Debenture Redemption Reserve

From CEOpedia | Management online

Debenture Redemption Reserve is a kind of sinking fund which is created by enterprises in order to redeem the issued bonds. Bonds may be redeemed after a specified number of years or after a specified period of time from their issue in connection with the giving of a specified notice or an annual draw of lots[1].

The corresponding amount must be added to this profit reserve each year until such bonds are redeemed. The amount allocated to the redemption reserve will not be used by the company to redeem the bonds. In some cases, debt scripts may be redeemed with a premium. In such a case, the allocation of funds to the fund should be sufficient to pay both the amount of debentures and redemption premium. In the absence of a sinking fund, a provision should be made for the premium payable at maturity of the bonds[2].

Each time a debenture is redeemed, at least 50% of the debenture issue amount must be credited to the debenture redemption reserve account[3].

Duration of Debenture Redemption Reserve

Debenture Redemption Reserve should be created before the redemption begins. If the bonds are issued to finance a project, a bond redemption reserve may be created up to the date of commercial production in equal instalments or at a higher amount if profits permit. In the case of convertible issues by companies, the creation of Debenture Redemption Reserve will begin from the year in which the company makes profits for the remaining useful life of the bonds[4].

Debenture Redemption Reserve's mandatory

There can be a few cases where Debenture Redemption Reserve will not me mandatory. It can occur when[5][6]:

  1. Debentures have a maturity period of 18 months of less
  2. Debentures are fully convertible
  3. Debentures are issued by AllIndia Financial Institutions regulated by RBI
  4. Debentures are issued by Banking Companies
  5. Debentures are issued by NBFCs registered with RBI on private placement basis
  6. They are for infrastructure companies (i.e. companies working in the business of developing, maintaining and operating infrastructure)

Examples of Debenture Redemption Reserve

  • A company issues debentures to raise funds for its expansion and sets aside a portion of its profits in the Debenture Redemption Reserve account. Each year, the company uses the money from this account to buy back the debentures on the open market or to redeem them through a draw of lots.
  • An infrastructure company issues debentures to raise funds for its construction projects and sets aside a portion of its profits in the Debenture Redemption Reserve account. The company uses the money from this account to buy back the debentures on the open market or to redeem them through a draw of lots.
  • A manufacturing company issues debentures to raise funds for its production and sets aside a portion of its profits in the Debenture Redemption Reserve account. The company uses the money from this account to buy back the debentures on the open market or to redeem them through a draw of lots.

Advantages of Debenture Redemption Reserve

Debenture Redemption Reserve is an essential tool for the companies to fulfill their obligations towards the bond holders. It helps in ensuring that the company has the financial resources to redeem the bonds at the time of maturity. Some of the key advantages of Debenture Redemption Reserve are as follows:

  • It helps in creating a sense of security among the bond holders as they know that the company has enough resources to redeem the bonds at the time of maturity.
  • It also helps in maintaining the liquidity of the company as the Debenture Redemption Reserve is created out of the profits earned by the company.
  • It helps in avoiding any default on the part of the company and thus helps in maintaining a good credit rating.
  • It also helps in reducing the financial burden on the company as it reduces the need for the company to borrow funds for redeeming the bonds.
  • It also helps in increasing the investor confidence in the company and thus helps in attracting more investors.

Limitations of Debenture Redemption Reserve

Debenture Redemption Reserve is a sinking fund created by enterprises to redeem the issued bonds. However, there are certain limitations associated with the use of such reserve funds, including:

  • Insufficient funds: The Debenture Redemption Reserve may not have enough funds to meet the redemption commitments of all issued bonds. In such cases, companies may need to look for alternative sources to finance the redemption.
  • Limited Flexibility: Once the Debenture Redemption Reserve is established, it cannot be used for other purposes. This limits the company’s ability to use the funds for other activities that may help the company in terms of growth and sustainability.
  • Market Risk: The Debenture Redemption Reserve is subject to market risk if the investments made by the company to maintain the reserve are not performing well. This may result in insufficient funds to meet the redemption commitments.
  • Administrative Cost: Companies need to bear administrative cost in order to maintain and manage the Debenture Redemption Reserve. This cost could be significant and could have an impact on the company’s profitability.

Other approaches related to Debenture Redemption Reserve

  • One approach to Debenture Redemption Reserve is to set aside a fixed amount of money each year in order to redeem the bonds. This is done by allocating a portion of the profits and setting it aside as the Debenture Redemption Reserve.
  • Another approach is to use sinking funds, which are collections of investments, such as government bonds, stocks, and other securities, that generate income to be used for debt repayment.
  • Another approach is to use market premium, which is the amount above the face value of the bond that is paid upon redemption.
  • A fourth approach is to use a combination of the above approaches, such as setting aside a portion of the profits and investing the remainder in sinking funds and/or market premiums.

In summary, Debenture Redemption Reserve can be created through a fixed annual allocation of profits, the use of sinking funds, the use of market premiums, or a combination of the three.

Footnotes

  1. ↑ Asish K (2018)
  2. ↑ Asish K (2018)
  3. ↑ Tulisian C.P (2007)
  4. ↑ Tulisian C.P (2007)
  5. ↑ Tulisian C.P (2007)
  6. ↑ Tulisian C.P, Tulisian B (2017)


Debenture Redemption Reserve — recommended articles
Reserve capital — Non current liability — Capital Base — External sources of finance — Contributed Surplus — Patronage Dividend — Sinkable bond — Creation of money — Capital buffer

References

Author: Angelika Załęska

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