Methods of Redemption of Debentures

Debentures Meaning, Types, Redemption, Issue   

Table of Contents:

  • Debentures Meaning
  • Define Debentures
  • What is Debentures?
  • Features of Debentures
  • Difference Between Shares and Debentures
  • Types of Debentures
  • Issue of Debentures
  • Redemption of Debentures
  • Advantages of Debentures
  • Disadvantages of Debentures

Debentures Meaning

The term ‘debenture’ originates from the Latin word ‘debere’ which means to borrow. Companies officially acknowledge their debts using written documents referred to as debentures, typically sealed with the company’s official seal. It includes a contractual agreement outlining the repayment terms for the principal amount, either after a specified period at intervals or as determined by the company. Additionally, it outlines the obligation to pay interest at a fixed rate usually either half-yearly or yearly on fixed dates. As per Section 2(12) of the Companies Act, 1956, ‘Debentures’ include Debenture Inventory, bonds and any other securities of a company, whether or not they bear any charge on the property of the company.

Define Debentures

According to Tophan, “Debenture is a document given by a company as evidence of a debt to the holder, usually arising out of a loan and most commonly secured by the charge”.

According to Section 2(30) of the Companies Act 2013, “Debenture includes debenture stock, bonds or any other instrument of a company evidencing a debt, whether constituting a charge on assets of the company or not”.

What is Debentures?

A debenture document, sealed by the company, is an official acknowledgement of its indebtedness to one or more individuals, ensuring security for the advanced sum. A debenture document represents a security that companies issue to offset their debt. A public limited company in India can raise debt capital through debentures upon obtaining a certificate of commencement of business, subject to the memorandum of association permitting it. The Act does not define the term “debenture”.

Indian Companies Act simply says “Debenture includes debenture stock, bonds, and any other security of a company whether constituting a charge on the assets of the company or not. What is debenture is nowhere stated in the act.”

As per Prof. Naidu and Datta, “A debenture is an instrument issued by the company under this common seal acknowledging a debt and setting forth the terms under which they are issued and are to be paid”.

Features of Debentures

The following points are the main features of debentures:

(i) A debenture is a formal document that serves as a written acknowledgement of debt taken by the company.

(ii) Companies issue a debenture in the form of a certificate.

(iii) Companies execute bonds under their seal.

(iv) A debenture holder can expect to receive periodic interest payments and the repayment of the principal amount after a specific period.

(v) Companies commonly secure bonds with a fixed or floating charge on their assets.

(vi) The funds generated through the issuance of securities are long-term.

(vii) It carries the promise to pay interest at a fixed rate and regular intervals.

(viii) Debenture holders do not have voting rights during meetings.

Therefore, debenture holders serve as the company’s creditors and get interest at a fixed rate, whether the company makes a profit or not. They do not have any involvement in the management or control of the company.

Difference Between Shares and Debentures

The basis for understanding the difference between shares and debentures lies in certain factors.

1. On the basis of Ownership

A ‘share’ represents ownership of the company whereas a debenture is only an acknowledgement of Debt. Shares represent ownership in a company’s capital, whereas a debenture is a part of borrowed capital.

2. On the basis of Return

Dividends are the term for the return on shares, while interest is the return on debentures. The annual rate of return on shares can fluctuate based on the company’s profits, while the rate of interest on debentures remains fixed. Companies distribute profits through dividend payments, while interest payments are mandatory deductions from profits, regardless of the company’s profitability.

3. On the basis of Voting Rights

Shareholders enjoy voting rights whereas debenture holders do not have the privilege of voting.

4. On the basis of Repayment

Normally, companies do not refund the amount of shares throughout their existence, while they issue debentures for a specified period and repay them upon the period’s expiration. However, the Companies Act of 1956 saw amendments in 1998, specifically to Section 77A and 77B Subsection 2, allowing companies to repurchase their shares, especially when the market value of the shares was lower than their book value.

5. On the basis of Security

Shares do not have a security charge associated with them, while debentures typically include a fixed or floating charge on the company’s assets.

6. On the basis of Convertibility

Companies cannot transform shares into debentures, but they can convert debentures into shares if the terms of the issue allow it, and these are termed convertible debentures in such cases.

7. On the basis of Rate of issue discount

Companies can issue both shares and debentures at a discount. However, shares can be issued at a discount by the provisions of Section 79 of The Companies Act, 1956 which stipulates that the rate of discount must not exceed 10% of the face value while debentures can be issued at any rate of discount.

Distinguish Between Shares and Debentures

1. A shareholder is a company member, whereas a debenture holder is a creditor of the company.

2. A share represents a portion of a company’s capital, whereas a debenture represents a portion of a company’s debt.

3. A shareholder has the right to control the company’s workings by attending and voting in the general meeting, which is the supreme authority of the company. In contrast, a debenture holder has no such right.

4. A shareholder enjoys proprietorship rights in a company, whereas a debenture holder can only enjoy the rights of a lender.

5. A debenture holder receives a fixed interest rate per annum payable on selected dates. In contrast, a shareholder receives a dividend, which may be higher if the company earns good profits.

6. A shareholder can receive dividends only when there are profits, whereas a debenture holder is entitled to the interest that the company must pay whether or not there are profits.

7. Debentures are usually issued for a specified period after which they are repaid, but no such repayment is possible for shares.

8. A shareholder claims the company’s accumulated profits and is typically rewarded with bonus shares, whereas a debenture holder has no claims after receiving the interest amount.

