Redemption of Debentures

What Is Redemption of Debentures?

Redemption of debentures is an important concept in the oeuvre of accounting and corporate finance.  The process refers to redeeming or paying off the existing debentures that a company has previously issued. To know the redemption of debentures meaning, it is essential to know what debentures are.
 

Why Do Companies Issue Debentures?

The main purpose behind the issue of debentures is that it serves as a means of raising funds from institutional investors or the public for an extended period. There are various reasons behind the company’s preference for debenture issues, including. 

●       Investors get a fixed rate of interest that makes them a feasible option, especially for investors who don’t want to involve in any risk and prefer a stable and predictive return.
●       Compared to equity, they offer a cheaper source of funding. This is primarily because interest payments on debentures are tax deductible.
●       Companies entertain a lot of flexibility for repayment as they are generally structured to go hand in hand with the financial position and needs of a company's cash flow.
●       Companies get an opportunity to diversify their funding source and prevent dependence on a single funding source.
 

What Is The Usual Time Given To Redeem The Debenture? 

The usual time to redeem the debenture primarily depends on the terms of the debenture issue, which in turn varies from one company to the other. Generally, there’s a fixed maturity date for debentures. This is the date when the principal amount would become due for repayment. The maturity period can range from a few years to a few decades based on the purpose and type of the debenture.
 

Methods of Redemption of Debentures 

Some popular redemption of debenture methods are as follows:
1. Lump-sum Payment On A Prefixed Date 
This is considered one of the easiest and simplest options for the redemption of debentures. In this method, the debenture holder receives a lumpsum amount on a date that has been fixed before. The accounting treatment is mentioned below: 

2. Payment In Annual Installments      

Payment in annual instalments can be similar to that of the procedure of redemption of a term loan. In this method, companies a part of the principal of debenture is paid by the company to their holders until the date of maturity arrives.

3. Debenture Redemption Reserve       

As the name suggests, this kind of reserve is developed with the accumulation of 25% of the debenture face value each year until maturity. The main motto is to protect the debenture holder’s interest.

4. Call And Put Option         

For the purpose of redemption, some companies issue debentures using put and call options. The call option allows the purchase of debentures on or before the maturity date at a prefixed price. On the other hand, for the put option, the holder of the debenture is enabled to sell the debenture back at a predetermined price. 

5. Conversion Into Shares 

This encompasses convertible debentures, which possess a clause which allows holders to transform their units into the ordinary equity shares of the company. It is at the conversion point that the debenture liability is released.

6. Buy From The Open Market   

Companies are allowed to buy debentures from the open market if the units are traded on an regulated exchange rate. This prevents them from getting into the hassle of administrative documentation.

Its Accounting Treatment Is Shown In A Tabular Format Below

a) When purchased for a premium

b) When purchased at a discount

Advantages Offered By Redemption Of Debentures

There are innumerable benefits that companies can secure by redeeming debentures; these are: 

●       Enhanced Creditworthiness: Redemption of debentures enhances the ability of the company to meet its obligation for debts and eventually improve creditworthiness. With this, the company will also be able to access news funding sources at low-interest rates in the future. 
●      Low-Interest Expense: The company’s interest expense can also be reduced through redemption of debentures primarily because it obliterates the need for interest payment in the future. 
●       Enhance Flexibility In Finance: Redemption of debentures reduces debt burdens and frees up cash for various purposes involving payment of dividends or other capital expenditures. This, however, increases the financial flexibility of the company. 
●  Green Signal For Investors: Redeeming debentures highlights the company’s commitment to financial discipline and eventually enhances the confidence of the investor.
 

Fund Sources For Redeeming Debentures 

For the redemption of debentures to be funded, companies can resort to various sources depending on the needs of cash flow and their financial position; some common sources of funds are mentioned below: 

●  Sale Of Assets: Companies may sell assets to raise funds for redemption of debentures. This involves selling non-core assets like other companies’ equity holdings, real estate or equipment.
●    Bank Loans: To fund the redemption of the debenture company may also opt for a bank loan if it entertains a good credit rating and feasible loan terms. 
●     Existing Cash Reserves: The existing cash reserve can also be used by the company to fund debenture redemption. Although being the most feasible method for funding, it often fails to prove helpful if the company has sufficient cash reserves. 
●  Equity Issue: Companies can also issue new equity shares to fund debenture redemption. Although it greatly benefits the capital structure of the company, it may hamper existing shareholders’ ownership. 
●    Issue Of New Debt: New debts, such as debentures or bonds, to fund the existing debenture’s redemption. It will prove helpful in managing the debt obligation of the company, especially with favourable interest rates. 
 

Therefore, as long-term debt instruments for companies, debentures ensure that a company remains in a respected financial position and secures decent creditworthiness.