Benefits and Disadvantages of Debentures

Long-term debt financing is majorly categorized into a term loan and debentures. Debentures are one of the common long-term sources of finance. They normally carry a fixed interest rate and a certain date of maturity. One has to pay interest every year and the principal on the date of maturity. Term loan carries a fixed interest rate and the payment is done in installments which consists of both principal and interest. There are several advantages and disadvantages of debentures explained in this article.

The term loan is lent by a financial institution or a bank so the financier is the bank / financial institution. Whereas the debentures are issued to the general public and therefore the financier is the general public. This is the basic difference between these two types of long-term source of debt finance. The difference between the terms – Debentures, Bank loan, equity shares, and bond.

Since both debenture and term loan is a type of debt financing, they share basic characteristics of debt and hence their advantages and disadvantages are also similar. Following are some benefits and disadvantages of debt financing (debentures or term loans) from the point of view of a company.

ADVANTAGES OF DEBT FINANCING – DEBENTURES AND TERM LOANS

Benefit of Tax

Benefits and Disadvantages of DebenturesDebt Financing’ or ‘Issuing of Debenture’ results in interest expense for the borrower which is a tax-deductible expense. A company can claim an interest as an expense against its profits. Whereas dividends paid to equity or preference shareholders are paid out of net profits after taxes. In short, debt financing such as debentures, term loans etc avails tax benefit to the borrower which is not there in case of equity.

Cheaper Source of Finance

As discussed above, the interest cost incurred on debt financings such as debentures or term loans enjoys a tax shield which indirectly lowers the cost. Effective interest cost of a 12% debenture with current tax rate of 30% is 8.4% {12% * (1-30%)}. The underlying assumption behind the calculation is that the entity is making the profit at least to the tune of total interest payment. Even the rate of interest is lower than the cost of equity. It is because of the reason that debt financiers have comparatively lower risk, so they are offered less return. Following are the reasons due to which investors of debenture have a comparatively lower risk.

Sr. No.DebentureEquity
1The company has to pay Interest no matter profit or loss.There is no Equity Dividend in case of loss. If there is a profit, even in that case unless the Board of Directors offers a dividend, equity shareholders do not receive a dividend.
2Assets of the company are mortgaged in favor of debenture holder, in case of liquidation of the company, sale value of these assets will be used first to redeem debentures.Equity Shareholders don’t get such facility of the mortgage.
3If the sale value of these assets is insufficient to redeem debentures holders, then the sale value of other assets will be used first to redeem debentures and after that equity shareholders.Equity shareholders are last in the queue to receive their amount in case of liquidation of the company.

No Dilution of Control

Issuing of debentures or accepting bank loan does not dilute the control of the existing shareholders or the owners of the company over their business. If there is a rise in the same fund using equity finance, there are chances of losing the control of existing shareholders.

No Dilution in Share of Profits

Opting for debentures over the equity as a source of finance keeps intact the profit-sharing percentage of existing shareholders. Debenture holders or financial institutions do not share profits with the company. They are liable to receive the agreed amount of interest only. Therefore, the same number of hands share the profits before and after the new project. However, in the case of convertible debentures (debentures who convert into equity shares after a certain point of time), this may no more remain an advantage. As the debenture holders would then become equity shareholders receiving all the rights as of the equity shareholder’s.

The benefit of Financial Leverage

By involving debt in a profit-making company, the management can always maximize the wealth of the shareholders. For example, the internal rate of return of a company is 15% against a 12% rate of interest on debt funds. The shareholders share the extra 3% of earning out of the money of say debenture holders. Since there is a definite interest cost on the debt. Therefore the returns over and above the cost of interest spill over into the hands of shareholders only. This is how financial leverage converts into wealth maximization. All this is true under the condition that the rate of return on investment on debt funds is at least greater than the percentage of interest.

Disciplinary Effect

There is a burden of interest despite business profit or loss, operational situations etc. This makes the entrepreneur all the more cautious and committed to managing the business and maintaining the cash flows effectively. It is because a severe punishment i.e. ‘bankruptcy’ is enclosed for nonpayment of debenture interest on time. It is similar to the situation of a car seat belt. One uses it more because of the penalties, the government authority imposes rather than for the safety reason. Similarly, a fixed installment of debt repayment brings in a discipline in the management for better management of cash flows and other operations.

Low Issue Cost

In the case of a term loan, there is a comparatively lower cost of the issuance. Whereas in the case of equity financing, there is a huge cost of issuance.

Fixed Installments

Debt financing by term loan or debentures has fixed installments/coupon payments till the maturity of the loan. In a rising economy with increasing inflation, the effective cost of future installments decreases due to a decline in the value of the currency.

No Harm in Communicating Critical Business Secrets

In the case of a term loan, the company may have to reveal a lot of information about the company to the financial institutions. By entering into NDA (non-disclosure agreement), the company can ensure its secrets remaining hidden from its competitors.

Callable Debentures / Bonds

There can a debenture or Bond issuance with a callable feature. If in case there is a decrease in the rate of interest in the market, the company can redeem existing debenture. It can do so by offering premium and can issue new debt financing at a lower interest rate.

Advantages and Disadvantages of Debentures

DISADVANTAGES OF DEBT FINANCING – DEBENTURES AND TERM LOANS

Rigid Obligation

‘Interest paid to the debenture holders’ or ‘installment and interest of term loan’ is a legal obligation and the business has to honor the same come what may. This feature of debt financing, in general, creates a problem for the business in the bad times. Economic and other environmental ups and down are certain to come. Under those situations, a new business which is just about to take off cannot have such disciplined cash flows to pay the interest or installment timely.

Therefore, debenture and term loans are not a right kind of financing option for them, especially in their nascent stage. This fixed expense may create a big mismatch with their cash flows and the company may have to go into bankruptcy. A term loan can still be viable because banks provide moratorium or gestation period or at times adjust the obligation with the pattern of cash inflows of the company. Such modifications are not possible in debentures.

Enlarge Leverage Ratios

Debt financing raises the leverage of the business. High leverage means the high risk of bankruptcy. Bankruptcy is not the only risk but if the rate of return of the company declines below the debenture interest rate at a later stage after issuing the debentures, it can bring the whole project on a toss. The costs of projects may increase due to market conditions but interest payment would not change to compensate such increase in costs.

Restrictive Covenants

In the trust deed formed between the company and the trustee bank or financial institution, there are certain restrictive covenants which restrict the hands of the management from doing business with liberty. There are various restrictions with respect to usage of assets, the creation of liabilities, cash flows, control etc. They may stumble upon every business decision and affect the effectiveness of the overall decision-making process.

Bad for Low Inflationary Conditions

Although fixed interest has certain benefits like it is beneficial to high inflation environment, it also accompanies disadvantages. Under low inflationary conditions, the cash outflow remains constant but the value of the money increases. To compare it with business situations, the market price of the products of the company will decline in low inflationary conditions but the interest payment will remain the same and hence that will create a loss-making mismatch.

ADVANTAGES AND DISADVANTAGES OF DEBENTURES FROM INVESTOR’S POINT OF VIEW

From an investor’s viewpoint, the prime advantage of investing in debenture is the fixed and stable return. They not only get that benefit but also a preferential right of payment at the time of liquidation. Whereas that is not in case of equity or preference shares. The main disadvantage of preferring debenture over equities is that the debenture holder does not get right to vote and there is no profit sharing. The returns are finite to the extent of interest irrespective of the higher earnings of the company. Also, there is another benefit besides this. In case of an increase in the market interest rate, debenture holder will get their fixed interest income. Even though the rate of interest has increased in the market.

Last updated on : March 23rd, 2019
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