The Companies Act, 1956 does not lay down any stringent guidelines or conditions for the redemption of debentures. Regardless, this debt instrument is invariably redeemable, and the process is usually carried out as per the terms stated in a prospectus formulated during issuance.
- Lump-sum payment on a prefixed date
This one-time method is considered to be among the simplest redeeming options. As per this method, debenture holders receive the promised sum on the prefixed date.
If the debentures are not redeemed at discount or premium, the lump sum amount, calculated by the summation of the principal value of all debentures, is paid out on the prefixed or maturity date that is mentioned on debenture agreement. The issuing company may decide to pay off the debenture amount before its maturity. Since companies know in advance, when they have to pay off for debenture, they are better positioned to streamline it.
The accounting treatment of redemption of debentures:
| S.N. |
Particulars |
Amount (Rs.) |
Amount (Rs.) |
| 1. |
Bank A/C (Dr)
To Debenture Redemption Investment A/C
(investment sold) |
xxxx |
xxxx |
| 2. |
Profit and Loss Appropriation A/C (Dr)
To Debenture Redemption A/C
(Being amount of profit transferred) |
xxxx |
xxxx |
|
Debenture Redemption Fund A/C (Dr)
To General Reserve A/C
To Capital Reserve A/C
(Profit on sale of investment) |
|
|
Buy from the open market
Companies can also purchase debentures from an open market if their units are being traded on a regulated exchange. It will save them from the hassle of being subject to administrative documentation. Furthermore, often debentures are traded at a discount in the market. In turn, it allows individuals to lower redemption payout and helps retain more revenue.
Its accounting treatment is shown in a tabular format below:
a) When purchased for a premium
| S.N. |
Particulars |
Amount (Rs.) |
Amount (Rs.) |
| 1. |
Debenture A/c (Dr)
Loss on Redemption A/C (Dr)
To Bank A/c |
xxxx
xxxx |
|
| 2. |
Profit & Loss A/c (Dr)
To Loss on Redemption A/c |
xxxx |
xxxx |
b) When purchased at a discount
| S.N. |
Particulars |
Amount (Rs.) |
Amount (Rs.) |
| 1. |
Debenture A/C (Dr)
To Profit on Redemption A/C (Dr)
To Bank A/C |
xxxx
xxxx |
xxxx |
| 2. |
Profit on Redemption A/C (Dr)
To Capital Reserve A/c |
xxxx |
xxxx |
Regardless, before proceeding with the redemption of debentures, both investors and issuers must weigh in the pros and cons of redeeming them in the prevailing market condition. Also, one should be clear about their purpose of redeeming these debt-instruments and research extensively on their prospect.
Conversion Method
Convertible Debentures are those which can be converted into equity shares at the option of the holder. The most significant feature of issuing these debentures is that it gives a fixed income to the holder along with a chance of having equity shares if the holder exercises his conversion option to the company as capital gains.
An enterprise can reclaim its debentures by transforming them into a new class of debentures or shares. If debenture holders find that the proffer is useful to them, they can exercise their right of transforming their debentures into new class of debentures or shares. These new shares or debentures can be either circulated at a premium, at a discount or at par. It may be noted that this method is applicable only to convertible debentures.
- Under this method, the debentures are redeemed by converting them into new class debentures or shares.
- At the time of conversion, new shares or debentures can be issued at par or at a premium or at a discount.
Features of Convertible Debentures:
It has been stated above that when a company issues convertible debentures it clearly states the terms and conditions and timing of conversion. Moreover, it also states the rate of conversion (i.e., how much equity shares will be converted for each debenture), the price at which the debentures will be converted, and the time period (i.e., at what time the conversion procedure will take place).
Conversion Ratio:
It indicates the number of equity shares a holder will get in exchange of his convertible debentures. In short, the number of equity shares per convertible debenture is known as Conversion Ratio. In the previous example, the ratio was 1: 2, i.e., the holder of one convertible debenture of Rs. 100 each would be allotted two equity shares of Rs. 50 each. Hence, the ratio of conversion is 1: 2.
