Benefits of Issuing Debentures Rather than Shares
Companies raising capital to raise funds in order to expand are at liberty to opt for shares or debentures. While both can raise the needed capital, oftentimes debentures offer more benefits compared to shares, especially to businesses that require maintaining tight control and want to maintain costs.
In this article, we have discussed a few reasons why issuing debentures is always preferred over issuing shares by corporations.
1. Maintaining Ownership and Control
One of the major reasons debentures may be preferred over shares is that they offer the company access to funds without diluting ownership interest. When shares are issued, it implies every new shareholder is to be given voting rights and a degree of control over corporate decisions. This might lead to the dilution of original owners’ or the management control especially when large numbers of shares have to be issued.
However, debenture holders are not allowed any equity and voting rights in the company. It is rather an obligation wherein the creditors are entitled to a periodic payment of interest along with return of their principal amount at maturity. Thus, the original shareholders retain all control over decisions of the corporation with the original intention of maintaining the strategic direction and management structure of the company.
2. Fixed Interest Payments Lead to Predictable Financial Planning
Debentures are normally issued with a fixed rate of interest. This way, companies can figure out, with relative certainty, how much they will pay in interest. Unlike dividends on shares, which may change or are even dependent on the profitability of a company, debenture interest is strictly constant. This is a definite advantage for companies requiring predictability and curving expenses, more so in planning long-term projects or growth initiatives.
Cost predictability also helps in maintaining cash flow stability and prevents unwarranted disbursement on expenses. For companies operating in industries where revenue would fluctuate but have boundless cash flows from operational activities, the secured fixed obligations associated with debentures are more manageable and advantageous.
3. Tax Advantages on Interest Payments
Interest on debentures issued by companies is generally tax-deductible to the issuer, which lowers the cost in tax terms. Thus, this tax benefit is equally important as it makes the expense of borrowing to the company relatively lower. For example, while a company issues its debentures at 6%, its actual cost could be substantially lower after proper deductions of taxes imposed on the company’s tax rate.
Unlike this, dividends paid on shares is not tax-deductible and issuance of shares turns out to be a costlier proposition when viewed in terms of tax. By controlling expenses as efficiently as possible, companies would benefit immensely due to the tax advantage that debentures have.
4. Limited Impact on Earnings Per Share (EPS)
As debentures are debt, issuance of debentures does not alter the number of shares outstanding or EPS (Earnings Per Share) for the company. More share issuance from a company increases the outstanding shares in circulation. This, consequently results in dilution of EPS and also the overall value of the exiting stakeholders’ shares. Lowered EPS can also have a market drag on the company, especially on companies that trade on the open market, as EPS is one of the most vital metrics under which investors analyze a firm.
Since the company issues debentures rather than shares, it avoids diluted EPS and maintains the value of its shares. Thus, debentures will always be a preferable option for those companies who would like to preserve shareholder returns and not lose out on their market reputation.
5. Flexibility and Redemption Options
The terms of debentures redemption are always flexible and even allow the redemption before the term matures or the debentures can be converted into shares. In most cases, this gets tailored to the cash flows of the company. Companies get to decide the maturity period along with other details of the debentures that might align with their financial plans perceived and that they might not be able to do so in shares.
Conclusion
Companies can benefit from issuing debentures because it gives the scope to retain control, provides a predictable financial obligation, tax benefits, minimal impact on EPS, and can return freely. All such benefits thus make debentures a very attractive issuance for companies seeking funds without losing equity or even control over business operations. Though both debentures and shares have their applications in corporate finance, debentures can function particularly well for companies that are keen on stability and long-term growth.