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TABLE OF CONTENT

Certificate.............................................................................

Acknowledgement.................................................................

Abstract .................

Introduction.......................................................................

Debenture: Meaning and Characteristics ..................

Classification of Debentures.....

Advantages and Disadvantages....

Debentures and Debt Market: Indian Context..................

Conclusion..

Abstract

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Any informed borrower is simply less vulnerable to fraud and abuse
-Alan Greenspan
Being a qualified Company Secretary, it was an interesting task to take up topics from corporate
world. Having worked under various circumstances, one thing was clear that a project shall be
based on some real time experiences that author has faced during her professional tenure. The
concept of debenture struck in mind of author because she has seen that there is a lack of
organized debt market in India and also, during her work experience, she has faced some
challenges in legal compliance in issuing and listing of long term debt instruments: Debentures.

Introduction

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Finance is the lifeblood of every business. It is perhaps the most crucial factor in deciding fate of

any business enterprise. Finance is required in day-to-day transactions of business as well as for

carrying out capital (long term) investments of the business. Keeping this in view, it is the most

important function of a financial manager that is to arrange funds for the business from different

sources. This becomes necessary under the fact that pre determined goals of business could only

be achieved when a business does not suffer from lack of finance. It is evident in daily lives too

that a person cannot carry on his daily tasks without having financial support. Other than this,

just like daily lives, a business cannot run smoothly in absence of finance.

This therefore is the most crucial decision that a financial manager needs to take up- composition

of capital structure of an organization. Following diagram shows capital structure and its various

components:

Hybrid Instruments: Preference


Capital

Capital Structure of a Borrowed


Other
business organization Capital (Debt)
Short
Term
Securities

Equity Capital
Let us get a brief introduction of each of components of capital structures:

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Equity Capital:

Shareholders' equity (or stockholders' equity, shareholders' funds, shareholders' capital

employed) is the interest in remaining assets, spread among individual shareholders of common

or preferred stock. At the start of a business, owners put some funding into the business to

finance assets. Businesses can be considered to be, for accounting purposes, sums of liabilities

and assets; this is the accounting equation. After liabilities have been accounted for, the positive

remainder is deemed the owner's interest in the business.

Preference Capital:

Preferred stock, also called preferred shares or preference shares, is typically a 'higher ranking'

stock than voting shares, and its terms are negotiated between the corporation and the investor.

Preferred stock usually carries no voting rights, but may carry superior priority over common

stock in the payment of dividends and upon liquidation. Preferred stock may carry a dividend

that is paid out prior to any dividends being paid to common stock holders. Preferred stock may

have a convertibility feature into common stock. Preferred stockholders will be paid out in assets

before common stockholders and after debt holders in bankruptcy. Terms of the preferred stock

are stated in a "Certificate of Designation".

Debt Capital:

Debt capital is the capital that a business raises by taking out a loan. It is a loan made to a

company that is normally repaid at some future date. Debt capital differs from equity or share

capital because subscribers to debt capital do not become part owners of the business, but are

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merely creditors, and the suppliers of debt capital usually receive a contractually fixed annual

percentage return on their loan, and this is known as the coupon rate.

Debt capital ranks higher than equity capital for the repayment of annual returns. This means that

legally, the interest on debt capital must be repaid in full before any dividends are paid to any

suppliers of equity.

Debentures: Meaning and Nomenclature:

A debenture is defined as a certificate of agreement of loans which is given under the company's

stamp and carries an undertaking that the debenture holder will get a fixed return (fixed on the

basis of interest rates) and the principal amount whenever the debenture matures.

In finance, a debenture is a long-term debt instrument used by governments and large companies

to obtain funds. It is defined as "a debt secured only by the debtors earning power, not by a lien

on any specific asset." It is similar to a bond except the security conditions are different. A

debenture is usually unsecured in the sense that there are no liens or pledges on specific assets. It

is, however, secured by all properties not otherwise pledged. In the case of bankruptcy, debenture

holders are considered general creditors. The advantage of debentures to the issuer is they leave

specific assets burden free, and thereby leave them open for subsequent financing. Debentures

are generally freely transferable by the debenture holder. Debenture holders have no voting rights

and the interest given to them is a charge against profit

Definition of Debentures by Indian Companies Act, 1956:

The term debenture includes debenture stocks, bonds and any other security of a company,

whether constituting a charge on the assets of a company or not.

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Features of Debentures as a long-term financial (Debt) instrument:

Following are the basic features of debentures that differentiate them from other sources of

finance. After understanding meaning of different capital structures, we need to understand

peculiar characteristics of debentures that make them different from commonly used finance

sources:

Investors who invest in the debentures of the company are not the owners of the

company. They are the creditors of the company or in other words, the company borrows

the money from them.

