MAKERERE UNIVERSITY BUSINESS SCHOOL

PROGRAMME: MASTER OF BUSINESS ADMINISTRATION

COURSE WORK: LEGAL FRAMEWORK OF BUSINESS

COURSE CODE: MBA 7212

YEAR OF STUDY: ONE

TOPIC: COMPANY FINANCE

GROUP MEMBERS

NO NAME REG NO STD NO

1 JULIET NSHABOHURIRA 2020/HD10/20674U 2000720674
2 LEOPOLD AHUMUZA 2020/HD10/20730U 2000720730
KAMUGYENE
3 MAURICIUS KANYANGE 2020/HD10/20802U 2000720802
4 LEAH KATASI 2020/HD10/20806U 2000720806
5 MAHAD MUBIRU 2020/HD10/20639U 2000720639
6 TIMOTHY NABAALA 2020/HD10/20650U 2000720650
7 SSENYONDO PHILLIP DAVID 2019/HD10/29312U 1900729312
8 MUSHEMEZA CHRISPUS 2020/HD10/20646U 2000720646
9 DAVID KISEMBO 2020/HD10/20844U 2000720844
10 KUNIHIRA MAUREEEN 2020/HD10/21603U 2000721603
11 ENOCK LUBWAMA 2019/HD10/25654U 1900725654
12 NANKUNDA TESSY 2020/HD10/20888U 2000720888
13 TUHAIRWE MOREEN 2020/HD10/20695U 2000720695

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COMPANY FINANCE

What is capital?

Capital is anything that increases one’s ability to generate value. It can be used to increase value
across a wide range of categories, such as financial, social, physical, intellectual, etc. In business
and economics, the two most common types of capital are financial and human. This guide will
explore all the above categories in more detail.

Types of Capital

The different types of capital include:

1. What is Nominal Capital?

Nominal capital is the aggregate par value of those shares that have been issued by a corporation.
Since par value is typically set at $0.01 per share, the total nominal value of a company is quite
low. In cases where there is no par value at all, a firm has no nominal capital.

2. What is Issued Capital?

Issued (share) capital is the amount of nominal value of share held by the shareholders. It is the
face value of the shares that have been issued to the shareholders. Issued share capital and share
premium represent the amount invested by the shareholders in the company.

3. What is Called up capital?

Typically, companies don't ask for the full amount of shares to be paid at once. They often call for
partial payments during allotment. The amount of shares companies call for as partial payment is
what is referred to as called up share capital. Companies issue shares in this manner to sell their
shares to potential shareholders on relaxed terms, which can potentially raise the sum of equity
obtainable by a business.

If a company receives full payments for called up capital from its shareholders, the called up capital
and the paid-up capital will be equal. However, because of defaulting investors who don't pay as
they should, a company's called up share capital doesn't equal its paid-up capital.

The moment a shareholder pays an issuing entity the complete amount due for issued shares, the
shares are said to be issued, called up, and fully paid. However, that isn't the same as registering
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the shares, which would qualify the shareholder to sell them to another party. The registration
process requires the issuer to register the shares with the governmental overseeing body, which
takes a long process of application and continued public reporting of the issuer's financial results.

4. Reserve Capital

Reserve Capital is the money set aside by a company that essentially acts as an emergency fund.
The reserve capital is withheld and is not used unless the company is forced into liquidation and
needs those funds as a lifeline. Reserve capital does not require disclosure and it does not show on
the balance sheets.

RAISING CAPITAL

Running a business requires a great deal of capital. Capital can take different forms, from human
and labor capital to economic capital. But when most people hear the term financial capital, the
first thing that comes to mind is usually money.

That's not necessarily untrue. Financial capital is represented by assets, securities, and yes, cash.
Having access to cash can mean the difference between companies expanding or staying behind
and being left in the lurch. But how can companies raise the capital they need to keep them going
and to fund their future projects? And what options do they have available?

There are two types of capital that a company can use to fund operations: debt and equity. Prudent
corporate finance practice involves determining the mix of debt and equity that is most cost-
effective. This article examines both kinds of capital.

KEY TAKEAWAYS

Businesses can use either debt or equity capital to raise money, where the cost of debt is usually
lower than the cost of equity, given debt has recourse.

