Many times, companies may need more capital for expansion and growth of multiple factors. Therefore, the next feasible option that naturally comes up is to get money from the public by issuing debentures. Debentures offer companies a long-term financing option to meet their objectives like expansion, growth, or financing acquisition of assets. Once a company issue debentures, they treat them as long-term liabilities in its balance sheet.
Getting debentures from a company is like offering them a loan. After acquiring debentures, a person becomes a debenture holder, and the company pays within the agreed period. The process of repaying the debenture holder is called the redemption of debentures. Do you seek to invest in debentures? Read on to explore everything you need to know about debenture redemption and the methods of redemption of debentures.
Redemption of Debentures- A Brief
Redemption of debenture refers to the process of how the company repays debentures issued by them to the debenture holders- they debenture holders get paid upon debenture maturity. However, the company may repay the debentures before they mature.
The law requires a company issuing debentures to open a debenture redemption reserve account. Money deposited into the reserve account goes to pay the debenture holders. Companies can't spend reserve funds for any other purpose.
Debentures are redeemable at three different values. There is a premium value, at par or discount value. Redemption of debentures at premium value means exchanging debentures at a higher value than their face value. Let's say the face value of a debenture is Rs.100. Then, the premium value of such debentures could be R.110 or 120 and more.
On the other hand, redeeming debentures at par value means exchanging debentures at a value equal to the face value.
At the discount value, debentures are redeemable at a lower value than the face value. Let's assume the face value of a debenture is Rs.100. Then, at a discounted value, the redemption value could be Rs.90 or 80.
Benefits of Redeeming Debentures
When a company issues debentures, it raises capital at lower costs than equity. Here are other benefits of redeeming debentures.
- Debenture redemption keeps the solvency ratio at a satisfactory level
- A company y can raise capital at a cheaper cost through debenture than equities
- Companies lower operating costs through the redemption of debentures
- When the debenture interest rate is higher than market rates, companies that issue the debentures can gain by rebalancing their balance sheets and reducing the expensive external liability
- Companies use the excess or idle resources to get maximum return on investment through debentures
Source of Funds for Redemption of Debentures
Where do companies get funds for debenture redemption? Issuing debentures comes with a commitment to pay. So, upon maturity, a company can redeem debentures using the following sources.
- Money from the sale of fixed assets
- Company's profits
- Company's partial capital or small share of the capital
- Conversion of debentures into shares
- Funds from new debenture issuing
- Own purchased debentures to finance company growth and expansion.
Methods of Redemption of Debentures
Redeeming debentures means the company pays the principal amount it owes the debenture holders. Below are various methods that companies use to redeem debentures.
Lump-Sum Method
The lump sum method is a one-time payment of debentures. A company determines the amount it owes the debenture holders and repays at once. But the payment is based on the terms of the issue. The lump sum payment method is simple. When a company knows the debenture repayment date, it becomes easy to plan its finances. However, a company may choose to pay debentures before maturing.
Conversion Method of Redeeming Debentures
A company may choose not to pay debentures at maturity. Instead, the debentures are converted into preference or equity shares. Also, the company can change the old debentures into new ones at a higher coupon rate.
Companies follow due procedure before converting debentures. First, a company needs to have a conversion option in its rules. Then, a board and general meeting will be held to approve the debentures' conversion.
Redemption of Debentures in Instalment
Companies issue debentures. But instead of repaying once at maturity, they pay in portions. The repayment schedule might be different. However, redeeming debentures in installments relieves the company of the burden of seeking huge amounts of money at once.
Companies that redeem debentures in installments should have a redemption reserve account equal to 50% of the total debentures. During installment redemption, the company follows the agreed terms and rates.
Purchasing Method of Debenture Redemption
Let's say a company issues debentures and then goes to the open market to rebuy them. That means a company redeems its shares.
If the company acquires the debentures at a discounted value, it makes a profit. However, the company's articles should have the rule of own share redemption. In addition, companies buy debentures from holders before maturity to save on payable interest on those bonds.
Many companies buy their debentures for cancellation. Only the board of directors can revoke the decision to cancel the debentures. Instead of withdrawing the debentures, other companies keep them alive and issue them later. A company doesn't get paid for redeeming its debentures.
Redemption of Debentures through Sinking Funds
Companies get profit from issuing debentures and redemption. So, some organizations use the profit from the redemption of debentures to create a sinking fund. The sinking funds are further reinvested and help to pay off debenture holders.
Sinking funds are divided into cumulative and non-cumulative funds. For cumulative sinking funds, the profit from investments is reinvested into the new sinking funds. On the other hand, a non-cumulative sinking fund doesn't include the reinvestment of earned profit from the sinking funds.
Final Words
Debentures are debt instruments that help a company raise capital for growth and expansion. The investors who obtain the debentures are debenture holders. Paying the debenture holders the amount owed to them by a company is the redemption of debentures.
Companies use various methods to pay debenture holders. These include the installment method, open market debenture purchase, lump sum, and conversion method. Some companies also create sinking funds for debenture redemption.
Redemption of debentures comes with befits. A company raises capital at a lower cost than equity by issuing debentures. Debentures also help keep a company's solvency ratio at a satisfactory level.
FAQs:
Does redemption of debentures benefit a company?
Yes. Issuing and redeeming debentures helps to reduce the operating cost of a company. In addition, a company can use idle resources to increase its return on investment. Redemption of debentures also keeps the company's solvency ratio in a good position.
Is a debenture redemption reserve account mandatory?
Yes, the law requires a company issuing debentures to create a reserve account to protect the debenture holders in case the company defaults on debenture repayment.
Why do companies issue debentures?
Issuing debentures helps a company to raise capital in a long-term liability. When a company issues debentures, it gets capital to expand and grow at a lower cost than issuing equities.
Does the law make it compulsory for companies to pay interest after issuing debentures?
The law mandates that companies issuing debentures pay profits every year. When a company doesn't make any profit, they are liable for penalties if they fail to deliver profit to the debenture holders.
Can a company redeem its debentures?
Yes. A company can issue debentures and buy them from the open market. Redeeming own debentures before maturity saves the company payable interest. Companies may redeem their debentures at a discounted value, making a profit.