Funds raised by the company by way of debentures are required to be repaid during the

life time of the company at the time stipulated by the company. As such, debenture is not

a source of permanent capital. It can be considered as a long-term source.

In practical circumstances, debentures are generally secured i.e. the company offers some

of the assets as security to the investors in debentures.

Return paid by the company is in the form of interest. Rate of interest is predetermined,

but the company can freely decide the same. The interest on debenture is payable even if

the company does not earn the profits

In financial terms, debentures prove to be a cheap source of funds from the companys

point of view

So this thing needs to be kept in mind by a company that an investor is expected to invest in

debentures only when liquidity and financial position of company is very sound. An investor is

always careful before investing in any company, especially in debt instruments where there is

hardly any chance of capital appreciation. So, a company that is very much sure about it financial

well-being could very well come up with issue of debentures. Debentures are also ideal for

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companies, which do not want any kind of dilution in control of management. That means,

organizations, which do not want to issue shares, could come up with issue of debentures.

Apart from that, financial manager must make sure that company is in sound enough position to

make periodic interest payments and also, repayment of principal amount at the right time.

Classification of debentures

In India, debentures could be classified in basically two categories: on the basis of security and

on the basis of convertibility. Following diagram shows details of classification of debentures in

Indian context:

On the basis of convertibility:

Fully convertible Debentures (FCD): These are fully convertible into Equity

shares at the issuer's notice. The issuer decides the ratio of conversion. Upon conversion

the investors enjoy the same status as ordinary shareholders of the company.

Partly Convertible Debentures (PCD): A part of these instruments are converted


into Equity shares in the future at notice of the issuer. The issuer decides the ratio for

conversion. This is normally decided at the time of subscription.

Non-Convertible Debentures (NCD): These instruments retain the debt character

and cannot be converted in to equity shares.

Optionally Convertible Debentures (OCD): The investor has the option to

either convert these debentures into shares at price decided by the issuer/agreed upon at

the time of issue.

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On the basis of security:

Secured Debentures: These instruments are secured by a charge on the fixed assets

of the issuer company. So if the issuer fails on payment of either the principal or interest

amount, his assets can be sold to repay the liability to the investors.

Unsecured Debentures: These instruments are unsecured in the sense that if the

issuer defaults on payment of the interest or principal amount, the investor has to be

along with other unsecured creditors of the company.

Advantages of Debentures

Continuing the classification of debentures, next step to be undertaken during course of our

analysis is to look at fact as to how debentures have an advantage over other sources of long-

term finance. In this section of our study, we shall look as to what are the pros and cons of

debentures that make it one of the most reliable sources of long-term finance and also create a

huge scope in Indian financial markets.

Following are advantages of debentures that make them a reliable source of finance as compared

to other long-term finance sources:

Let us divide our analysis into three major points i.e., division of advantages of debentures by

different prospective:

Advantages of Debentures

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General Advantages Advantages to Advantages to Financial
Investors Institutions

Let us now take a look at the description of above-mentioned topics in brief. During course of

description, efforts will be made to make sure that a reader understands relative advantage of

debentures and conclusions could be drawn out as to how under utilized this very source of

finance has been in Indian context:

General Advantages:

These advantages are highly dependable on the success rate of the current interest rate and

economic situation of society.

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Greater Returns on Corporate Debentures: Corporate bonds and debentures

are usually much more rewarding than government debentures or bank investments and

provide a higher rate of financial return for their investors. If a company is selling

debentures to people, it means that they definitely need the money and are willing to pay

you quite a bit of additional money to use it. The fact of receiving a greater return on

corporate debentures is a great advantage to these types of investment.

Financially Convertible: Another great advantage to debentures is that at the end of

the lending period companies usually offer the assets in the form of stock, which can

ultimately be very valuable. Stocks are another great form of investment and are

sometimes better than receiving immediate cash in return. Although the advantages of

debentures can be clearly seen, there are a number risks and disadvantages to investing in

corporate debentures.

Success or Failure: You are taking a great risk when investing in a corporate

debenture because the success of the company will determine how valuable your

debenture is. A company debenture is only valuable when the company is successful and

profitable, but if it fails, then you will lose a great amount of money. Debentures and

bonds hold greater risks because the company could eventually go out of business, so this

type of investment should be done very carefully.

Debentures can be a very attractive form of investment, but only should be taken advantage of

with companies that have a very high probability of being successful. Large and already

successful businesses are smart forms of investments when considering buying corporate

debentures.

Advantages to investors:

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They have the possibility to acquire shares at a lower price to that of the market- by way

of investment in convertible debentures with embedded options of conversion into equity

shares.

They have the right for subscription of shares at a lower price to that of the market.

They are less exposed to the risks of inflation.

