High borrowing costs force companies to diversify into other sources of financing, such as debentures. A debenture is a type of debt instrument issued by corporations to raise capital. The debenture holders have a right to receive regular interest payments and a fixed sum called the principal on maturity. Debentures are not secured by any asset but are backed by the general credit worthiness and integrity of the issuing entity. They are documented by an agreement called an indenture.
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Control of Company
If the issuing entity is a company, the ownership and control of the company remain unaffected when debentures are issued, as debenture holders do not have any voting rights. This allows the company to raise additional capital without ceding any ownership rights.
Investors' Risk Tolerance
For risk-averse investors, debentures are a worthwhile investment opportunity as they provide income in form of regular interest rate payments. Although debentures are unsecured, so that there is not an asset serving as collateral to guarantee repayment, debenture holders are given priority over other unsecured creditors when it comes to debt repayment during a company's winding up or bankruptcy.
Transparency and Efficiency
Debentures are traded in public securities exchanges where the bid and ask prices are visible to all market participants. The bid price is the buying price of a unit of the debenture while the ask price is the selling price. The presence of adequate information on market prices of the debentures ensures transparency and efficiency in the establishment of the prices.
Debentures have fixed maturity dates upon which they are fully repaid, or in some cases, a call date when they can be redeemed or recalled by the issuer before the maturity date. During the term of debentures, the issuer pays regular interest amounts to the debenture holders. However, if a cheaper source of financing becomes available, the issuer can recall the debenture and offer a new security at a lower cost. Additionally, the cost associated with debentures is less than the cost associated with overdrafts or equity shares.
Interest paid on debentures is treated as an ordinary expense item, thus it is charged against the profits of the issuing entity. This results in the issuer netting some substantial tax savings.
Reliable Source of Long-Term Financing
Debentures are ordinarily issued for a long period of time. Such long durations ensure that the issuer can make the maximum use of the funds. This factor also enables the issuer to engage in long-term resources planning.
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- Organization for Economic Cooperation and Development: Glossary of Statistical Terms - Bonds and Debentures
- E-conomic: What is a Debenture
- "Financial Management"; Prasanna Chandra; 2008
- "Fundamentals of Financial Management"; Eugene F. Brigham, et al.; 2008
- "Corporate Finance: A Focused Approach"; Michael C. Erhardt, et al.; 2009