Companies frequently require supplementary funds for growth initiatives, purchase deals or financial requirements. One viable option is issuing debentures, which serve as long-term financial instruments allowing companies to raise funds from the public. Repaying these debenture holders upon maturity is known as the redemption of debentures.
Debentures appear as long-term liabilities on a company’s balance sheet. Acquiring debentures is similar to lending money to a company, with debenture holders receiving repayment based on agreed-upon terms. The redemption of debentures is a significant financial commitment, impacting the company’s credibility and financial stability.
Understanding Redemption of Debentures
A company can repay borrowed debenture amounts to its holders during either term maturity or earlier than the scheduled due date under the process of debenture redemption. Debenture issuers need to establish a Debenture Redemption Reserve (DRR) because it serves as dedicated funds for repayment obligations. The dedicated reserve is a financial safeguard because it can only be spent for debenture repayment.
Redeemable debentures have three possible redemption options: Face Value, Premium, and Discount:
- Redemption at Par: The repayment amount equals the face value of the debenture.
- Redemption at Premium: Debenture holders can receive a payment above face value through redemption at a Premium.
- Redemption at Discount: The repayment amount is lower than the face value, though this is a rare practice.
The repayment value of a debenture with a face value of Rs.100 can amount to Rs.110 or more during premium redemption or Rs.90 in discount redemption cases.
Benefits of Debenture Redemption
Key Advantages of Debenture Redemption:
- The solvency ratio of a company remains effective through debenture redemption measures.
- Companies obtain capital funding through debentures at lower rates than they would pay for equity.
- Repaying debt obligations through debenture redemption helps firms decrease their overall operating expenses.
- A company can efficiently handle liabilities when its debenture interest rates surpass market rates.
- Excess funds enable businesses to invest their resources so they generate higher yields.
Sources of Funds for Debenture Redemption
Businesses usually draw upon these sources when they want to pay back their debentures:
- Profits from Business Operations
- Sale of Fixed Assets
- New Debenture Issuance
- Conversion of Debentures into Equity
- Reserves or Capital
- Purchasing Debentures from the Market
Methods of Redemption of Debentures
Redemption of debentures is accomplished through various accepted procedures. The most common ones include:
- Lump-Sum Redemption
The company performs a prearranged single-payment transaction to repay the debenture principal. A company using this payment method can properly plan its finances, but it needs to maintain enough cash flow before the repayment date.
- Redemption in Instalments
Instead of a one-time repayment, the company redeems debentures in periodic instalments. Through this approach, companies distribute financial strain across time and maintain improved money resources.
- Conversion into Shares or New Debentures
A few organisations allow debenture holders to convert these financial instruments into new debentures or equity shares rather than receiving cash payments. The approach proves advantageous for firms since it prevents loss of cash but grants investors business equity participation.
- Open Market Purchase
Companies can purchase their debentures from market sources before the end of the maturity period. Purchasing debentures at reduced prices decreases the expense for both parties. Companies can cancel repurchased debentures or maintain them to issue again for future use.
- Redemption through Sinking Funds
Companies create Sinking Funds from profits to accumulate reserves for debenture redemption. The funds may be cumulative (where profits are reinvested) or non-cumulative (where profits are not reinvested). This ensures the company has a dedicated reserve for meeting its debenture obligations.
- Call and Put Options
Some debentures have built-in options for early redemption. A call option allows the company to redeem the debenture before maturity, while a put option gives the debenture holder the right to demand early repayment.
Accounting Treatment of Debenture Redemption
Businesses need to document appropriate accounting functions after finalising debenture redemption procedures:
When Redeemed at a Premium:
-
- Debit: Debenture Account
- Debit: Loss on Redemption Account
- Credit: Bank Account
- Debit: Profit & Loss Account
- Credit: Loss on Redemption Account
When Redeemed at a Discount:
- Debit: Debenture Account
- Credit: Profit on Redemption Account
- Credit: Bank Account
- Debit: Profit on Redemption Account
- Credit: Capital Reserve Account
Premium on Redemption of Debentures
The company utilises funds to pay debenture holders above the debenture value when it conducts a redemption at a premium. The premium payment as an investment benefit drives investors’ interest in debenture investments. The company must provide Rs.1050 for each Rs.1000 debenture when executing a redemption process by paying a 5% premium.
Conclusion
Redemption of debentures is one of the financial obligations that companies have to fulfil. The redemption methods, like lump-sum, installment, conversion, or repurchase, could be used by investors and/or companies to consider debt management. Knowing the various redemption methods enables companies to strategise and plan their financial obligations, enhancing market credibility for long-term financial stability.
Frequently Asked Questions (FAQs)
- Why do companies redeem debentures?
The redemption of debentures serves three purposes for companies: debt obligation management and financial burden reduction together with improved solvency status and increased investor confidence. The process of proper redemption planning contributes to financial stability by maintaining strong corporate credibility.
- What is the difference between redemption at par and redemption at premium?
The procedure of repaying debenture holders at their stated face value constitutes redemption at par whereas redemption at premium requires issuing the payment at a value surpassing the stated face value.
- What is the purpose of a Debenture Redemption Reserve (DRR)?
A Debenture Redemption Reserve (DRR) is a reserve fund that companies must maintain as per regulatory requirements. It ensures that sufficient funds are available for debenture repayment, providing security to investors and demonstrating financial discipline.
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