Benefits and Disadvantages of Debentures

Long term debt financing is majorly categorized into term loan and 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. Interest is paid every year and principal is paid on the date of maturity. Term loan carry a fixed interest rate and the payment is done in installments which is consisted of both principal and interest.

Benefits and Disadvantages of Debentures

Term loan is lent by a financial institution or a bank so the financier is the bank / financial institution whereas the debentures are issued to general public and therefore the financier is the general public. This is the basic difference between these two types of long term source of debt finance.

Since, both debenture and term loan are a type of debt financing, they share basic characteristics of a debt and hence their advantages and disadvantages are also similar. Following are some benefits and disadvantages of debt financing (debentures or term loans) from the point of view of a company.

BENEFITS OF DEBT FINANCING - DEBENTURES AND TERM LOANS:

Benefit of Tax: ‘Debt Financing’ or ‘Issuing of Debenture’ results in interest expense for the borrower which is a tax deductible expense. A company can claim interest as an expense against its profits whereas dividends paid to equity or preference shareholders are paid out of net profits after taxes. In short, debt financing such as debentures, term loans etc avails tax benefit to the borrower which is not there in case of equity. 

Cheaper Source of Finance: As discussed above, the interest cost incurred on debt financing such as debentures or term loans enjoys a tax shield which indirectly lowers the cost. Effective interest 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 or accepting bank loan does not dilute the control of the existing shareholders or the owners of the company over their business. If the same fund is raised using equity finance, the control of existing shareholders would dilute proportionately.

No Dilution in Share of Profits: Opting for debentures over the equity as a source of finance keeps intact the profit-sharing percentage of existing shareholders. Debenture holders or financial institutions do not share profits of the company. They are liable to receive the agreed amount of interest only. Therefore, profits are shared among the same number of hands before and after the new project. The profit sharing percentage of individual shareholders would reduce in case if the equity funds are availed.

Benefit of Financial Leverage: By involving debt in a profit making company, the management can always maximize wealth of the shareholders. For example, the internal rate of return of a company is 15% against a 12% rate of interest on debt funds. The extra 3% which is earned out of the money of say debenture holders is shared by the equity shareholders. Since the interest cost on the debt is fixed and therefore the returns over and above the cost of interest spill over in the hands of shareholders only. This is how financial leverage converts into wealth maximization. All this is true under the condition that the rate of return on investment on debt funds is at least greater than the percentage of interest.

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. It is similar to the situation of a car seat belt which is used more because there are penalties imposed by the government authorities than for the safety reason. Similarly, a fixed installment of debt repayment brings in discipline in the management for better management of cash flows and other operations.

Low Issue Cost: In case of term loan, there is almost no cost of issue involved which is a huge cost in case of equity financing.

Fixed Installments: Debt financing by term loan or debentures has fixed installments / coupon payments till the maturity of the loan. In a rising economy with increasing inflation, the effective cost of future installments decrease due to decline in value of the currency.

No Harm in Communicating Critical Business Secrets: In case of term loan, the company may have to reveal a lot of information about the company to the financial institutions. By entering into NDA (non disclosure agreement), the company can ensure its secrets remaining hidden from its competitors.

DISADVANTAGES OF DEBT FINANCING - DEBENTURES AND TERM LOANS:

Rigid Obligation: ‘Interest payment to the debenture holders’ or ‘installment and interest of term loan’ is a legal obligation and the business has to honor the same come what may. This feature of debt financing in general creates a problem for the business in the bad times. Economic and other environmental ups and down are certain to come. Under those situations, a new business which is just about to take off cannot have such disciplined cash flows to pay the interest or installment timely. Therefore, debenture and term loans are not a right kind of financing option for them especially in their nascent stage. This fixed expense may create big mismatch with their cash flows and the company may have to go for bankruptcy. Term loan can still be viable because banks provide moratorium or gestation period or at times adjust the obligation with the pattern of cash inflows of the company. Such modifications are not possible in debentures.

Enlarge Leverage Ratios: Debt financing raises the leverage of the business. High leverage means high risk 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. The costs of projects may increase due to market conditions but interest payment would not change to compensate such increase in costs. 

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. There are various restrictions with respect to usage of assets, creation of liabilities, cash flows, control etc. 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 like it is beneficial under high inflation environment, 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.

ADVANTAGES AND DISADVANTAGES OF DEBENTURES FROM INVESTOR’S POINT OF VIEW:
From an investor point of view, the prime advantages of investing in debenture is the fixed and stable return with preferential rights of payment at the time of liquidation in comparison to equity or preference shares. The main disadvantage of preferring debenture over equities is that the debenture holder does not get right to vote and there is no profit sharing. The returns are limited to the extent of interest irrespective of the higher or lower earnings of the company.