Debentures

Debenture Meaning

A debenture is most often defined as an unsecured (no collateral) debt instrument, which has maturity ranging from medium to long term. It is commonly used by corporate and government entities to borrow money at fixed or floating interest rates, which then contributes to the capital structure of the entity. It is, however, different from share capital.

The way in which a debenture functions is more or less similar to bonds. The term is interchangeably used with bonds or notes in some countries, but there are some differences that we shall see next.

How is it different from a typical bond?

An unsecured bond is typically referred to as a debenture in most countries. However, for some, the two terms are interchangeable, and in Britain, debentures are secured by the assets of the entity.

  • Bonds are usually backed by physical assets or collateral, while unsecured bonds (debentures) are solely backed by the creditworthiness of the issuer.
  • Unsecured bonds are ordinarily issued to meet some specific needs, like say, an upcoming project or expansion.
  • The unsecured bond can be characterized by fixed or floating rates of interest, while bonds are mostly fixed-rate instruments.
  • Repayment of principal can be in one lump sum or installments every year until maturity.

Types of Debentures

Given below are the various types of debentures.

Debentures

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For eg:
Source: Debentures (wallstreetmojo.com)

  1. Convertible- Some investors are provided with an option to receive maturity value or have their debentures converted into equity, a feature that alleviates the fear of investing in an unsecured instrument to some extent.
  2. Non-convertible- Investors only receive the maturity value along with the accrued interestAccrued InterestAccrued Interest is the unsettled interest amount which is either earned by the company or which is payable by the company within the same accounting period.read more with no opportunity for equity conversion.
  3. Perpetual – Unsecured bonds with no maturity date are said to be perpetual. They are considered akin to equity and not as a debt instrument.
  4. Floating rate- interest payments fluctuate as rates vary.
  5. Fixed-rate- interest payments remain the same throughout the life of the unsecured bond.

Debenture Valuation Formula with Examples

Depending on how the principal is repaid, the unsecured bonds can be valued by using the following methods:

You can download this Debentures here – Debentures

#1 – Entire Maturity Value Paid at the Maturity Date

This process of valuation is exactly similar to bonds.

Debenture Value= Present value of future interest payments + Present value of maturity value

debentures valuation formula1

Where,

Example

An investor wants to invest in a 6%, $ 1000 debenture redeemable after 5 years at par. The investor’s required rate of returnRequired Rate Of ReturnRequired Rate of Return (RRR), also known as Hurdle Rate, is the minimum capital amount or return that an investor expects to receive from an investment. It is determined by, Required Rate of Return = (Expected Dividend Payment/Existing Stock Price) + Dividend Growth Rateread more is 8%. Calculate the debenture value.

  • Debenture value= [60/(1.08) + 60/(1.08)^2 + 60/(1.08)^3 + 60/(1.08)^4 + 60/(1.08)^5] + 1000/(1.08)^5
  • =$920.15

This value can also be computed in MS Excel using the PV function in excel.

debentures valuation example 1

#2 – Principal is Repaid in Installments

The principal amount is repaid in installments along with interest. Interest declines in each period since the same is calculated on the outstanding principal amount.

Debenture value= (I1+P1)/(1+r)^1 +(I2+P2)/(1+r)^2+……….(I3+P3)/(1+r)^n

Debenture value= ∑ t=1to n (It+Pt )/ (1+r)t

Where,

  • It= Interest payment for a particular period
  • Pt=Principal payment for the same period
  • r = Required rate of return

Example

An entity is issuing a debenture of 5 years, $1,000 to be remitted in equal installments at an 8% percent interest rate. The minimum required rate of return is 10%. Calculate the Debenture’s present value.

A table depicting the discounted cash flows in each period is shown below:

example 2

#3 – Perpetual Debenture

Perpetual debentures are known to have infinite maturity. They are valued by discounting the infinite streams of interest cash flows. Principal or maturity value is not discounted since they never mature.

Debenture value= I1/ (1+r) ^1+I2/ (1+r) ^2+…..I / (1+r) ^∞

Debenture value = I/r

Where,

  • I= Interest
  • r = Required Rate of Return

Example:

A perpetual debenture with a face value of $1000 receives an interest of $50 annually. Calculate debenture value of required rate of return is 10%.

Calculation:

example 3
  • Debenture value= 50/5%=50/0.10
  • = $500

Debenture Advantages and Disadvantages

Below are the advantages and disadvantages of debentures.

Advantages

  1. Risk-averse investors who want an income they can rely on the go for an unsecured bond.
  2. Financing through debentures is cost-effective for companies since the interest payment is tax-exempt.
  3. Excellent source of funds for expansion and project-related purposes without increasing the share capital.
  4. Unsecured bondholders are paid before shareholders, so investors feel more secure since debentures are anyways not secured.
  5. Profit-sharing for shareholders is not reduced since unsecured bondholders are not entitled to any profit.
  6. During inflationary times, fixed income debentures are a viable way for entities.

Disadvantages

  1. They are obligatory in nature for the issuer. They must be paid off before sharing any profit with shareholders.
  2. They become a burden during a slowdown, to the brink of rendering the issuer insolvent.
  3. Holders are not entitled to any company profits.

Limitations

Unsecured bond has a few limitations that mostly account to being disadvantaged.

For the Issuer:

  1. There is an obligation to pay interest.
  2. Too much dependency on unsecured bonds elevates the leverage ratio, which is not good for the financial health of the company.

For the Investor:

  1. Holders do not have any voting rights in company matters.
  2. Debentures might have an embedded call option, which is not attractive to investors a lot of times.

Conclusion

Debentures do not have collateral backing, yet they are considered risk-free since the payments are an obligation for the issuer and must be done before paying any shareholders. Liquidating assets to make payment in case the entity goes bankrupt is also not uncommon.

So, unsecured bonds are not as unsafe as they look, although investment decisions should always be based on the creditworthiness and past performance of the issuer.

Recommended Articles

This has been a guide to what are Debentures and its meaning. Here we discuss the types of Debentures along with valuation examples, advantages, and disadvantages. You can learn more about financing from the following articles –

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