Debt capital comes in the form of loans or issues of corporate bonds.

Equity capital comes in the form of cash in exchange for company ownership, usually through
stocks.
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Debt holders usually charge businesses interest, while equity holders rely on stock appreciation or
dividends for a return.

Preferred equity has a senior claim on a company’s assets compared to common equity, making
the cost of capital lower for preferred equity.

1. Debt Capital

Debt capital is also referred to as debt financing. Funding by means of debt capital happens when
a company borrows money and agrees to pay it back to the lender at a later date.1 The most
common types of debt capital companies use are loans and bonds, which larger companies use to
fuel their expansion plans or to fund new projects. Smaller businesses may even use credit cards
to raise their own capital.

A company looking to raise capital through debt may need to approach a bank for a loan, where
the bank becomes the lender and the company becomes the debtor. In exchange for the loan, the
bank charges interest, which the company will note, along with the loan, on its balance sheet.

The other option is to issue corporate bonds. These bonds are sold to investors—also known as
bondholders or lenders—and mature after a certain date. Before reaching maturity, the company
is responsible for issuing interest payments on the bond to investors.

Pros and Cons of Debt Capital

Because corporate bonds generally come with a high amount of risk, they pay a much higher yield.
That's because the chances of default are higher than bonds issued by the government. The money
raised from bond issuance can be used by the company for its expansion plans.

While this is a great way to raise much-needed money, debt capital does come with a downside,
notably the additional burden of interest. This expense, incurred just for the privilege of accessing
funds, is referred to as the cost of debt capital. Interest payments must be made to lenders
regardless of business performance. In a low season or bad economy, a highly leveraged company
may have debt payments that exceed its revenue.

Example of Debt Capital

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Let's look at the loan scenario as an example. Assume a company takes out a $100,000 business
loan from a bank that carries a 6% annual interest rate. If the loan is repaid one year later, the total
amount repaid is $100,000 x 1.06, or $106,000. Of course, most loans are not repaid so quickly,
so the actual amount of compounded interest on such a large loan can add up quickly.

Rating agencies, such as Standard and Poor's (S&P), are responsible for rating the quality of
corporate debt, signaling how risky the bonds are to investors.

2. Equity Capital

Equity capital is generated through the sale of shares of company stock rather than through
borrowing. If taking on more debt is not financially viable, a company can raise capital by selling
additional shares. These can be either common shares or preferred shares.2

Common stock gives shareholders voting rights but doesn't really give them much else in terms of
importance. They are at the bottom of the ladder, meaning their ownership isn't prioritized as other
shareholders are. If the company goes under or liquidates, other creditors and shareholders are paid
first.

Preferred shares are unique in that payment of a specified dividend is guaranteed before any such
payments are made on common shares. In exchange, preferred shareholders have limited
ownership rights and have no voting rights.

Pros and Cons of Raising Equity

The primary benefit of raising equity capital is that, unlike debt capital, the company is not required
to repay shareholder investment. Instead, the cost of equity capital refers to the amount of return
on investment shareholders expect based on the performance of the larger market. These returns
come from the payment of dividends and stock valuation.

The disadvantage to equity capital is that each shareholder owns a small piece of the company, so
ownership becomes diluted. Business owners are also beholden to their shareholders and must
ensure the company remains profitable to maintain an elevated stock valuation while continuing
to pay any expected dividends.

Because preferred shareholders have a higher claim on company assets, the risk to preferred
shareholders is lower than to common shareholders, who occupy the bottom of the payment food

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chain. Therefore, the cost of capital for the sale of preferred shares is lower than for the sale of
common shares. In comparison, both types of equity capital are typically more costly than debt
capital, since lenders are always guaranteed payment by law.

Example of Equity Capital

As mentioned above, some companies choose not to borrow more money to raise their capital.
Perhaps they're already leveraged and just can't take on any more debt. They may turn to the market
to raise some cash.

