As bonus debentures are issued from accumulated profits of the company, they have no impact on the reported profits.
As an equity investor you may also be entitled to regular interest payments. Wondering how? Welcome to the concept of bonus debentures.
Companies usually reward shareholders by sharing a portion of the profits with them.
Cash dividends or bonus share issues are widely used as rewards. While dividend payments mean cash receipt for investors, bonus issues usually mean free shares credited to your demat account. Like bonus shares, companies have the option to issue bonus debentures to shareholders too. Hindustan Unilever was the first company to issue them in 2001.
HOW IT WORKS
Bonus debentures are issued out of the accumulated profits of the company (reserves and surplus). Just like free shares are credited to you when a company makes a bonus share issue, free debentures are credited to you when it makes a bonus debenture issue. Investors holding shares of the issuing company on the record date will be allotted bonus debentures. As an investor holding the bonus debentures, you are eligible to receive interest payments, similar to other debt instruments, until the maturity of the instrument. On maturity, you are entitled to receive the principal amount (face value).
Even if you sell all the shares of the issuing company prior to the maturity, you will still continue to receive interest payments regularly and principal amount on maturity of these debentures. Companies may choose to get the debentures listed in the stock exchanges. In such cases, you can cash-in by selling the debentures through the exchanges even before they mature.
To understand this better, let us consider the bonus debenture proposal by Dr Reddy’s Labs.
For every 1,000 shares of Dr Reddy's held by the investor in March 2011, the company allotted 6,000 bonus debentures with a face value of Rs 5, carrying an interest rate of 9.25 per cent. The debentures are redeemable at the end of the third year (i.e. March 2014). The interest payment works out to Rs 2,775. On maturity, an investor holding 1,000 shares will receive the principal amount of Rs 30,000.
Adding up the interest and principal payment works out to a per share benefit of Rs 38.3.
WHY COMPANIES PREFER THEM
Issuing a bonus debenture is indeed a beneficial proposition for the company. As these debentures are issued from the accumulated profits of the company, there is no impact on the reported profits on account of this.
But, the annual interest payments are adjusted against the company’s profits. Hence, the company’s profits will be lower to that extent.
While dividend payments entail full cash outflow in the same year for the company, the immediate cash outgo in the case of bonus debentures is limited to the current year’s interest payment. The principal, which is the bigger chunk, is paid only at the time of redemption. This ensures availability of funds in the interim period to meet funding requirement for expansion or day-to-day business needs.
Further, as the principal is charged to the company’s reserves, it improves the return on equity.
This is in contrast to a bonus share which expands the equity base for the company and leads to dilution in earnings per share for the issuing company.
The other important advantage for the company is that interest payments made to investors are tax deductible. Hence, the company can save on tax outgo to the extent of interest payment made in a given period.
However, there are some disadvantages for the issuing company too. The bonus debenture issue is subject to statutory approval from various regulatory bodies.
For instance, in addition to the approval by the board of directors, the proposal will also have to be approved by the shareholders, High Court and the Reserve Bank of India.
The concept of bonus debenture is still evolving and is yet to gain ground among Indian companies. However, companies such as Coromandel International, Dr Reddy's Laboratories, and Britannia Industries have tasted success in their attempts in recent times.
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