The price of conversion is always lower to that of the market so the effects of a possible

inflation are mitigated. This inflation effects causes a rise on the stocks quotations.

Investors get better returns as compared to bank deposits.

Debentures are less volatile as compared to equity shares.

At times, companies come up with offers like principal guarantee.

Due to SEBI guidelines, chances of default by corporate are very less.

Advantages to issuing institutions:

There is an improvement in the financial structure of the company, because the extra

resources (debentures) are transformed into own resources (shares). It transforms debt

into capital.

The financial cost is lessening, because if the investor chooses for the conversion they

dont have to obey the requisites from the debentures: to pay interests and to refund the

capital. On the other side, the interests from the debentures or bonds are usually lower

than that on the market, this way, in case of not converting, the company will finance

itself with cheap debt.

The sooner the conversion is made, the greater are the discounts, so the lesser are the

numbers of shares that you can obtain with each debenture.

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After talking about advantages of debentures, lets take a look on various demerits this source of

finance suffers from. No doubt that there are few cons from which debentures suffer, but these

demerits are small enough to overlook and advantages always override the disadvantages:

General Disadvantages:

By issuing the debentures, the company accepts the risk of two types. These are payment

of the interest at a fixed rate, irrespective of the non-availability of profits and repayment

of principal amount at the pre-decided time. If earnings of the company are not stable or

if the demand for the products of the company is highly elastic, debentures prove to be a

very risky proposition for the company. Any adverse change in the earnings or demand

may prove to be fatal for the company.

Debentures are usually a secured source for raising the long-term requirement of funds

and usually the security offered to the investors is the fixed assets of the company. A

company, which requires less investment in fixed assets, such as a trading company, may

find debentures as a wrong source for raising the long-term requirement of funds, as it

does not have sufficient fixed assets to offer as security.

Disadvantages for the Investor

They dont pass immediately through the quotations.

The securities have a less quotation price due that temporarily they have lesser rights.

They are less liquid, due that there is a lesser amount of them.

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You cant dispose of money soon due to the former explanation. Usually the type of

interests that they offer is inferior to that of the ordinary debentures due that they offer

the additional advantage of placing them as shares on the market.

Disadvantages for the Issuing Institution

You cant foresee an exact dividend distribution politic due that existing amounts of

shares swill depend on the number of debentures that will exercise their option of

conversion.

There are doubts when you cant calculate the interests of the debentures. Again, the

number of securities to be converted is unknown or unknown of the amount of funds to

be returned with the amortizations.

Debentures and Debt market in Indian context:

After understanding in brief some of legal compliances related with issue of debentures in public

as well as private companies, we should conclude our analysis by taking a look at current

economic conditions and implications of debentures in Indian financial structure.

It is very discouraging to see that debt market in India is not as organized as in other advanced

economies. Taking example of the US, where debt market (bonds) has a size, which is more that

thrice the size of equity markets. In India, companies have been issuing debentures to public as

well as to financial institutions, but the level of issue has not been as large as equity issue. Also

there is no organization in Indian secondary debt markets as compared to organized equity

markets. In India, public at large averse themselves from investing in debentures issued by large

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corporate houses. In most cases, it is financial institutions, which invest in debentures of

corporate bodies. Public at large is interested in investing in debentures which are issued by

financial institutions. In Indian markets there are about 8000 companies, which come up with

issues of securities. Out of them, only about 2000 are traded on stock exchanges on a regular

basis. Most often, there is a lack of liquidity in Indian stock markets that lead to a disinterest by

investors in debt instruments. This difference in Indian scenario with that of advanced economy

(USA) will become more clear by way of following case analysis.

In this case illustration, we will take two companies from each nation: Reliance Industries

Limited from India and Wal-Mart Inc. from USA. We will see that both the companies have

significant effect on their respective economies and in a way they reflect financial structure and

pattern followed by investors in that nation. We will take into account respective contribution of

debt- bonds and debentures in total capital as well as total liabilities of these companies. After

this analysis, we will be in a position to draw conclusions of illustration as well as make our

recommendations on project and debentures scenario in Indian market.

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Conclusion of Analysis

It is not just about a single company, whole debt market of India needs reorganization and that

too at a rapid rate. In todays context when due to recession, equity markets have fallen

drastically in India, debentures could just help in saving day for all troubled financial markets of

India. Apart from that, government should take account of SEBIs advices when the authority has

constantly urged them to work for organization of debt market in India. This is necessary because

in an emerging economy, it is important that there is an active participation of public in corporate

world activities. Role of a Company Secretary is important because in this condition hes the one

who has to maintain equilibrium between interest of investors, company and government of

India. This is perhaps real challenge that a Company Secretary will have to face in some years to

come.

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