A startup company may raise capital through angel investors and venture capitalists. Private
companies, on the other hand, may decide to go public by issuing an initial public offering (IPO).
This is done by issuing stock on the primary market—usually to institutional investors—after
which shares are traded on the secondary market by investors. For example, Meta, formerly
Facebook, went public in May 2012, raising $16 billion in capital through its IPO, which put the
company's value at $104 billion.3

Debt holders are generally known as lenders while equity holders are known as investors.

Conclusion

Companies can raise capital through either debt or equity financing. Debt financing requires
borrowing money from a bank or other lender or issuing corporate bonds. The full amount of the
loan has to be paid back, plus interest, which is the cost of borrowing

Equity financing involves giving up a percentage of ownership in a company to investors, who

purchase shares of the company. This can either be done on a stock market for public companies,
or for private companies, via private investors that receive a percentage of ownership.

Both types of financing have their pros and cons, and the right choice, or the right mix, will depend
on the type of company, its current business profile, its financing needs, and its financial condition.

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THE PROSPECTUS

“A prospectus means any document described or issued as a prospectus and includes any notice,
circular, advertisement or other documents inviting deposits from the public or inviting offers from
the public for the subscription or purchase of shares in or debentures of a corporate body.”

From the above definition, it is clear that a prospectus is a document that invites the public to
subscribe to the share capital or debentures of a company. If it does not do that, it cannot be called
a prospectus. Some companies do not directly to the public themselves but allot the entire share
capital to an intermediary, which then offers the shares to the public by an advertisement of its
own. Any document by which such offer for sale to the public is made is deemed to be a prospectus.

After getting the company incorporated, promoters will raise finances. The public is invited to
purchase shares and debentures of the company through an advertisement. A document containing
detailed information about the company and an invitation to the public subscribing to the share
capital and debentures is issued. This document is called a ‘prospectus.

Private companies cannot issue a prospectus because they are strictly prohibited from inviting the
public to subscribe to their shares. Only public companies can issue a prospectus. The prospectus
is not an offer in the contractual sense but only an invitation to offer.

A document constructed to be a prospectus should be issued to the public. A prospectus should

have the following essentials.

• There must be an invitation offering to the public.

• The invitation must be made on behalf of the company or intended company.

• The invitation must be to subscribe or purchase.

• The invitation must relate to shares or debentures.

A prospectus must be filed with the Registrar of companies before it is issued to the public. The
issue of prospectus is essential when the company wishes the public to purchase its shares or
debentures.

Through the prospectus, the company tries to convince the public that it offers best opportunity for
their investment. A prospectus outlines a detail the terms and conditions on which the shares or

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debentures have been offered to the public. Every prospectus contains an application from on
which an intending investor can apply for the purchase of shares or debentures.

The objects of issuing a prospectus are as under:

1. To invite the public to invest in the shares or debenture of a market.

2. To give a set of conditions on which the public is invited to invest in shares and debentures.

3. To make a declaration that the directors of the company are liable for the conditions stated
in the prospectus.

When the prospectus is not needed to be issued

In the following situation, there is no need for a prospectus to be issued.

1. When the shares and debentures are to be allotted to the existing holders of shares and
debentures.

2. When the shares and debenture to be allotted are similar to the current (already issued) shares
and debentures that are being traded in a recognized stock exchange.

3. When the allotment of shares and debenture is not permissible by law as in the case of a
private company.

4. When the invitation is to some such person who has a contract for underwriting the shares
and debentures of the company.

Golden rule in prospectus

Prospectus is the basis of the contract between the company and the persons who have interest in
the company’s shares or debentures. The officers of the company have knowledge of the
company’s present status and its prospects in future or have the means to acquire such knowledge.
But the potential investor has no such knowledge, nor the means to acquire it. It, therefore,
becomes the duty of those who issue the prospectus that they not only projects the company’s
image in the right perspective but also makes sure that no vital information which could be of
interest to the potential investors in the company’s shares and debentures is left out from the
company’s prospectus. it therefore becomes important that the prospectus states the basic
important facts about the company with utmost honesty and good faith and that no information
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that is important is twisted or partially presented. That is what is refers to as the ‘golden rule for
making a prospectus’.

In short the following must be kept in mind when preparing the prospectus of a company:

1. The prospectus must be an honest statement of the company’s profile; there must be no
misleading, ambiguous or erroneous reference to the company in its prospectus.

