DEBENTURES

1. Introduction and Meaning

A debenture is a long‑term debt instrument issued by a company to borrow money from the public or institutional investors. It is a written acknowledgment of debt issued under the company’s seal, promising to pay a fixed rate of interest (called coupon) at regular intervals and to repay the principal amount on a specified date (maturity).

Debentures are a common source of long‑term finance for companies. The holders of debentures are creditors of the company, not owners. Therefore, they do not have voting rights, but they have a prior claim on the company’s income (interest) and assets (in case of liquidation) over shareholders.

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2. Features of Debentures

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3. Types of Debentures

Debentures can be classified on several bases:

A. Based on Security (Collateral)

B. Based on Redemption

C. Based on Convertibility

D. Based on Priority

E. Based on Coupon (Interest)

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4. Debentures vs Preference Shares vs Equity Shares

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5. Advantages of Debentures (From Company’s Perspective)

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6. Disadvantages of Debentures

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7. Cost of Debentures ($K_d$)

The cost of debentures is the effective rate of interest that the company pays, adjusted for tax benefits.

Formula (Irredeemable / Perpetual Debentures)

$K_d = \frac{I \times (1 – t)}{NP}$

Where:

• I = Annual interest payment (Face value $\times$ Coupon rate)
• t = Corporate tax rate
• NP = Net proceeds from issue (Issue price – Flotation costs)

Example:

• Face value = ₹100
• Coupon rate = 12% → I = ₹12
• Tax rate = 30%
• Issue price = ₹100, flotation cost = ₹2 → NP = ₹98
• $K_d = \frac{12 \times (1 – 0.30)}{98} = \frac{12 \times 0.7}{98} = \frac{8.4}{98} = 8.57%$

Formula (Redeemable Debentures)

$K_d = \frac{I \times (1 – t) + \frac{RV – NP}{n}}{\frac{RV + NP}{2}}$

Where:

• RV = Redemption value (usually face value, may include premium)
• n = Number of years to maturity

Example:

• Face value = ₹100, issued at ₹95, flotation cost ₹3 → NP = ₹92
• Coupon = 10% → I = ₹10
• Tax = 30% → I(1–t) = 7
• Redeemable after 5 years at par (₹100)
• n = 5
• $K_d = \frac{7 + \frac{100 – 92}{5}}{\frac{100 + 92}{2}} = \frac{7 + 1.6}{96} = \frac{8.6}{96} = 8.96%$

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8. Accounting Treatment of Debentures

Issue of Debentures (at par)

Issue at Discount

Interest Payment

Redemption of Debentures

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9. Debentures vs Bonds

In common usage, the terms are often used interchangeably. However, there are subtle differences:

In the Indian context, debentures are typically issued by companies and are often secured; bonds are issued by government entities (e.g., RBI bonds) or corporations with specific features.

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10. Illustrative Problems

Problem 1: Cost of Irredeemable Debentures

Question: A company issues 1,000, 10% debentures of ₹500 each at a discount of 5%. Flotation costs are ₹10 per debenture. Tax rate is 25%. Calculate cost of debentures.

Solution:

• Face value = ₹500
• Interest = 500 $\times$ 10% = ₹50
• After‑tax interest = 50 $\times$ (1 – 0.25) = 50 $\times$ 0.75 = ₹37.50
• Issue price = 500 – 5% discount = ₹475
• Flotation cost = ₹10
• Net proceeds = 475 – 10 = ₹465
• $K_d = \frac{37.50}{465} = 8.06%$

Problem 2: Cost of Redeemable Debentures

Question: A company issues 12% debentures of ₹100 each at a premium of 5%. They are redeemable after 4 years at a premium of 10%. Flotation cost is ₹2 per debenture. Tax rate 30%. Calculate $K_d$.

Solution:

• Face value = ₹100
• Interest = ₹12
• After‑tax interest = 12 $\times$ (1 – 0.30) = ₹8.40
• Issue price = 100 + 5% premium = ₹105
• Flotation cost = ₹2
• Net proceeds (NP) = 105 – 2 = ₹103
• Redemption value = 100 + 10% premium = ₹110
• n = 4 years
• $K_d = \frac{8.40 + \frac{110 – 103}{4}}{\frac{110 + 103}{2}} = \frac{8.40 + 1.75}{106.5} = \frac{10.15}{106.5} = 9.53%$

Problem 3: WACC including Debentures

Question: A company has:

• Equity: ₹50 lakhs (cost 16%)
• Preference: ₹10 lakhs (cost 12%)
• Debentures: ₹20 lakhs (cost 8% after tax)
• Retained earnings: ₹20 lakhs (cost 15%)
  Calculate WACC.

Solution:
Total capital = 50 + 10 + 20 + 20 = ₹100 lakhs

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11. Practice Problems

Problem 1
A company issues 8% debentures of ₹100 each at par. Flotation cost ₹2 per debenture. Tax rate 25%. Calculate cost of debentures (irredeemable).

Problem 2
10% debentures of ₹100 each are issued at ₹90. Redeemable after 6 years at ₹105. Flotation cost ₹5 per debenture. Tax rate 30%. Find $K_d$.

Problem 3
Calculate EBIT‑EPS Analysis with Debentures:
A company needs ₹30 lakhs.

• Plan A: All equity (30,000 shares of ₹100 each)
• Plan B: ₹15 lakhs equity (15,000 shares) + ₹15 lakhs debentures (10% interest)
• Plan C: ₹10 lakhs equity (10,000 shares) + ₹20 lakhs debentures (10% interest)
  Tax rate 30%. Expected EBIT = ₹6 lakhs. Calculate EPS for each plan.

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12. Summary – Key Points

1. Debentures are long‑term debt instruments issued by companies to raise funds.
2. Features: Fixed interest, fixed maturity, priority over shareholders, tax‑deductible interest, no voting rights.
3. Types: Secured/unsecured, redeemable/irredeemable, convertible/non‑convertible, fixed/floating/zero coupon.
4. Advantages: Cheaper than equity, no dilution of control, tax benefit, financial leverage.
5. Disadvantages: Fixed interest burden, redemption obligation, financial risk, restrictive covenants.
6. Cost of debentures is calculated after tax: $K_d = \frac{\text{Interest}(1–t)}{\text{Net proceeds}}$ (for irredeemable).
7. Interest coverage ratio = EBIT / Interest – measures safety of interest payments.

Interactive Practice Lab

Test your mastery of Debentures with our MCQ-based assessment.