Chapter 7 Sources of finance

Convertible debentures are a type of debt security that offers the holder the option to convert them into equity shares of the issuing company after a specified period. This conversion feature provides investors with potential upside if the company’s stock price appreciates. A primary consideration for choosing between preferred shares and debentures depends on risk.

Because they are not backed by any form of collateral, they are inherently more risky than an otherwise identical note that is secured. Debentures are advantageous for companies since they carry lower interest rates and longer repayment dates as compared to other types of loans and debt instruments. Similar to most bonds, debentures may pay periodic interest payments called coupon payments. Like other types of bonds, debentures are documented in an indenture. An indenture is a legal and binding contract between bond issuers and bondholders.

Factors Determining Working Capital Requirements

If the company or limited liability partnership later fails, they can call in the loan and appoint an administrator to take control of the asset(s). The convertible debt feature is factored into the calculation of the diluted per-share metrics of the stock. The conversion will increase the share count—number of shares available—and reduces metrics such as earnings per share (EPS). The underlying objective is to be a part of the company’s growth and benefit mutually. While bonds and stocks have become fairly popular amongst investors, many still do not understand debentures. Read on to understand the meaning, features, merits, and demerits of debentures.

What are Shares?

Security may take the form of either a fixed charge or a floating charge. When companies ‘go public’ for the first time, a ‘large’ issue will probably take the form of an offer for sale. A smaller issue is more likely to be a placing, since the amount to be raised can be obtained more cheaply if the issuing house or other sponsoring firm approaches selected institutional investors privately.

1. Debentures are used by companies and organisations to raise funds for various purposes, including financing expansion, research and development, debt refinancing, and working capital.
2. Preferred shareholders are typically promised dividend payments and some liquidation rights.
3. This increase in the number of shares would result in a diluted earnings-per-share.
4. Traditional areas of need may be for capital asset acquirement – new machinery or the construction of a new building or depot.
5. The rate of interest charged on medium-term bank lending to large companies will be a set margin, with the size of the margin depending on the credit standing and riskiness of the borrower.
6. However, with party convertibles, only a limited part can be converted into stocks as per the norms of the contract.

D. On the basis of Coupon Rate:

When company debentures are secured against assets of the concerned company, these are called secured or mortgage debenture. Although the franchisor will probably pay a large part of the initial investment cost of a franchisee’s outlet, the franchisee will be expected to contribute a share of the investment himself. The franchisor may well help the franchisee to obtain loan capital to provide his-share of the investment cost. For example, the Indigenous Business Development Corporation of Zimbabwe (IBDC) was set up by the government to assist small indigenous businesses in that country. Are a form of ordinary shares, which are entitled to a dividend only after a certain date or if profits rise above a certain amount. Voting rights might also differ from those attached to other ordinary shares.

Convertible debentures are hybrid products that try to strike a balance between debt and equity. Investors gain the benefit of fixed interest payments while also having the option to convert the loan to equity if the company performs well, rising stock prices over time. Equity, unlike debentures, does not require repayment, nor does it require the payment of interest to holders. However, a company might pay dividends to shareholders, which although voluntary, could be seen as a cost of issuing equity since the firm’s retained earnings or accumulated profits would be reduced. Just as there are convertible debentures, there are also non-convertible debentures whereby the debt cannot be converted into equity.

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One implication of a fixed charge debenture is that you cannot sell the asset whilst the loan is outstanding unless you obtain written permission from the lender. They might agree that you purchase a replacement asset, for instance, and then place a new charge against that. The financier places a legal charge against the asset or assets mentioned.

A convertible debenture will usually return a lower interest debentures advantages and disadvantages rate since the debt holder has the option to convert the loan to stock, which is to the investors’ benefit. Investors are thus willing to accept a lower rate of interest in exchange for the embedded option to convert into common shares. Convertible debentures therefore allow investors to participate in share price appreciation.

Many investors don’t like to risk their capital in stocks and prefer the safety of bonds. These types of securities are known as “creditorship securities.” Creditorship securities are also known as “debt finance.” Another factor that may be of importance is the financial and taxation position of the company’s shareholders. Loan stock is long-term debt capital raised by a company for which interest is paid, usually half yearly and at a fixed rate. Holders of loan stock are therefore long-term creditors of the company.

Usually, debentures are secured by a charge on or mortgage of the company. A debenture is a document issued by a company as evidence of debt due from the company with or without a charge on the assets of the company. It is an acknowledgment of the company‘s indebtedness to its debenture holders. For nonconvertible debentures, mentioned above, the date of maturity is also an important feature.

1. Hence, if the said company does not want to compromise the ownership, issuing debentures could be a better option.
2. An indenture is a legal and binding contract between bond issuers and bondholders.
3. During liquidation, bond and debenture holders receive their money before the company’s shareholders.
4. Investments in debt or equity instruments of corporations demands for an analysis of the entity’s fundamentals in addition to other material information.
5. If stock is used you can still buy and sell it with a floating charge and it doesn’t impinge on your freedom to carry out day-to-day business operations.
6. Provisions can also require preferred share dividends in liquidation and may include special rights for share values in liquidation as well.

Debenture holders will be paid before preferred shareholders but may be subordinate to other types of debt on the company’s books such as senior loans. If the funds allow, a debenture holder may receive their full repayment of the bond’s principal with interest. Each liquidation is different and will affect the final payout to a debenture holder. Preference shares are an optimal alternative for risk-averse equity investors.