When companies need to raise funds, one option is to issue Debentures. These are essentially loans that investors provide to the company, with a fixed maturity date. At the end of this period, the company is required to repay the investors, a process known as redemption of debentures. The redemption price may be higher, lower, or equal to the face value of the debentures, which is determined at the time of issuance. The terms and conditions of the debentures are outlined in the prospectus and must be adhered to by the company.
For companies, debenture redemption is a critical process as it removes the liability and debt from their balance sheets. As this is often a significant transaction involving a large sum of money, companies will usually set up a Debenture Redemption Reserve (DRR) account to ensure that funds are available for redemption. The DRR is solely used for this purpose and is an important aspect of a company’s financial management.
Here’s a detailed look at what comprises redemption of debentures, how does it work, and what are its advantages.
What is the redemption of debentures?
Redemption of the debentures refers to the paying back of the debt of the company raised in the form of debentures. The company issued the debentures with a fixed maturity period. At the time of such maturity, the value of the investment made by the debenture holders is repaid to them at a price that is at par with the face value of the debentures or at a premium or at a discount. The company has to adhere to all the terms and conditions mentioned in the prospectus at the time of issue of the debentures.
Understanding debentures redemption values: Par, Premium and Discount
When it comes to redeeming debentures, the company has the flexibility to choose the value at which they can be redeemed. The redemption value can be determined at the time of issue and can be set to one of the following options:
- Par Value: This means that the redemption value is equal to the face value of the debentures.
- Premium Value: In this case, the redemption value is set higher than the face value of the debentures. For example, if the face value of a debenture is INR 100, the company may decide to redeem it at INR 120.
- Discounted Value: On the other hand, the redemption value can be set lower than the face value of the debentures. In this scenario, if the face value of the debenture is INR 100, the company may redeem it at INR 90.
The company has the discretion to choose the redemption value based on its financial needs and market conditions. It is important for investors to consider the chosen redemption value when investing in debentures, as it will affect the overall return on investment.
What are the advantages of the redemption of debentures?
There are many advantages of issuing debentures, the primary advantage being raising funds at a relatively lower cost than raising through equity as the cost of equity is higher. Similarly, the redemption of the debentures also has many advantages for the company. Some of such advantages are highlighted below.
- Reduction in the operating costs of the company.
- Maintaining the solvency ratio of the company
- Optimum utilization of idle or excess resources of the company
- Rebalancing the balance sheet of the company by reducing the expensive external liability in a scenario when the interest rate on debentures is higher than the current interest rate in the market.
What is Debenture Redemption Reserve?
Debenture Redemption Reserves is a mandatory reserve to be maintained by every company issuing debentures as per the provisions of section 71(4) of the Companies Act, 2013. This reserve is to be created out of the profits of the company that is used to issue dividends.
The Debenture Redemption Reserve (DRR) should be 25% of the value of the debentures in case of debentures issued by NBFCs, listed or unlisted companies. The provisions of the Companies Act, 2013 further require the companies issuing debentures to invest at least 15% of the value of debentures maturing during the year ending on 31st March of the following year, in any of the notified securities.
In the case of convertible debentures (debentures that have an option to be converted into equity shares), DDR is to be maintained for the non-convertible portion of the debentures. The amount reserved in the DDR cannot be utilized by the company for any other purpose other than the redemption of the debentures upon their maturity.
What are the sources for the redemption of debentures?
The redemption of debentures is a commitment by the company at the time of issue of such debentures. At the maturity of the debentures, the company can redeem them through any of the following resources.
- From the sale proceeds received from the sale of any fixed assets
- By utilizing the profits of the company.
- By purchasing own debentures
- Out of fresh issue of debentures or shares
- By converting the debentures into shares or new debentures that may or may not have the same coupon rate.
- Out of the part capital of the company
Methods of redemption of debentures?
The provisions of the Companies Act. 2013, allow the debenture issuing companies to redeem them through multiple options to ensure that the interest of the debenture holders, as well as the company, is not endangered. At the time of redemption of the debentures, the company can redeem them at a value pre decided at the time of issuing the debentures. The various values at which debentures can be redeemed are,
|Value at the time of redemption||Meaning|
|At par||The redemption value of the debentures is equal to the face value of the debentures.|
|At a premium||The redemption value of the debentures is higher than the face value of the debentures. For example, if the face value of the debentures is Rs. 100, the redemption value can be Rs. 110 or 120 per debenture as agreed at the time of issue of debentures.|
|At discounted value||The redemption value of the debentures is lower than the face value of the debentures. For example, if the face value of the debentures is Rs. 100, the redemption value can be Rs. 90 or 80 per debenture as agreed at the time of issue of debentures.|
After discussing the various values at which the debentures can be redeemed, let us discuss the various modes available for the redemption of debentures.
a. Redemption through a lump sum payment
Under this mode of redemption, the debenture holders are paid the agreed value of their debentures in a single one-time payment. The amount to be paid will be as per the agreement at the time of issue of such debentures. For making such payment =, the company can make suitable investments and arrange their finances to be able to meet their commitments in time along with the funds set aside under the DRR.
b. Redemption in installments
This is another mode of redemption of debentures where the company agrees to redeem the debentures through installments that have to be paid as per the agreement at the time of issuing the debentures. These payments may or may not be at regular intervals as agreed at the time of issue of debentures. Such a mode of redemption eases the burden of the company to raise an adhoc amount at the maturity of the debentures.
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c. Redemption by purchasing the debentures through open market
The redemption of debentures can also be done by purchasing them through the open market. This provides the option of redemption at a discounted value which is beneficial to the bottom line of the company.
d. Redemption by conversion of debentures into shares or new debentures.
The most common mode of redemption of debentures is by converting them into equity shares or preference shares or even new debentures. Such new debentures can be with the same coupon rate as the existing debentures or at a higher or lower rate as the case may be. The company has to mention the term ‘convertible’ as a prefix to the debentures in their balance sheet to provide adequate information to the shareholders of the company about the impending addition to the share capital of the company or new long term liability.
Redemption of debentures is a normal course of business for companies and has to be done in accordance with the various provisions, rules, and regulations laid down by the Companies Act, 2013, and relevant Rules framed in this regard. The redemption of the debentures is a binding contract which the company has to fulfill failing which they are liable to many penalties as per the provisions of the Act.
Yes. The DRR set aside by the company for the redemption of debentures can be invested in notified securities to earn interest or profit as the case may be. The income generated from such investment has to be included in the DRR and utilized for the redemption of the debentures.
The excess DRR after the redemption of the debentures has to be transferred to the Capital Reserve of the company.
Apart from the redemption modes mentioned above, the company can also redeem the debentures through an insurance policy taken for such redemption or through a sinking fund created to meet the redemption obligation.
Companies issue debentures as a form of raising capital through a long term liability. The biggest advantage of issuing debentures is the reduced cost of capital as the cost of issuing equity is higher than the cost of debt and the redemption of the debentures is a long term commitment (usually 7 to 10 years or more) which provides the company adequate time to meet its commitment.
Yes. The interest to be paid on debentures is a mandatory payment every year from the profits of the company and is also considered to be among the operating costs of the company. If the company fails to make timely interest payments to the debenture holders, they are liable to penalties as per the applicable provisions of the Companies Act 2013.