Debenture is a legal document containing an acknowledgement of indebtedness by a company. It contains a promise to pay a stated rate of interest for a defined period and then to repay the principal at a given date of maturity.
In short, a debenture is a formal legal evidence of debt and is termed as the senior securities of a company. The position of a bond-holder contrasts sharply with that of an equity-holder.
Whereas the former are creditors, the latter are the ultimate owners of a company. Bond-holders assume risk but comparatively lower than the equity holders in the same organisation.
Unlike equity holders, the bond investor does not share in the growth of a company to any appreciable extent. The debenture holder, it is assumed, is a happy being who is totally unconcerned with fluctuation in earning power. For preference and ordinary shareholders the hard rule is: No profits, no dividends.
A company may acquire long term finance through public borrowings. These loans are raised by the issue of debentures. As per Thomas Evelyn, “A debenture is a document under the company’s seal which provides for the payment of a principal sum and interest there on at regular intervals, which is usually secured by a fixed or floating charge on the company’s property or undertaking and which acknowledges a loan to the company.”
Thus a debenture is a loan to the company at fixed rate of debentures are printed or written on the back of the document, the debenture holders do not take any risk unlike shareholders They are the creditors of the company, profit or no profit, the debenture holders must get their interest. The debentures are redeemable after a fixed time which may be five years or more.
Debenture financing is a cheaper source of finance in comparison to equity and preference shares the interest is paid to the debenture holders at a fixed rate and after fixed time intervals and that too before any dividend payment is made to shareholders. In the event of winding up of the company, the claims of debenture holders get first preference to the payment of shareholders.
Characteristics of Debentures:
(1) The debenture holders get interest at a fixed rate. They have priority of claim over that of shareholders.
(2) The company may have profit or no profit, the debenture holders receive interest.
(3) The debenture holders are the creditors of the company and in the event of winding up of the company. They hold priority of claim to assets over that of shareholders
(4) Since the debenture holders have no voting power so they do not enjoy control over the affairs of the company. However in case of non-payment of interest or principal amount they can interfere in the company working by adopting legal action.
(5) The face value of debenture is always higher in comparison with equity shares.
(6) It is a cheaper source of finance in comparison with other sources.
(7) The interest paid on debenture is considered as the deductible business expenditure for purpose of tax calculations.
Types of Debentures:
(i) Secured and Unsecured Debentures:
Secured debentures are those which create fixed or floating charge on the assets of the company. Such debentures are also called as mortgage debentures. They are empowered to dispose of such assets for the recovery of their claims in case issuing company makes default.
On the other hand, debentures which do not create any charge or security on assets of the company are called unsecured debentures. However, their claim is settled before any payments are made to equity and preference shareholders.
(ii) Registered and Bearer Debentures:
A registered debenture holder is one whose name exists on the debenture certificate and is registered with the company. Such debentures are transferred by more delivery without intimating the company.
Generally, the interest coupons are attached to the debenture certificates and the bearer of such certificate can fill in the coupon and can claim interest by sending it to the company.
(iii) Redeemable and Irredeemable Debentures:
Redeemable debentures are those which are issued on redeemable basis i.e. issued on conditional basis that they shall be redeemed after a certain fixed period.
Irredeemable debentures are those which are not redeemable during the existence of the company. But the debt becomes due for redemption if the company goes into liquidation or when the interest is not regularly paid as and when accrued.
(iv) Convertible and Non-convertible Debentures:
Convertible debenture holders have the option to convert their holdings into equity shares after a specified period of time. Such holder thus gets the chance to participate in the company affairs. Non- convertible debentures are those which cannot be covered into equity shares.