Cost of Debentures - Definitions, Features, Classifications, Advantages, Disadvantages, Formula with Examples

Debentures

When a company need funds to raise their capital from the market then they issue debentures for the investors so that they can get fund easily. Debentures are basically a long term promissory note for raising loan capital. Long term promissory note means a financial instrument that contain a written promise by one party to another party a definite sum of money at a specific future date. It is a debt instrument used by the companies and government to issue the loan. It also known as a bond and serve as an IOU between issuer and payer.

Features of Debentures

Debentures are instruments of debt, which means that debenture holders become creditors of the company.
They are a certificate of debt, with the date of redemption and amount of repayment mentioned on it. This certificate is issued under the company seal and is known as a Debenture Deed.
Debenture holders do not get any voting rights. This is because they are not instruments of equity, so debenture holders are not owners of the company, only creditors.
It is a long term, fixed income financial security.
The contractual rate of interest is fixed and known. It indicates the percentage of par value of the debentures that will be paid, non cumulatively– annually, semi-annually or quarterly; cumulatively – along with principal on maturity.
Debentures are issued for a specific period of time, and on maturity date redeemed by company.
Debenture issues may include buy-back provision. Buy-back provisions enable the company to redeem debentures at specified price before maturity date.
Debentures are either secured (by alien on company’s specific assets) or unsecured.
The yield on a debenture is related to its market price; therefore, it could be different from the coupon rate of interest.
An indenture or debenture trust deed is a legal agreement between the company issuing debentures and the debenture trustee who represents the debenture holders.

Types of Debentures

Secured Debentures : These bonds are issued with collateral. The party issuing the bond offers a piece of property or other assets to states and bondholders along with signed permission for those entities to take possession of the collateral if the issuer doesn't repay the debt.
Unsecured Debentures: It means the principal of (and premium, if any), interest on, and all fees and other amounts (including, without limitation, any reasonable out-of-pocket costs, enforcement expenses (including reasonable out-of-pocket legal fees and disbursements and other reimbursement or indemnity obligations relating thereto) payable by Company under or in connection with those certain 12% Unsecured Convertible Debentures of the Company, due August 6, 2017, outstanding as of the Subscription Date (after giving effect to the exchange of Unsecured Debentures for Subordinated Debentures) and upon the terms and conditions of such debentures as in effect as of the Subscription Date.
Ordinary Debentures: Such debentures are issued without mortgaging any asset, i.e. this is unsecured. It is very difficult to raise funds through ordinary debenture.
Mortgage Debentures: This type of debenture is issued by mortgaging an asset and debenture holders can recover their dues by selling that particular asset in case the company fails to repay the claim of debenture holders.
Fully Convertible Debentures: Fully convertible debentures are those debentures which are fully converted into specified number of equity shares after predetermined period at the option of the debenture holders.
Non-convertible Debentures: A non-convertible debenture is a debenture where there is no option for its conversion into equity shares. Thus the debenture holders remain debenture holders till maturity.
Partly convertible debentures: The holders of partly convertible debentures are given an option to convert part of their debentures. After conversion they will enjoy the benefit of both debenture holders as well as equity shareholders.
Redeemable debentures: Redeemable debenture is a debenture which is redeemed/repaid on a predetermined date and at predetermined price.
Irredeemable debentures: Such debentures are generally not redeemed during the lifetime of the company. So, it is also termed as perpetual debt. Repayment of such debenture takes place at the time of liquidation of the company.
Registered Debentures: Registered debentures are those debentures where names, address, serial number, etc., of the debenture holders are recorded in the register book of the company. Such debentures cannot be easily transferred to another person.
Unregistered Debentures: Unregistered debentures may be referred to those debentures which are not recorded in the company’s register book. Such a type of debenture is also known as bearer debenture and this can be easily transferred to any other person.

Advantages of Debentures

One of the biggest advantages of debentures is that the company can get its required funds without diluting equity. Since debentures are a form of debt, the equity of the company remains unchanged.
Interest to be paid on debentures is a charge against profit for the company. But this also means it is a tax-deductible expense and is useful while tax planning.
Cost of debenture is relatively lower than preference shares and equity shares.
Interest on debenture is payable even if there is a loss, so debenture holders bear no risk.
Debentures encourage long-term planning and funding. And compared to other forms of lending debentures tend to be cheaper.
Debenture holders bear very little risk since the loan is secured and the interest is payable even in the case of a loss to the company.
At times of inflation, debentures are the preferred instrument to raise funds since they have a fixed rate of interest.

Disadvantages of Debentures

Payment of interest on debenture is obligatory and hence it becomes burden if the company incurs loss.
Debentures are issued to trade on equity but too much dependence on debentures increases the financial risk of the company.
Redemption of debenture involves a larger amount of cash outflow.
During depression, the profit of the company goes on declining and it becomes difficult for the company to pay interest.

Formula with Examples

(a) The formula for computing the Cost of Long Term debt at par is

Kd = (1 – T) R

where

Kd = Cost pf long term debt

T = Marginal Tax Rate

R = Debenture Interest Rate

For example, if a company has issued 10% debentures and the tax rate is 50%, the cost of

debt will be

(1 - .5) 10 = 5%

(b) In case the debentures are issued at premium or discount, the cost of debt should be calculated on the basis of net proceeds realised. The formula will be as follows :

Kd = ------ (1 – T)

Where

Kd = Cost of debt after tax

I = Annual Interest Payment

NP = Net Proceeds of Loans

T = Tax Rate

For example: A company issue 10% irredeemable debentures of Rs. 10,000. The

company is in 50% tax bracket. Calculate cost of debt capital at par, at 10% discount and

at 10% premium

Solution :

Rs. 1,000

Cost of debt at par = ----------------- * (1 - .50)

Rs. 10,000

= 5%

Rs. 1,000

Cost of debt issued at = ----------------- * (1 - .50)

10% discount Rs. 9,000

= 5.55%

Rs. 1,000

Cost of debt issued at = ----------------- * (1 - .50)

10% premium Rs. 11,000

= 4.55%

(c) For computing cost of redeemble debts, the period of redemption is considered. The cost of long term debt is the investor’s yield to maturity adjusted by the firm’s tax rate

plus distribution cost. The question of yield to maturity arises only when the loan is taken

either at discount or at premium. The formula for cost of debt will be

Discount Premium

I + --------------- (In case of Premium, --------------- will be subtracted)

mp mp

---------------------- * 100 (1 – T)

p + np

-----------

For example: A firm issued 100 10% debentures, each of Rs. 100 at 5% discount.

The debentures are to be redeemed at the end of 10th year. The tax rate is 50%. Calculate

cost of debt capital.

Solution :