Module 3: Debt Instruments

Debt instruments are the instruments used by the companies to provide finance (short term as
well as long term) for their growth, investments and future planning and comes with an
agreement to repay the same within the stipulated time period. Long-term instruments include
debentures, bonds, long-term loans from the financial institutions, GDRs from foreign investors.
Short-term instruments include working capital loans, short-term loans from financial
instruments.

Types of Debt Instruments: There are two types of debts instruments, which are as follows:

1. Long-term
2. Medium & Short-term

1 – Long-Term Debt Instruments

The company uses these instruments for its growth, heavy investments, and future planning.
These are those instruments which generally have a period of financing of more than 5 years.
These instruments have a charge on the company’s assets and also bear an interest paid
regularly.

#1 – Debentures: A debenture is the most used and most accepted source of long-term
financing by a company. These carry a fixed Interest Rate on the finance raised by the company
through this mode of the debt instrument. These are raised for a minimum period of 5 years.
Debenture forms part of the capital structure of the company but is not clubbed
with calculating share capital in the balance sheet.

#2 – Bonds:- Bonds are just like debentures, but the main difference is that bonds are used by
the government, central bank & large companies, and also these are backed by securities,
which means these have a charge over the company’s assets. These also have a fixed interest
rate, and the minimum period is also at least 5 years.

#3 – Long-Term Loans:- It is another method that is used by companies to get loans from
banks, financial institutions. It is not as much a favorable option method of financing as the
companies have to mortgage their assets to banks or financial institutions. And also, the
Interest rates are too high as compared to Debentures.

#4 – Mortgage:- Under this option, the company can raise funds by mortgaging its assets with
anyone either from other companies, individuals, banks, or financial institutions. These have a
higher rate of interest in funding the companies. The interest of the party providing funds is
secured as they have a charge over the asset being mortgaged.
 Medium & Short-Term Debt Instruments

These are those instruments which are generally used by the companies for their day to day
activities and working capital requirements of the companies. The period of financing in this
case of Instruments is generally less than 2-5 years. They don’t have any charge over the
companies assets and also don’t have a high-interest liability on the companies. Examples are
as follows:-

#1 – Working Capital Loans: Working capital loans are the loans that are used by the
companies for their day to day activities like clearing of creditors outstanding, payment for the
rent of the premises, purchase of raw material, repairs of machinery. These have interest
charges on the monthly limit used by the company during the month from the limit allowed by
financial institutions.

#2 – Short-Term Loans: Banks and financial institutions also finance these, but they do not
charge interest monthly; they have a fixed rate of interest, but the period for funds transferred
is for less than 5 years.

#3 – Treasury Bills: Treasury Bills are short-term debt instruments that mature within 12
months. They are redeemed at the maturity in full, and if sold before maturity, then they can be
sold at a discounted price. The interest on these T-bills is covered in the issue price as they are
issued at a premium and redeemed at par value.

Advantages

1. Tax Benefit for Interest Paid:- In debt financing, the companies get the benefit of interest
deduction from the profit before calculation of tax liability.
2. Ownership of Company:- One of the major advantages of debt financing is that the company
does not lose its ownership to the new shareholders as the debenture does not form part of the
share capital.
3. Flexibility in Raising Funds:- Funds can be raised from debts instruments more easily as
compared to equity funding as there is a fixed rate of interest payment to the debt holder at
regular intervals
4. Easier Planning for Cashflows:- The companies know the payment schedule of the funds raised
from debt instruments such as there is an annual payment of interest and a fixed time period
for redemption of these instruments, which helps companies to plan well in advance regarding
their cash flow/funds flow status.
5. Periodic Meetings of Companies:- The companies raising funds from such instruments are not
required to send notices, mails to debt holders for the regular meetings, as in the case of equity
holders. Only those meetings which affect the interest of the debt holders would be sent to
them.
 Disadvantages

1. Repayment:- They come with a repayment tag on them. Once funds are raised from debt
instruments, these are to be repaid on their maturity.
2. Interest Burden:- This instrument carries an interest payment at a regular interval, which needs
to be met for which the company needs to maintain sufficient cash flow. Interest payment
reduces the company profit by a significant amount.
3. Cashflow Requirement:- The company needs to pay interest as well as the principal amount for
the company to keep the cash flows for making these payments well in time.
4. Debt-Equity Ratio:- The companies having a larger debt-equity Ratio are considered risky by
the lenders and investors. It should be used up to such an amount, which does not fall below
that risky debt financing.
5. Charge Over the Assets:- It has a charge over the companies assets, many of which require the
company to pledge/mortgage their assets in order to keep their interest/funds safe for
redemption.