Debenture: Advantages and Disadvantages

After reading this article you will learn about the Advantages and Disadvantages of Debenture.

Advantages of Debenture:

Debentures offer a number of advantages both to the company as well as investors.

These are discussed as below:

(a) Advantages to the Company:

The company has the following main advantages of using debentures and bonds as a source of finance:

(i) Debentures provide long-term funds to a company.

(ii) The rate of interest payable on debentures is, usually, lower than the rate of dividend paid on shares.

(iii) The interest on debentures is a tax-deductible expense and hence the effective cost of debentures (debt-capital) is lower as compared to ownership securities where dividend is not a tax-deductible expense.

(iv) Debt financing does not result into dilution of control because debenture-holders do not have any voting rights.

(v) A company can trade on equity by mixing debentures in its capital structure and thereby increase its earnings per share.

(vi) Many companies prefer issue of debentures because of the fixed rate of interest attached to them irrespective of the changes in price levels.

(vii) Debentures provide flexibility in the capital structure of a company as the same can be redeemed as and when the company has surplus funds and desires to do so.

(viii) Even during depression, when stock market sentiment is very low, a company may be able to raise funds through issue of debentures or bonds because of certainty of income and low risk to investors.

(b) Advantages to Investors:

It is not only the company but also the investors who are benefited by investing in debentures or bonds.

The following are the main advantages from the point of view of investors:

(i) Debentures provide a fixed, regular and stable source of income to its investors.

(ii) It is comparatively a safer investment because debenture-holders have either a specific or a floating charge on all the assets of the company and enjoy the status of a superior creditor in the event of liquidation of the company.

(iii) Many investors prefer debentures because of a definite maturity period.

(iv) A debenture is usually more liquid investment and an investor can sell or mortgage his instrument to obtain loans from financial institutions.

(v) The interest of debenture-holders is protected by various provisions of the debenture trust deed and the guidelines issued by the Securities and Exchange Board of India in this regard.

Disadvantages of Debenture Finance:

In spite of many advantages, debenture financing suffers from certain limitations. The following are the major disadvantages of debentures:

(a) From the Point of View of Company:

A company suffers from the following disadvantages of debt- financing:

(i) The fixed interest charges and repayment of principal amount on maturity are legal obligations of the company. These have to be paid even when there are no profits. Hence, it is a permanent burden on the company. Default in these payments, adversely affects the credit-worthiness of the firm and even may lead to winding up of the company.

(ii) Charge on the assets of the company and other protective measures provided to investors by the issue of debentures usually restrict a company from using this source of finance. A company cannot raise further loans against the security of assets already mortgaged to debenture-holders.

(iii) The use of debt financing usually increases the risk perception of investors in the firm. This enhanced financial risk increases the cost of equity capital.

(iv) Cost of raising finance through debentures is also high because of high stamp duty.

(v) A company whose expected future earnings are not stable or who deals in products with highly elastic demand or who does not have sufficient fixed assets to offer as security to debenture-holders cannot use this source of rasing funds to its benefit.

(b) From the Point of View of Investors:

Many investors do not find debentures or bonds as an attractive investment because of the following:

(i) Debentures do not carry any voting rights and hence its holders do not have any controlling power over the management of the company.

(ii) Debenture-holders are merely creditors and not the owners of the company. They do not have any claim on the surplus assets and profit of the company beyond the fixed interest and their principal amount.

(iii) Interest on debentures is fully taxable while shareholders may avoid tax by way of stock dividend (bonus shares) in place of cash dividend.

(iv) The prices of debentures in the market fluctuate with the changes in the interest rates.

(v) Uncertainty about redemption also restricts certain investors from investing in such securities.