Benefits and Disadvantages of Debentures

Debentures are one of the common long term sources of finance. They normally carry a fixed interest rate and a certain date of maturity. There are several benefits of employing debentures as a source of long term finance but at the same time they come along with certain disadvantages also. Following are some benefits and disadvantages of debentures from the point of view of a company.

Benefits and Disadvantages of DebenturesBENEFITS OF DEBENTURES:

Benefit of Tax: Issuing of debenture would attract interest expense for the company. As per normal tax laws, interest is a tax deductible expense. On the contrary, the dividends paid to equity shareholders are not tax free. They are paid out of divisible profits i.e. profits remaining after all the expenses and taxes well known as profit after tax (PAT).

Cheaper Source of Finance: As discussed above, the interest cost incurred on debentures enjoys a tax shield which indirectly makes the cost of debenture low. Effective cost of a 12% debenture with current tax rate of 30% is 8.4% {12% * (1-30%)}. Underlying assumption behind the calculation is that the entity is making profit at least to the tune of total interest payment.

No Dilution of Control: Issuing of debentures does not affect control of the existing shareholders or the owners of the company. If the same fund is raised using equity finance, the control of existing shareholders would dilute accordingly.

No Dilution in Share of Profits: Opting for debentures over the equity as a source of finance saves the profit shares of existing shareholders. Debenture holders do not share profits of the company. They are liable to receive the agreed amount of interest only.

Benefit of Leverage: By involving debt in a company making profits, the management can always maximize wealth of the shareholders. Let’s take an example, suppose the internal rate of return of a company is 15% against a 12% rate of interest which is paid to the debenture holders. The extra 3% which is earned out of the money of debenture holders is shared by the equity shareholders. This is how involvement of debentures can lead to welfare of the shareholders. All this is true under a handsome rate of return on the company’s projects which are at least higher than the interest rate offered on debentures.

Disciplinary Effect: The burden of interest is fixed in debentures irrespective of the business profits, operational situations etc. This makes the entrepreneur all the more cautious and committed towards managing the business and maintaining the cash flows effectively. It is because a severe punishment i.e. bankruptcy is enclosed to nonpayment of debenture interest on time which is not affordable.

DISADVANTAGES OF DEBENTURES:

Rigid Obligation: Interest payment to the debenture holders is a legal obligation and the business has to honor the same come what may. This feature of debenture creates a problem for the business in the bad times. Debenture holders are not going to understand the genuine business problems and why should they? Under this situation, a new business which is just about to take off cannot have such disciplined cash flows to pay the interest timely. Debenture is not a right kind of financing option for them especially in their nascent stage. 

Enlarge Leverage Ratios: Debenture raises the leverage of the business. High leverage means high risk in the form of bankruptcy. Bankruptcy is not the only risk but if the rate of return of the company declines below the debenture interest rate at a later stage after issuing the debentures, it can bring the whole project on a toss.

Restrictive Covenants: In the trust deed formed between the company and the trustee bank or financial institution, there are certain restrictive covenants which restrict the hands of the management from doing business with liberty. They may stumble upon every business decision and affect the effectiveness of overall decision making process.

Bad for Low Inflationary Conditions: Although fixed interest has certain benefits, they are also accompanied with disadvantages. Under low inflationary conditions, the cash outflow remains constant but the value of the money increases. To compare it with business situations, the market price of the products of the company will decline in low inflationary conditions but the interest payment will remain same and hence that will create loss making mismatch.