Conversion Price:
The price so paid at the time of conversion from debentures to equity shares is called conversion price. If both the prices of each debenture and each equity share are known the same can be easily found out. In the example stated above, the Conversion price of each equity share was Rs. 50 and of debenture Rs. 100.
Thus, the ratio is calculated as:
Conversion Ratio = Per Value of Convertible Debentures/ Conversion Price
However, from the above guidelines framed by SEBI, it becomes clear that there are three types of convertible debentures:
(a) The convertible debentures which are compulsorily converted must be converted within 18 months;
(b) Those which are optional must be converted within 36 months; and
(c) Those which are converted after 36 months will carry “Put” and “Call” options.
From the discussions made so far it becomes clear that convertible debentures are issued for the following purposes:
(a) Sweetening Fixed Income Securities;
(b) Lower Cost of Capital;
(c) Deferred Equity Financing; and
(d) Dilution of Earnings.
(a) Sweetening Fixed Income Securities:
Since the convertible debentures are very much attractive to the fixed income group for the fixed rate of interest/income along with the benefit of capital gains, it may be termed as “Sweetening Fixed Income Securities”, rather, the convertibility features make the debenture ‘sweety’.
Moreover, the convertibility features help the company to save the amount of interest to be paid in cash, rather, they pay dividend (or Bonus Shares), after the debentures are converted into equity shares.
(b) Lower Cost of Capital:
We know that every firm needs financing both for long-term as well as for short-term for its various activities including promotional expansion and development at its different phases, and in most of the cases the needs are satisfied by equity financing. But, instead of issuing equity, if a firm issues convertible debentures it will be less costly as interest on debentures is tax deductible at its initial stages.
Obviously, when the purpose of having loans will be completed, i.e., during prosperity, instead of redeeming the debentures the company may convert them into equity shares and they will take part in the share of the profit by way of dividend. At the same time, no cash is required to redeem such debentures.
(c) Deferred Equity Financing:
It has been stated above that a company, after issuing Convertible Debentures, is practically issuing equity shares of a future date. This is particularly done by a company when the current market price of a share is below the face value of a share, although the shares are issued at a higher price.
In other words, this technique can successfully be implemented by increasing the Conversion Price than the prevailing market price of an equity share.
(d) Dilution of Earnings:
Dilution of earnings can be avoided if a firm issues convertible debentures. Usually, a firm cannot increase the number of equity shares till its investment pattern is found to be suitable, rather, it will prefer to issue fixed interest securities just to take its benefits.
Conversion Value of Premium:
Needless to say that the conversion value of a convertible debenture or security is nothing but the conversion ratio of the security times the market price per share of the equity share. It has already been stated earlier in the above paragraph that convertible debentures or securities help the potential investors with a fixed return from a debenture as interest or a fixed amount of dividend from the preference shares.
Moreover, the investor receives an option to convert his debentures/pref. shares into equity shares and comes under capital gains. Due to the above, a company usually sells the convertible securities at a lower yield than it would have to pay on a convertible debenture or preference share.
At the time of issue, the convertible debentures are priced higher than its conversion value, the difference between the two represents the Conversion Premium. The Conversion Premium is expressed as a percentage.
The Conversion Premium is calculated as:
Conversion Premium = {(Market Value- Conversion/Investment Value)/ Conversion/Investment Value}*100
Redemption by Conversion of Debentures into Shares/New Debentures:
Sometimes a company may issue convertible debentures, i.e., the debentures which may be converted into shares.
Practically, it provides the debenture holders the right to exercise the option to convert their debenture into shares within a stipulated period at a stipulated rate. Issue of such convertible debentures must be authorised by special resolution of the company which must also be approved by the Central Government.
Generally, this conversion is affected at a discount on the market price of the shares but at a premium on the face value of shares. The debenture holders will exercise their option if it becomes beneficial to them; otherwise they will be repaid in cash.
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