2. Every important aspect of a contract of the company should be clarified.

3. The contents of the prospectus should conform to the provision of the Companies Act.

4. The restrictions on the appointment of directors must be kept in mind.

5. The conditions of civil liability as laid down must be strictly adhered to and registration of
prospectus or legal requirement regarding issue of prospectus must be observed.

Legal requirement regarding issue of prospectus:

The Companies Act has defined some legal requirements about the issue and registration of a
prospectus. The issue of the prospectus would be deemed to be legal only if the requirements are
met.

1. Issue after the incorporation: As a rule, the prospectus of a company can only be issued
after its incorporation. A prospectus issued by, or on behalf of a company, or in relation to an
intended company, shall be dated, and that date shall be taken as the date of publication of the
prospectus.

2. Registration of prospectus: it is mandatory to get the prospectus registered with the

Registrar of Companies before it is issued to the public. The procedure of getting the prospectus
registered is as under:

a. A copy of the prospectus, duly signed by every person who is named therein as a director or
a proposed director of the company must be filed with Registrar of Companies before the
prospectus is issued to the public.

b. The following document must be attached thereto:

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(i) Consent to the issue of the prospectus required under any person as an expert confirming his
written consent to the issue thereof, and that he has not withdrawn his consent as aforesaid appears
in the prospectus.

(ii) Copies of all contracts entered into with respect to the appointment of the managing director,
directors and other officers of the company must also be filed with Registrar.

(iii) If the auditor or accountant of the company has made any adjustments in the company’s
account, the said adjustments and the reasons thereof must be filed with the documents.

(iv) There must be a copy of the application which is to be filled for the issue of the company’s
shares and debentures attached with the prospectus.

(v) The prospectus must have the written consent of all the persons who have been named as
auditors, solicitors, bankers, brokers, etc.

Every prospectus must have, on the face of it, a statement that:

(i) A copy of the prospectus has been delivered to the Registrar for registration.

(ii) Specifies that any documents required to be endorsed have been delivered to the Registrar.

Contents of prospectus

The main contents of a prospectus are:

1. Main object of the company with the names, addresses, description and occupation of
signatories to the memorandum and the number of shares subscribed for by them.

2. Number and classes of shares and the nature and extent of the interest of holders thereof in
the property and profits of the company.

3. The number of redeemable preference shares intended to be issued and the date of redemption
or where no date is fixed; the period of notice required for redeeming the share s and proposed
method of redemption.

4. The number of shares. If any, fixed by the Articles as the qualification of a director and the
remuneration of the directors for the service.

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5. The names, occupation and addresses of directors, managing director and manager together
with any provision in the Articles or a contract regarding their appointment remuneration or
compensation for loss of office.

6. The time of opening of the subscription list should be given in the prospectus.

7. The amount payable on application and allotment on each share should be stated. If any
prospectus is issued within two years, the details of the shares subscribed for any allotted.

8. The particular about any option or preferential right to be given to any person to subscribe
for shares or debentures of the company.

9. The number of shares or debentures which within the two preceding year been issued for a
considerations other than cash.

10. Particulars about premium received on shares within two preceding years or to be received.

11. The amount or rate of underwriting commission.

12. Preliminary expenses.

13. The names and addresses of auditors, if any, of the company.

14. Where the shares are of more than one class, the rights of voting and rights as to capital and
dividend attached to several classes of shares.

15. If nay reserve or profits of the company have been capitalized, particulars of capitalizations
and particulars of the surplus arising from any revaluation of the assets of the company.

16. A reasonable time and place at which copies of all accounts on which the report of auditors is
based may be inspected.

Conclusion

A public company raises its capital from the public and it issues prospectus for this purpose.
Sometimes, the promoters of a company decide not to approach the public for raising necessary
capital. They are hopeful of raising funds from the friends and relations or through underwriters.
In that case a prospectus need not be issued but a Statement in Lieu of Prospectus must be filed

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with the registrar at least three days before the first allotment of shares. Such a statement must be
signed by every person who is named therein as a director or proposed director of the company.

The offer must be made to the public.