9. In liquidation, debenture holders, being secured creditors, typically have priority in payment, whereas shareholders are the last to receive compensation after all other claims have been satisfied.

10. A company cannot purchase its shares from the market but can buy its debentures and either cancel or re-issue them.

Types of Debentures

A company may issue various types of debentures, which can be classified as under:

1. From the Security Point of View

(a) Secured Debentures: Secured debentures involve the creation of a charge on a company’s assets to secure payment in case of default. A fixed or floating charge is an option for companies. Companies create a fixed charge on a designated asset, and they place a floating charge on their general assets. A company places a fixed charge on assets used for operational purposes, rather than those intended for sale. On the other hand, a floating charge involves all assets excluding those assigned to the secured credit.

(b) Unsecured Debentures: Unsecured debentures do not have a specific charge on the company’s assets. However, these debentures may automatically incur a floating charge by default. Normally, companies do not typically issue these types of debentures.

2. From the Tenure Point of View

(a) Redeemable Debentures: Redeemable debentures are financial instruments that are payable on the expiry of the specific period either in a lump sum or in Instalments during the lifetime of the company. The redemption of debentures can occur at either par value or at a premium, as decided by the company.

(b) Irredeemable Debentures: Perpetual Debentures is another term for irredeemable debentures. This is because the issuing company does not give any undertaking for the repayment of money borrowed by issuing such debentures.  Instead, these debentures are repayable only on the winding-up of a company or the expiry of a long period.

3. From the Convertibility Point of View

(a) Convertible Debentures: Convertible debentures are debentures that companies can choose to convert into equity shares or other securities. These types of debentures are either fully convertible or partly convertible.

(b) Non-Convertible Debentures: The term nonconvertible debentures refers to debentures that lack the possibility of conversion into shares or other securities. The majority of the debentures issued by companies fall in this category.

4. From a Coupon Rate ViewPoint

(a) Specific Coupon Rate Debentures: These debentures come with a fixed interest rate, referred to as the coupon rate, as established by the company. Companies set the specified rate as either fixed or floating by the debenture’s terms. The prevailing bank rate typically accompanies the floating interest rate.

(b) Zero Coupon Rate Debentures: These debentures do not bear a predetermined interest rate. Companies issue these debentures at a substantial discount as compensation to the investors. Subtracting the issue price from the nominal value provides the interest amount for the debentures’ duration.

5. From the Registration ViewPoint

(a) Registered Debentures: Registered debentures are those debentures in respect of which all details including names, addresses and particulars of holding of the debenture holders are recorded in a register maintained by the company. The transfer of these debentures is possible only through the execution of a formal transfer deed.

(b) Bearer Debentures: These debentures can be transferred through physical delivery without the company maintaining any record of the debenture holders. Individuals who produce the interest coupon attached to these debentures are eligible for interest payments.

Issue of Debentures

The process for issuing debentures same as that for the issue of shares. The intending investors apply for debentures based on the prospectus issued by the company. The company may either ask for the entire amount to be paid on the application or use instalments on the application, on allotment and various calls. Companies can issue debentures at their par value, at a premium, or at a discount. Issuing these instruments for non-monetary considerations or as collateral security is an option available to companies.

Terms of Issue of Debentures

Companies typically specify the terms for the redemption of debentures upon maturity when they issue them. Redemption of debentures refers to the discharge of liability on account of debentures by repayment made to the debenture holders. The redemption of debentures can occur at either par value or at a premium, as decided by the company.

There are commonly six situations that arise depending on the terms and conditions of the issue and redemption of debentures.

The following journal entries will be passed in all six cases mentioned below.

  1. Issued at a Discount, Redeemable at Par
  2. Issued at Face Value, Redeemable at Face Value
  3. Issued at Face Value, Redeemable at a Premium
  4. Issued at a Premium, Redeemable at Face Value
  5. Issued at Premium, Redeemable at a Premium
  6. Issued at a Discount, Redeemable at Premium

Redemption of Debentures

Redemption of debentures means extinguishing or discharging the liability on account of debentures by the terms of issue. It refers to the company’s repayment of the debenture amount. In other words, it is the process through which the company pays back the borrowed funds from debenture holders.

Methods of Redemption of Debentures

There are four ways to redeem debentures.

These are :

  1. Payment in a lump sum
  2. Payment in instalments
  3. Purchase in the open market
  4. By conversion into shares or new debentures

1. Payment in lump sum

The company redeems the debentures by paying the amount in a lump sum to the debenture holders at the maturity thereof as per the terms of the issue.

2. Payment in instalments

In this method, normally redemption of debentures is made in instalments on the specified date throughout the debenture’s tenure. The debenture liability is calculated by dividing the total amount by the number of years. It is noted that the actual debentures redeemable are identified using drawing the requisite number of lots out of the debentures outstanding for payment.

3. Purchase in the open market

When a company purchases its debentures for cancellation, such an act of purchasing and cancelling the debentures constitutes redemption of debentures by purchase in the open market.

4. Conversion into shares or new debentures

A company can redeem its debentures by converting them into shares or a new class of debentures. If debenture holders find that the offer is beneficial to them, they can exercise their right to convert their debentures into shares or a new class of debentures. These new shares or debentures can be issued at par, discount or premium.

It should be noted that only the actual proceeds of bonds are to be taken into account for ascertaining the number of shares to be issued instead of the debentures to be converted. If securities were originally issued at a discount, the actual amount realised from them at the time of issue would be used as the basis for computing the actual number of shares to be issued. It may be noted that this method applies only to convertible debentures.

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