Methods of Redemptions: Redemption Out of Profit

The redemption of debentures refers to the repayment of the borrowed amount to debenture holders at maturity or before the due date. Companies use different methods to redeem debentures, primarily Redemption Out of Profits and Redemption Out of Capital. Both methods impact the company’s financial structure differently and must be planned strategically.

Redemption Out of Profits

In this method, debentures are redeemed using the company’s accumulated profits. The company transfers an equivalent amount of redeemable debentures from its profit and loss account to the Debenture Redemption Reserve (DRR) before making the payment. This ensures that profits are earmarked for debenture repayment rather than being distributed as dividends.

Features of Redemption Out of Profits

• The company sets aside a portion of its profit in a Debenture Redemption Reserve (DRR) before redemption.

• The company’s total capital remains unchanged since the payment is made from retained earnings.

• The company’s liquidity is not directly affected because profits are reserved in advance.

• It strengthens the financial position as the company retains sufficient reserves for debt repayment.

Procedure for Redemption Out of Profits

1. Creation of Debenture Redemption Reserve (DRR): A specific percentage of profits is transferred to the DRR account before redemption.

2. Investment in Specified Securities: As per regulatory norms, companies may need to invest a portion of the reserve in government securities or fixed deposits.

3. Payment to Debenture Holders: On maturity, debenture holders are repaid using funds allocated in the DRR.

4. Closing of DRR Account: After redemption, the DRR is closed, and any remaining balance may be transferred back to general reserves.

Advantages of Redemption Out of Profits:

• Ensures financial stability as funds are planned and reserved in advance.

• Reduces the burden on cash flow at the time of redemption.

• Maintains investor confidence by ensuring the company is prepared for debt repayment.

Disadvantages of Redemption Out of Profits:

• Reduces the amount of profits available for dividends or reinvestment.

• May affect the company’s growth potential if large amounts of profits are set aside.