Case Law: Nash vs. Lynde (1929)

Nash V.Lynde,1929•Nash applied for certain shares in a company,British & Foreign Industrial
Limited, based on adocument sent to him by Lynde, the managingdirector of the company.

The document had been issued as a prospectus

The directors of a company prepared a document which was in the form of a prospectus and was
in marked “strictly private and confidential”. The document did not contain all the material facts
required by the Acct to be disclosed. It was circulated among the directors and their friends. The
plaintiff had purchased shares on the footing of these documents, which he obtained from a friend
of a director.

It was held that the document received by him was not a prospectus as private communication
between business friends does not constitute a prospectus.

Case Law: Re. South of England Natural Gas and Petroleum Co. Ltd (1911)

3000 copies of a prospectus headed “for private circulation only” were distributed to shareholders
of gas companies. It was not publicly advertised.

It was held that the prospectus was an offer of shares “to the public” even though it was marked
“for private circulation only”.

Re South of England Natural Gas and Petroleum Co. Ltd [1911]. A newly formed company issued
3000 copies of a document which offered for subscription shares in a company and which was
headed “for private circulation only”. These copies were then circulated to the shareholders of a
number of gas companies and the question arose, Was this a prospectus?

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The court held that the distribution of a document entitled, “For Private Circulation only” offering
the company shares was an offer to the public and the document was a prospectus. The term
offering used in the definition is used in a non-technical sense as prospectus invites offers. The
term public is not restricted to the public at large. It may include a section thereof to whom the
offer is addressed.

In the words of Viscount Summer in ‘Nash Vs Lyde(1929) Stated;“The public in the definition
is of course a general word, no particular number are prescribed. Anything from two to infinity
may serve perhaps even one if he is intended to be the first of a series of subscribers but made
further proceedings needless by himself subscribing the whole. The point is that the offer is such
as to be opened to anyone who brings hismoney and applies in due from, whether the prospectus
was addressed to him on behalf of the company or not”

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COMPANY BORROWING

Companies borrow money from a range of sources, including their directors and shareholders,
personal contacts, banks, venture capital companies, institutional investors and personal line of
credit (PLCs only) through the Stock Exchange.
There are no particular statutory requirements except that charges to secure such borrowing must
be registered at Companies House.
Many companies borrow from their directors and shareholders, either formally, perhaps granting
them a debenture, or informally, with just book-keeping records, such as a director's loan account.
Lending money or assets to the company can be an alternative to putting it in as share capital.
If a private company borrows from its bank, the bank will probably require the directors to give
personal guarantees of the debt and, depending on the amount, may want security over the
company's assets, or perhaps other property, such as second mortgages on the directors' homes.
Security over the company's assets is usually in the form of an 'all-monies' debenture, secured with
fixed and floating charges over all the company's assets. Once signed, this will cover all future
arrangements the bank makes with the company - overdraft facilities, loans for specific purposes,
etc. In most cases, the terms are for repayment on demand, and any default will allow the bank to
claim from the directors immediately on default by the company if they have given personal
guarantees.
Borrowing from venture capital companies and, sometimes, from other financial institutions, is
often part of a larger finance package involving shares and loans. A company can adopt a number
of methods to satisfy its long-term and short-term financial needs. The Short-Term Borrowing and
Long-Term Borrowing of a company are briefly explained as below.

Short- Term Methods of Borrowing

1. By arranging an Overdraft, Cash Credit or Loan from Bankers
An overdraft is an arrangement by which a company is allowed to draw more than what is to the
credit of its account at the bank.
Cash credit is an arrangement by which a company borrows from its bankers up to a certain limit
against a bond of credit by one or more securities or some other security. The company is charged
interest on the amount actually utilized and not on the limit sanctioned.

