Debeture as sources of finance


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Debeture as sources of finance

  1. 1. Sources of Finance Finance is essential for a business’s operation, development and expansion. Finance is the core limiting factor for most businesses and therefore it is crucial for businesses to manage their financial resources properly. Finance is available to a business from a variety of sources both internal and external.It is also crucial for businesses to choose the most appropriate source of finance for its several needs as different sources have its own benefits and costs. Sources of financed can be classified based on a number of factors. They can be classified as Internal and External, Short-term and Long-term or Equity and Debt. It would be uncomplicated to classify the sources as internal and external. 2.1 Internal sources of finance Internal sources of finance are the funds readily available within the organisation. Internal sources of finance consist of: • Personal savings • Retained profits • Working capital • Sale of fixed assets External sources of finance Sources of finance that are not internal sources of finance are external sources of finance. External sources of finance are from sources that are outside the business. External sources of finance can either be: • Ownership capital or • Non-ownership capital
  2. 2. Sources of Finance: Ownership Capital Ownership capital is the capital owned by the shareholders of a company. A company can raise substantial funds through an IPO (initial public offering). These funds are usually used for large expenses, such as new product development, expansion into a new market and setting up a new plant. The various types of shares are: Ordinary shares: These are also known as equity shares and give the owner the right to share the company’s profits and vote at the firm’s general meetings.  Preference shares: The owners of these shares may be entitled to a fixed dividend, but usually do not have the right to vote.  Companies that are already listed on a stock exchange can opt for a rights issue, which seeks additional investment from existing shareholders. They could also opt for deferred ordinary shares, wherein the issuing company is not required to pay dividends until a specified date or before the profits reach a certain level. Unquoted companies (those not listed on stock exchanges) can also issue and trade their shares in over-the-counter (OTC) markets. Sources of Finance: Non-Ownership Capital Non-ownership capital includes funds raised from lenders, such as banks and creditors. Companies typically borrow a fixed amount from a bank, at a predetermined interest rate and with a fixed repayment schedule. Certain bank accounts offer overdraft facilities. This is used by companies to meet their short-term fund requirements, as they usually come at a very high interest rate. Factoring enables a company to raise funds using its outstanding invoices. The company typically receives about 85% of the value of the invoice from the factor. This method is more appropriate for overcoming short-term cash-flow issues. Hire purchase allows a company to use an asset without immediately paying the complete purchasing price. Trade credit enables a company to obtain products and services from another firm and pay the bill later. Sources of Finance: Venture Capital Firms in the early stages of development can opt for venture capital. This option gives the financing company some ownership as well as influence over the direction of the enterprise.
  3. 3. Sources of Finance: Duration Depending on the date of maturity, sources of finance can be clubbed into the following: Long-term sources of finance: Long-term financing can be raised from the following sources:           Share capital or equity share Preference shares Retained earnings Debentures/Bonds of different types Loans from financial institutions Loan from state financial corporation Loans from commercial banks Venture capital funding Asset securitisation International Medium-term sources of finance: Medium-term financing can be raised from the following sources:           Preference shares Debentures/bonds Public deposits/fixed deposits for duration of three years Commercial banks Financial institutions State financial corporations Lease financing / hire purchase financing External commercial borrowings Euro-issues Foreign currency bonds Short term sources of finance: Short-term financing can be raised from the following sources:     Trade credit Commercial banks Fixed deposits for a period of 1 year or less Advances received from customers
  4. 4.  Various short-term provisions Debentures a debenture is a document that either creates a debt or acknowledges it. In corporate finance, the term is used for a medium- to long-term debt instrument used by large companies to borrow money. In some countries the term is used interchangeably with bond, loan stock or note. A debenture is thus like a certificate of loan or a loan bond evidencing the fact that the company is liable to pay a specified amount with interest and although the money raised by the debentures becomes a part of the company's capital structure, it does not become share capital.. [1] Debentures are generally freely transferable by the debenture holder. Debenture holders have no rights to vote in the company's general meetings of shareholders, but they may have separate meetings or votes e.g. on changes to the rights attached to the debentures. The interest paid to them is a charge against profit in the company's financial statements. Whenever a company wants to borrow a large amount of fund for a long but fixed period, it can borrow from the general public by issuing loan certificates called Debentures. The total amount to be borrowed is divided into units of fixed amount say of Rs.100 each. These units are called Debentures. These are offered to the public to subscribe in the same manner as is done in the case of shares. A debenture is issued under the common seal of the company. It is a written acknowledgement of money borrowed. It specifies the terms and conditions, such as rate of interest, time repayment, security offered, etc. Features of Debentures
  5. 5. Debenture is a type of debt instrument issued to anyone who lend money to a company for a specified term and interest rate. In general, debentures have the following important features: 1) Debenture holders are not the owners of the company. They are considered the creditors of the corporation or in other words, the company borrow money from them through issuing debenture. 2) No voting rights. The debenture-holder is not a shareholder and cannot vote in the company's general meetings. 3) Fixed rate of interest. A debenture with a fixed charge has a fixed rate of interest. It can be presented as "10% Debenture". They are always unsecured and earns a fixed rate of interest but has no share of the profit. 4) Compulsory payment of interest. The interest on debenture is payable irrespective of whether there are profits made or not. 5) Redeemable and Irredeemable. A redeemable debenture is the one which is to be repaid within a maturity period, while Irredeemable or Non-redeemable debentures cannot be redeemed in the life time of the company and only repayable upon the liquidation of the corporation The different types of debentures have been explained in brief as follows: Registered Debentures: These are those debentures which are registered in the register of the company. the names, addresses and particulars of holdings of debenture holders are entered in a register kept by the company. Such debentures are treated as non-negotiable instruments and interest on such debentures are payable
