Characteristics of Debentures
Here are some of the important characteristics of debentures:
They have a set maturity period – Every specific debenture issued by a company has a specified period of maturity. The debentures are redeemed when the period expires or when the maturity date arrives.
They have a fixed rate of interest – Each issued debenture’s amount includes a fixed interest rate. At the time of issue, the rate of interest is prescribed by the company.
They are long-term debt instruments – Debentures are an integral part of the long-term borrowed funds set.
Extreme financial risks – Since the borrowing company is required to pay a fixed interest rate and has to redeem debentures at the time of maturity, irrespective of the loss or profit incurred, debentures involve extreme financial risks.
Zero voting rights – Anyone who holds debentures does not have voting rights like the company’s shareholders.
Debenture Redemption Reserve
A debenture redemption reserve or DRR refers to the reserve built by stockpiling a minimum of 25% of the debenture’s overall face value annually until it the date of maturity arrives. It is a provision that states that any Indian company which wishes to issue debentures must establish a debenture redemption service to safeguard investors in case of any mishaps, such as a company defaulting.
The Indian Companies Act of 1956, present in the Indian constitution, states that debenture-issuing companies are required to establish a reserve before the arrival of any debenture’s maturity date. An amendment to the Act was issued in 2000.
Popular Methods of Redeeming Debentures
There are numerous methods following which debentures can be reclaimed. Here are some of the most popular ones:
1. Lump-sum amount
It is the simplest and most convenient redemption method. This one-time debenture-redeeming method involves the holder receiving the entire amount on a pre-set redemption date.
Suppose the issued debentures do not get redeemed at discount or premium. In that case, the promised sum of money, which is calculated by adding the principal amount of every debenture, is cleared on the date mentioned in the officially-issued debenture agreement. However, if the company wants, they can pay off the promised lump sum before the maturity date arrives.
2. Payment in annual instalments
This debenture-redeeming procedure involves the issuing company paying holders small portions of the promised sum annually until the maturity date arrives. The outcome of such debentures is determined by dividing the overall liability by the total number of investment years and is paid to the holders every year.
3. Call and put option
Multiple companies use the call and put method of redeeming debentures. The call option facilitates debenture-issuing companies to pay a predetermined sum and purchase the debenture before or on the maturity date.
In contrast, the hold option allows debenture holders the power to return or sell the debenture to the issuing company at a specific price. Holders can either sell the debenture before or on the maturity date.
4. Conversion into shares
This method of redeeming debentures is used in cases of convertible debentures. Convertible debentures feature a clause that allows holders to turn their individual units into the issuing company’s regular equity shares. During the conversion process, the debentures’ complete liability is discharged.
5. Purchase from the open market
If needed, companies can buy debentures from any open market. The only requirement is that the units must be traded in a regulated exchange process.
This method of redemption of debentures offers numerous advantages. For instance, it saves companies from the hassle of going through an administrative documentation procedure. Moreover, since debentures are generally traded at discount, it facilitates individuals to have a lower payout value, which facilitates them to maximise their revenue.
Sources of Redemption of Debentures
There are numerous paths companies can follow when it comes to sourcing funds. Here are two of the most commonly used ones:
1. Out of Capital Reserve
Companies that follow this method set aside some of their fixed assets and use the amount acquired by selling them for redeeming debentures. However, compared to other methods, the redemption of debentures using capital is deemed an unusual source and hence is not followed by most companies.
Since the method involves the company using its working capital reserve to redeem debentures, it affects its working capital reserve. Moreover, it leads to a reduction in the company’s assets. Hence, it is not the path most companies choose when it comes to reclaiming debentures.
2. Out of Profits
Redeeming debentures out of profits refers to a fixed amount equivalent to the redeemed debentures’ face value. This fixed amount is sent over to Debenture Redemption Reserve or DRR. In this way, a portion of the profits earned is withheld from being distributed among shareholders of the company.
Process of Issue of Debentures
When it comes to issuing debentures, the process shares a close resemblance with that of issuing equity shares and stocks. The process is initiated by a company when it releases a prospectus or statement regarding the issuance of the debentures. Then, investors who are interested in investing start applying. Then, the company starts to issue debentures in numerous ways. Here are some of the most popular ones:
- At Par: The debenture is said to be issued at par when its issue price becomes equivalent to its face value. When the company uses this method of issuing debentures, the long-term borrowings tab present in the balance sheet’s liabilities section equals the amount of cash mentioned in the sheet’s assets side.
- At Discount: When the debenture’s issue price is below the nominal value mark, it is said to be sold at discount. In such cases, the liabilities in the balance sheet do not match the stated assets. Hence, the discount incurred is noted as a loss in capital reserve. As a result, it is charged to the “Securities Premium Account” and is reflected in the sheet as an asset.
Factors Affecting Redemption of Debentures
There are numerous factors that one must consider at the time of redemption of debentures. Here are some of the most important ones:
- Amount: When the time of redemption of debentures arrives, one must take into account and estimate the net amount payable to debenture holders. The net amount includes repaying the principal amount to the holder as well as the chargeable interest.
- Time: A significant factor one must keep in mind when it comes to the redemption of debentures is the specified due date. The issuing company should ensure stating the duration of the term or the debentures’ validity while issuing them. Moreover, the issuing company should provide the debenture certificate containing details about its expiry to the holder at the time of issuing the debenture.
- Source: Another key aspect that should be considered is the sources used to pay off the net redemption amount since the sources will be dependent on the requirements of the company.
Journal Entries of Debentures
Here are some of the necessary journal entries which are listed in the debenture-issuing company’s books:
- After debentures have been allotted
- For putting aside the fixed profit sum for the redemption of debentures:Profit and Loss A/c Dr.To Debenture Redemption Reserve A/c
- For investing the sum set aside for redemption of debentures:Debenture Redemption Reserve Investment A/c Dr.To Bank A/c
- For Interest receipt on Debenture Redemption Reserve Investments:Bank A/c Dr.To Interest on Debenture Redemption Reserve Investment A/c
For transfer of interest on Debenture Redemption Reserve Investments (DRRI):
Interest on Debenture Redemption Reserve Investment A/c Dr.
To profit and loss A/c
Advantages of Redemption of Debentures
Investors enjoy numerous benefits when it comes to the long-term debt instruments that debentures are. Here are some of them:
Acts as a Fixed Income Source – One of the biggest advantages of investing in redeemable debentures is that entities are facilitated to create a fixed income stream, which enhances stability. As opposed to a market-linked stream, the issuer can legally disburse a specific amount periodically to creditors.
Offers Security – Investing in redeemable debentures promises repayment to investors by a specific date. Thus, it significantly reduces the risk of having an aggressively-fluctuating portfolio. Besides this, it also acts as a convenient method of finance for companies and the central government.
Debentures are issued by companies to raise the capital required to meet and fulfill the expenses of any upcoming project. Besides this, companies also profit from debenture holders since it facilitates them to invest in or pay for expansions in any sector or field.
When the term period of issued debentures is over or when the maturity date arrives, the value or net amount payable is generally par value or at premium.
However, when redemption of debentures is done by purchasing in an open market, the payable amount depends on the market quotation.
One of the foremost requirements for redemption of debentures is that the investment made should at least be equivalent to 15% of the redeemable debentures’ face value.
Besides this, the securities premium or the sum invested as securities must be used for the redemption of debentures.
Some of the most common sources for the redemption of debentures include:
- Out of new issue of share capital
- Out of profits
- Out of share capital
- By conversion
- Out of provisions