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In a loan arrangement, the full amount of the loan sanctioned is placed to the credit of the company
and the loan account of the party is debited with the full amount. The company has to pay interest
on the full amount of the loan whether it makes use of the full amount or not.
2. By issuing a Bill of Exchange, Hundi or Promissory Note
This is another method of obtaining short-term finance. Here an officer authorized by the company
draws or executes a bill of exchange, hundi or promissory note on behalf of the company, and gets
the same discounted, either with a banker or a financier.
3. By Pledging any Movable Property
Securities can be pledged by lodging them with the banker along with a blank transfer and the
relative scrips and executing in favour of the banker a document called the “Memorandum of
Charge“, giving necessary power to the Banker to complete the transfer, and to dispose of the
securities, if and when necessary.
4. By Mortgaging Immovable Property
Under this form, the securities are the lands and buildings belonging to the company. These
securities can be mortgaged in which the whole legal interest in a property is conveyed to the
mortgagee subject to the right to redeem. The mortgagee is given the power to sell the security in
case of default.
Equitable mortgage is created by deposit of the title deeds of the property with the mortgagee,
along with an undertaking to execute a legal mortgage, when called upon.

Long-Term Methods of Borrowing

1. By Charging the Uncalled Share Capital and Book Debts
This is a long-term method of obtaining finance. In this method, the company may create a charge
on its uncalled capital, if it is allowed to do so by its Articles of Association. A company, however,
is not allowed to borrow on the security of its reserve capital, as the reserve capital is not capable
of being called up, except when the company is wound up.
A company may also create a charge on its book debts. The expression “Book Debts” refers to
those debts which become due to the company in the ordinary course of its business and which are
entered in the books of the company as such.
2. By Creating a Floating Charge on the Property

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A company may borrow by giving, what is called, a floating charge on its property or assets. It is
an arrangement in which the company gives security-its assets, present as well as future. However,
the company is not prevented from dealing with such assets, as it pleases, as long as it goes on
paying the interest.
3. By the Issue of Debentures or Debenture Stock
This is the most important method of obtaining loan for a longer period. The difference between
“Debenture Stock” and “Debenture Bonds” is very much like the difference between “Stock” and
“Shares”. In case of debenture stock, each lender is given a certificate called Debenture Stock
Certificate for the amount he lends.
In most cases of borrowing a debenture is issued. A debenture is the traditional name given to a
loan agreement where the borrower is a company as explained below;

Debenture
A debenture is a type of bond or other debt instrument that is unsecured by collateral and usually
has a term greater than 10 years. Since debentures have no collateral backing, they must rely on
the creditworthiness and reputation of the issuer for support Both corporations and governments
frequently issue debentures to raise capital or funds. Debentures are backed only by the
creditworthiness and reputation of the issuer. Some debentures can convert to equity shares while
others cannot.
Similar to most bonds, debentures may pay periodic interest payments called coupon payments.
Like other types of bonds, debentures are documented in an indenture. An indenture is a legal and
binding contract between bond issuers and bondholders. The contract specifies features of a debt
offering, such as the maturity date, the timing of interest or coupon payments, the method of
interest calculation, and other features. Corporations and governments can issue debentures.
Governments typically issue long-term bonds, those with maturities of longer than 10 years.
Considered low-risk investments, these government bonds have the backing of the government
issuer.
Corporations also use debentures as long-term loans. However, the debentures of corporations are
unsecured.1 Instead, they have the backing of only the financial viability and creditworthiness of
the underlying company. These debt instruments pay an interest rate and are redeemable or
repayable on a fixed date. A company typically makes these scheduled debt interest payments

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before they pay stock dividends to shareholders. Debentures are advantageous for companies since
they carry lower interest rates and longer repayment dates as compared to other types of loans and
debt instruments. Debentures may either be convertible or non-convertible into common stock.
Convertible
Convertible debentures are bonds that can convert into equity shares of the issuing corporation
after a specific period. Convertible debentures are hybrid financial products with the benefits of
both debt and equity. Companies use debentures as fixed-rate loans and pay fixed interest
payments. However, the holders of the debenture have the option of holding the loan until maturity
and receive the interest payments or convert the loan into equity shares.
Convertible debentures are attractive to investors that want to convert to equity if they believe the
company's stock will rise in the long term. However, the ability to convert to equity comes at a
price since convertible debentures pay a lower interest rate compared to other fixed-rate
investments.
Nonconvertible
Nonconvertible debentures are traditional debentures that cannot be converted into equity of the
issuing corporation. To compensate for the lack of convertibility investors are rewarded with a
higher interest rate when compared to convertible debentures.
Features of a Debenture
When issuing a debenture, first a trust indenture must be drafted, which is an agreement between
the issuing entity and the entity that manages the interests of the bondholders. The first trust is an
agreement between the issuing corporation and the trustee that manages the interest of the
investors. All debentures follow a standard structuring process and have common features. The
three main features of a debenture are the interest rate, the credit rating and the maturity date.
Interest Rate
The coupon rate is determined, which is the rate of interest that the company will pay the debenture
holder or investor. This coupon rate can be either fixed or floating. A floating rate might be tied to
a benchmark such as the yield of the 10-year Treasury bond and will change as the benchmark
changes.
Credit Rating
The company's credit rating and ultimately the debenture's credit rating impacts the interest rate
that investors will receive. Credit-rating agencies measure the creditworthiness of corporate and

