Debenture has its origin in the latin word Deboe which means “ I owe” it is a document that is evidence of a debt which is long term in nature, and confirms that the company has borrowed a specific sum of money from the bearer or person named in the debenture certificate. Most debentures are irredeemable thus forming a permanent source of finance to the company. If these are redeemable then these will be long-term loans which range between 10-15 years. They can be endorsed, negotiated, discounted or used as securities for loans. They carry a fixed rate of interest with is payable after six months i.e twice a year.
Classification of Debentures
1.Classification according to security
- Secured debentures- these are secured against the company’s assets or have a fixed charge against the company’s assets. In the event of the company’s liquidation such debentures will claim on any or all of the company’s assets not yet attached by other secured creditors. A debenture holder with a floating charge has a status of a general creditor, however floating charge debentures are rare and they are sold by financially strong companies.
- Unsecured (naked) debentures –these carry no security whatsoever and such they rank as general creditors. They carry a residual claim to the first class creditors but a superior claim to the first class creditors but a superior claim over ordinary shareholders. These are rare sources of finance and are sold by financially strong companies with a good record of dividend payment to the shareholders.
2.Classified According to Redemption
- Redeemable Debentures – these are bought back by the issuing company. Like preference shares, these have two redemption periods which are minimum and maximum redemption periods. This usually between 10-15 years. i.e. the company has the option to redeem these after 10 years but before expiry of 15 years. In most cases redeemable debentures are secured against specific assets e.g. land or buildings ( mortgage debentures) their interest is a legal obligation on the part of the issuing
- Irredeemable debentures (perpetual debentures) these can never be bought back by the issuing company except in the event of liquidation and as such they form a permanent source of finance to the company. These debentures are rare and are only sold by financially strong companies which must have had some good dividend history. These are unsecured and thus are known as naked perpetual debentures.
3.Classified according to convertibility.
- Convertible debentures- these are the type of debentures which can be converted into ordinary share capital and this conversion is optional as follows;
At the option of the company i,e at the company’s option.
At the option of both parties i,e debenture holder and the company
4.At the option of the holder.
However the conversion price of the debenture is given by
- Conversion price= nominal value of the debentures
No. of shares received
- Conversion ratio = Nominal value of debentures
Nominal value of shares to be converted.
In all, convertible debentures are never secured.
- Non- convertible debentures – these cannot be converted into any shares be it ordinary or preference shares and are usually secured.
5. Subordinate debentures (naked)
These are issued with a mutuality period of 10 years and above and usually they carry no security and depend upon the goodwill of the company. They are so called subordinate because they rank last in claims after all classes of creditors except trade creditors. Nevertheless their claims are superior to those of shareholders both preference and ordinary shares.
Advantages of using debenture finance (to the selling company)
In case the company sells irredeemable debentures these will form a permanent finance to the company which can be invested in long term venture or fixed assets. Their use does not entail dilution of the company’s control as they carry no voting rights with which to influence the company’s policies.
In case of convertible debentures, once converted into ordinary shares will be permanent finance to the company and can be used in finance to the company and can be used in financing of long- term ventures. Interest on debentures is tax –allowable expense and as such it will be less by the much of the tax on interest.
Disadvantages of using debenture finance (to the selling company.)
1. Interest on debenture is a legal obligation for the company to pay and failure to pay it may put the company into legal wrangles.
2. it raises the gearing level of the company which may expose it to risks of receivership and, in extreme, liquidation
3. In case of redeemable debentures once redeemed may leave the company in financial strain.
4. Since interest is paid twice a year it may be cumbersome to the company to pay and may pose liquidity problems.
5. For irredeemable debentures these place a permanent commitment in terms of cost to the company.
6. If they are redeemable and reach maximum redemption period before they are redeemed these may force the company into receivership and consequently liquidation.
7. For secured debentures, these may be expensive because they will carry implicit costs. i.e insurance and maintenance of the security and later explicit costs . i.e interest on these debentures.
Similarities between Debentures and Preference Shares Capital.
1. They both carry fixed rate of return.
2. Both increase the company‘s gearing level.
3. both can be converted into ordinary shares, if convertible
4. both carry no voting rights in the company
5. both may be unsecured if the company sells naked debentures
6. both claim on profits and assets before ordinary share holders
7. If they are both redeemable they can force the company into receivership after the expiry of the maximum redemption period if not yet redeemed.
Advantages of using Debenture Finance to Ordinary Shareholders.
1. The use of debenture finance does not dilute the shareholders control of the company unless they are convertible and are converted.
2. Under boom conditions ordinary shareholders may benefit from higher dividends due to fixed charges on debentures which is paid under conditions of high profits.
3. Interest on debentures is tax-allowable expense and as such this may allow the company to retain more and even pay higher ordinary dividends to its shareholders.
4. In case the company issues irredeemable debentures, these will be invested in long-term ventures with not only have the effect of raising the shares pieces of the company’s ordinary shares but will also increase the company’s future ordinary dividends.
5. After debentures are redeemed, the company will benefit from the asset/ investment they had financed which will increase the net worth of shareholders.