  6. 6. only to registered holders of debentures. Registered debentures are also called as Debentures payable to Registered holders.  Bearer Debentures: These are those debentures which are not registered in the register of the company. Bearer debentures are like a bearer check. They are payable to the bearer and are deemed to be negotiable instruments. They are transferable by mere delivery. No formality of executing a transfer deed is necessary. When bearer documents are transferred, stamp duty need not be paid. A person transferring a bearer debenture need not give any notice to the company to this effect. The transferee who acquires such a debenture in due course bonafide and for available consideration gets good title not withstanding any defect in the title of the transfer-or. Interest coupons are attached to each debenture and are payable to bearer.  Secured Debentures: These are those debentures which are secured against the assets of the company which means if the company is closing down its business, the assets will be sold and the debenture holders will be paid their money. The charge or the mortgage may be fixed or floating and they may be fixed mortgage debentures or floating mortgage depending upon the nature of charge under the category of secured debentures. In case of fixed charge, the charge is created on a particular asset such as plant, machinery etc. These assets can be utilized for payment in case of default. In case of floating charge, the charge is created on the general assets of the company. The assets which are available with the company at present as well as the assets in future are charged for the purpose. A mortgage deed is executed by the company. The deed includes the term of repayment, rate of interest, nature and value of security, dates of payment of interest, right of debenture holders in case of default in payment by the company. The deed may give a right to the debenture
  7. 7. holder to nominate a director as one of the Board of Directors. If the company fails to pay the principal amount and the interest thereon, they have the right to recover the same from the assets mortgaged.  Unsecured Debentures: These are those debentures which are not secured against the assets of the company which means when the company is closing down its business, the assets will not be sold to pay off the debenture holders. These debentures do not create any charge on the assets of the company. There is no security for repayment of principal amount and payment of interest. The only security available to such debenture holders is the general solvency of the company. Therefore the position of these debenture holders at the times of winding up of the company will be like that of unsecured debentures. That is they are considered with the ordinary creditors of the company.  Convertible Debentures: These are those debentures which can be converted into equity shares. These debentures have an option to convert them into equity or preference shares at the stated rate of exchange after a certain period. If the holders exercises the right of conversion, they cease to be the lender to the company and become the members. Thus convertible debentures may be referred as debentures which are convertible into shares at the option of the holders after a specified period. The rate of exchange of debentures into shares is also decided at the time of issue of debentures. Interest is paid on such debentures till its conversion. Prior approval of the shareholders is necessary for the issue of convertible debentures. It also requires sanction of the Central Government.  Non-Convertible Debentures: These are those debentures which cannot be converted either into equity shares or preference shares. They may be secured or unsecured. Non-convertible debentures are normally
  8. 8. redeemed on maturity period which may be 10 or 20 years.  Redeemable Debentures: These debentures are issued by the company for a specific period only. On the expiry of period, debenture capital is redeemed or paid back. Generally the company creates a special reserve account known as "Debenture Redemption Reserve Fund" for the redemption of such debentures. The company makes the payment of interest regularly. Under section 121 of the Indian Companies Act, 1956, redeemed debentures can be re-issued.  Irredeemable Debentures: These debentures are issued for an indefinite period which are also known as perpetual debentures. The debenture capital is repaid either at the option of the company by giving prior notice to that effect or at the winding up of the company. The interest is regularly paid on these debentures. The principal amount is repayable only at the time of winding up of the company. however, the company may decide to repay the principal amount during its lifetime. Advantages 1. Control of company is not surrendered to debenture holders because they do not have any voting rights. 2. Trading on equity is possible as debenture holders get a lower rate of return than the earnings of the company. 3. Interest on debenture is an allowable expenditure under income tax act, hence incidence of tax on the company is decreased. 4. Debenture can be redeemed when company has surplus funds. 5 Debenture holders have no right either to vote or take part in the
  9. 9. management of the company. 6 Since debentures are ordinarily issued for a fixed period, the company can make the best use of the money. It helps long term planning. 7 Interest paid on debentures is treated as an expense and is charged to the profits of the company. The company thus saves incometax. 8 Debentures are mostly secured. On winding up of the company, they are repayable before any payment is made to the shareholders. Interest on debentures is payable irrespective of profit or loss. Disadvantages 1. Cost of raising capital through debentures is high of high stamps duty. 2. Common people cannot buy debenture as they are of high denominations. 3. They are not meant for companies earning greater than the rate of interest which they are paying on the debentures. 4 As the interest on debentures have to be paid every year whether there are profits or not, it becomes burdensome in case the company incurs losses. 5 Usually the debentures are secured. The company creates a charge on its assets in favour of debentureholders. So a company which does not own enough fixed assets cannot borrow money by issuing debentures. Moreover, the assets of the company once mortgaged cannot be used for further borrowing. 6. Debenture-finance enables a company to trade on equity. But too much of such finance leaves little for shareholders, as most of the profits may be required to pay interest on debentures. This brings frustration in the minds of shareholders and the value of shares
  10. 10. may fall in the securities markets. 7. Burdensome in times of depression : During depression the profits of the company decline. It may be difficult to pay interest on debentures. As interest goes on accumulating, it may lead to the closure of the company.