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 bond or note 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.
- 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.
- Non-convertible- Investors only receive the maturity value along with the accrued interest with no opportunity for equity conversion.
- Perpetual – Unsecured bonds with no maturity date are said to be perpetual. They are considered akin to equity and not as a debt instrument.
- Floating rate- interest payments fluctuate as rates vary.
- 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:
#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
- r = Discount rate also called Yield to Maturity (YTM)
- n= Number of periods until maturity
- M= Maturity value
An investor wants to invest in a 6%, $ 1000 debenture redeemable after 5 years at par. The investor’s required rate of return is 8%. Calculate the debenture value.
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- 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
This value can also be computed in MS Excel using the PV function in excel.
#2 – Principal is Repaid in Installments
The principal amount is repaid in installments along with the 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
- It= Interest payment for a particular period
- Pt=Principal payment for the same period
- r = Required rate of return
An entity is issuing a debenture of 5 years, $1,000 to be remitted in equal installments at 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:
#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) ^∞
- I= Interest
- r = Required Rate of Return
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%.
- Debenture value= 50/5%=50/0.10
- = $500
Debenture Advantages and Disadvantages
Below are the advantages and disadvantages of debentures.
- Risk-averse investors who want an income they can rely on the go for an unsecured bond.
- Financing through debentures is cost-effective for companies since the interest payment is tax-exempt.
- Excellent source of funds for expansion and project-related purposes without increasing the share capital.
- Unsecured bondholders are paid before shareholders, so investors feel more secure since debentures are anyways not secured.
- Profit-sharing for shareholders is not reduced since unsecured bondholders are not entitled to any profit.
- During inflationary times, fixed income debentures are a viable way for entities.
- They are obligatory in nature for the issuer. They must be paid off before sharing any profit with shareholders.
- They become a burden during a slowdown, to the brink of rendering the issuer insolvent.
- Holders are not entitled to any company profits.
Unsecured bond has a few limitations that mostly account to being disadvantaged.
For the Issuer:
- There is an obligation to pay interest.
- Too much dependency on unsecured bond elevates the leverage ratio which is not good for the financial health of the company.
For the Investor:
- Holders do not have any voting rights in company matters.
- Debentures might have an embedded call option, which is not attractive to investors a lot of times.
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 like although investment decisions should always be based on the creditworthiness and past performance of the issuer.
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 –