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government issues. These entities provide investors with an overview of the risks involved in
investing in debt.
Credit rating agencies, such as Standard and Poor's, typically assign letter grades indicating the
underlying creditworthiness. The Standard & Poor’s system uses a scale that ranges from AAA
for excellent rating to the lowest rating of C and D. Any debt instrument receiving a rating of lower
than a BB is said to be of speculative grade. You may also hear these called junk bonds. It boils
down to the underlying issuer being more likely to default on the debt.
Maturity Date
For nonconvertible debentures, mentioned above, the date of maturity is also an important feature.
This date dictates when the company must pay back the debenture holders. The company has
options on the form the repayment will take. Most often, it is as redemption from the capital, where
the issuer pays a lump sum amount on the maturity of the debt. Alternatively, the payment may
use a redemption reserve, where the company pays specific amounts each year until full repayment
at the date of maturity.

Pros and Cons of Debentures

Pros
• A debenture pays a regular interest rate or coupon rate return to investors.
• Convertible debentures can be converted to equity shares after a specified period, making
them more appealing to investors.
• In the event of a corporation's bankruptcy, the debenture is paid before common stock
shareholders.

Cons
• Fixed-rate debentures may have interest rate risk exposure in environments where the
market interest rate is rising.
• Creditworthiness is important when considering the chance of default risk from the
underlying issuer's financial viability.
• Debentures may have inflationary risk if the coupon paid does not keep up with the rate of
inflation.
• Debenture Risks to Investors

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 • Debenture holders may face inflationary risk.
• Here, the risk is that the debt's interest rate paid may not keep up with the rate of inflation.
Inflation measures economy-based price increases. As an example, say inflation causes
prices to increase by 3%, should the debenture coupon pay at 2%, the holders may see a
net loss, in real terms.
• Debentures also carry interest rate risk. In this risk scenario, investors hold fixed-rate debts
during times of rising market interest rates. These investors may find their debt returning
less than what is available from other investments paying the current, higher, market rate.
If this happens, the debenture holder earns a lower yield in comparison.

• Further, debentures may carry credit risk and default risk. As stated earlier, debentures are
only as secure as the underlying issuer's financial strength. If the company struggles
financially due to internal or macroeconomic factors, investors are at risk of default on the
debenture. As some consolation, a debenture holder would be repaid before common stock
shareholders in the event of bankruptcy.

Difference between a Debenture and a Bond

A debenture is a type of bond. In particular, it is an unsecured or non-collateralized debt issued by
a firm or other entity and usually refers to such bonds with longer maturities.

Risk of debentures
Because debentures are debt securities, they tend to be less risky than investing in the same
company's common stock or preferred shares. Debenture holders would also be considered more
senior and take priority over those other types of investments in the case of bankruptcy.
Because these debts are not backed by any collateral, however, they are inherently riskier than
secured debts. Therefore, these may carry relatively higher interest rates than otherwise similar
bonds from the same issuer that are backed by collateral.
In fact, strictly speaking, a government Treasury bond and Treasury bill are both debentures. They
are not secured by collateral, yet they are considered risk-free securities.

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REFERENCES
1. Bakibinga Pp 87-99; 132 -152; Kiapi pp 40–53;
2. Regulation of Debentures Issue By: G.P Sahi, General Counsel,
http://www.legalserviceindia.com/articles/debentures.htm
3. Companies (Share Capital and Debenture ) Amendment Rules, 2019 By Devika Sharma

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