They cannot participate in the company’s management despite supplying funds to the company.

Frequently Asked Questions

What is a Debenture?

A Debenture is a type of debt security that companies use to raise money from investors. The company pledges its assets as collateral for the loan, and in return, the investor receives a regular stream of interest payments. Debentures are considered a safer investment than stocks, as they are backed by the assets of the company.

Why would a company choose to issue Debentures instead of shares?

There are a few reasons why a company might choose to issue Debentures instead of shares. First, companies can raise more money by issuing Debentures than they can by issuing shares. Additionally, Debenture holders do not have voting rights, so they cannot interfere with the company's management.

What is a creditor and what does being a creditor mean?

Debenture holders are creditors because they have lent money to the company through the sale of Debentures. Creditor means an entity that has a claim to receive money from another. In this case, it would be an individual who has purchased a Debenture from the company.

What is a shareholder and what does being a shareholder mean?

A shareholder refers to someone who owns part of a company, as well as receives dividends each year from the business's earnings. In this case, shareholders have invested money into the company by purchasing shares from it.

How risky is Debenture financing?

Debentures are considered riskier investments than stocks or fixed-income securities, because they are backed by the assets of the company. If the company goes bankrupt, Debenture holders will be repaid last after other creditors have been paid.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

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