Debentures: Background
Debentures are debt instruments. They are paid interest during the tenure and at the end of the tenure, they must be repaid. Like any debt instrument, the only risk which a debenture holder is exposed to is the default risk. Debenture holders are not the owners of the company and hence do not enjoy any management privileges which an equity shareholder enjoys. Debenture holders do not take any risk which an equity shareholder takes. Consequently, the return expectation of the debenture holder is less than the return expectation of the equity shareholders.
Hence, the postulate – Privileges, risks and consequently the Value of Debenture (“Vd”) issued by an entity is less than Value of the Equity (“Ve”) of that entity.
Debentures: Type
Debentures, being a debt instrument, have to be repaid (redeemed) at the end of the tenure. Such debentures that get repaid but not converted, are called Redeemable Debentures or Non-Convertible Debentures.
Alternatively, it might be agreed between the investor and the investee that instead of redeeming the debenture, the investee will issue a new alternate instrument. When this is done, the debenture, on retirement, is not redeemed but gets converted into a new instrument issued by the investee. Such debentures are termed as Irredeemable Debentures or Convertible Debentures.
Having understood the types of Debentures, let us see how debentures are valued.
1. Valuation of Non-Convertible Debentures
Non-Convertible Debentures (“NCD”) are pure debt instruments. Like any debt instrument, NCDs can be valued by discounting the cash flows associated with NCDs at the appropriate discount rate.
Cash Flows:
Cash flows associated with NCDs are,
- Periodical returns during the tenure of the NCD; and
- Repayment of principal on retirement of the
Periodical returns in the case of NCDs would be interest receivable on the NCDs upto the date of redemption. While identifying the periodical interest, care should be taken to ensure that the frequency of interest payment (monthly, quarterly, half yearly, annually) is considered.
On retirement NCDs are paid in full. In certain cases, in addition to the repayment of the principal, certain premium would also be paid. Such premium should also be considered for the purpose of valuation. (Zero Coupon Bonds are an example of NCDs, which do not carry any interest receipts. However, to compensate the non-payment of interests, such bonds are retired / redeemed at a high premium)
Appropriate Discount rate
The rate to be used for discounting should be the returns’ expectation rate of the investors from similar instruments. The investor’s expectations are reflected in Yield to Maturity (“YTM”) of comparable debt instruments. Comparable Debt Instrument is one, which,
- carries the same annualized coupon rate as that of the debt instrument being valued;
- has the same unexpired tenor as that of the debt instrument being valued and
- has the same default risk as that of the Company issuing the debt instrument being
While comparing the coupon rates, care should be taken to ensure that the coupon rates are comparable. Coupon Rates would be incomparable if the frequency of coupon payments is different. In such cases to ensure comparability, the stated annual coupon rates should be converted into Effective Annual Rates (“EAR”) by using the formula,
EAR = (1+ r ÷ f )f -1
where,
r = Stated Annual Coupon Rate
f = Frequency of Coupon payments in a year
For instance, if an instrument carries a coupon rate of 4% and has coupon payments semi-annually, EAR would be 4.04% i.e.., (1+ 0.04 ÷ 2)2 -1.
Unexpired Tenor
Unexpired Tenor refers to the period upto the date of redemption / retirement of the instrument which can be computed by using the formula,
UxTDays = (DoR – DoV + 1)
UxTMonths = (DoR – DoV + 1) ÷ 30
UxTYears = (DoR – DoV + 1) ÷ 365
where,
UxTDays = Unexpired Tenor expressed in days
UxTMonths = Unexpired Tenor expressed in months
UxTYears = Unexpired Tenor expressed in years
DoR = Date of Redemption / Retirement
DoV = Date of Valuation
For instance, if an instrument issued on 01/Jan/2021 due for redemption on 31/Dec/2030 has to be valued on 01/Apr/2022,
UxTDays = (31/Dec/2030 – 01/Apr/2022 + 1) = 3197 days
UxTMonths = (31/Dec/2030 – 01/Apr/2022 + 1) ÷ 30 = 106.57 Months
UxTYears = (31/Dec/2030 – 01/Apr/2022 + 1) ÷ 365 = 8.76 Years
Like how 𝛽 is the measure of non-diversifiable risk in the case of equities, credit rating issued by independent rating agencies can be used as a proxy for representing the default risk of the company issuing the NCDs. In case credit rating from an independent rating agency for the company issuing the NCD is not available, credit rating can be imputed by considering the profitability, debt equity ratio, interest coverage ratio, etc. of the company issuing the NCD.
Where it is not possible to obtain / impute the credit rating, YTM can be derived based on the guideline / clarification issued by the Fixed Income Money Market and Derivatives Association of India (FIMMDA) (Para C of FIMMDA Circular numbered FIMCIR/2019-20/35 dated March 31, 2020) for valuing bonds, debentures and preference shares which are not rated by a rating agency as follows:
- Obtain the YTM on the valuation date of a corporate debt instrument having the rating equivalent to “BBB-“and which carries the same annualized coupon rate as that of the NCD and has the same unexpired tenor as that of the NCD;
- Deduct the Risk Free Rate of Return on the valuation date from the above YTM to arrive at the default spread;
- Add 25% premium to the above default spread to arrive at the adjusted default spread;
- Add the Risk Free Rate of Return on the valuation date to the adjusted default spread to arrive at the discount rate.
2. Valuation of Convertible Debentures
While speaking of Convertible Debentures, the most prevalent instrument issued in lieu of a convertible debenture is a new equity instrument. Having said that, there is no requirement, regulatory or customary, that only equity shares must be issued on conversion of Convertible Debentures. There are also instances where preference shares or new debentures are issued in lieu of a convertible debenture. Since, such instances are exceptions rather than a rule, for the purpose of this discussion, Convertible Debentures unless otherwise specified, refer to debt instruments which are retired by issuing fresh equity shares.
Convertible Debentures: Types
Convertible Debentures are of two types – Compulsorily Convertible Debentures (“CCD”) and Optionally Convertibles Debentures (“OCD”). As the name itself suggests, if the terms of the debenture specify that the debenture will be converted into equity without any choice; but out of compulsion, they are CCDs, else OCDs. The terms of the OCD specify the party who holds the right of deciding about the conversion, which can either be the investor or the investee. Depending upon the party having the exercise rights, OCDs would be Debt Instruments with Call Option or Debt Instruments with Put Option. Irrespective of who holds the option of conversion, the conversion option might be exercisable at any time before maturity or at the time of maturity. Depending upon timing of the right to exercise the option, OCDs might be American Options or European Options. Following table summarises the type of OCDs:
Table: Type of OCDs
|
Right of conversion available with Right of conversion exercisable |
Investee [Put] | Investor [Call] |
| Any time upto the date of maturity [American] | American Put OCD | American Call OCD |
| At the time of Maturity [European] | European Put OCD | European Call OCD |
Whatever might be the type of option, OCDs are derivatives deriving a part of their value from the value of the underlying instrument. It goes without saying that in case the option is not exercised upto the date of maturity, the OCD will become NCDs. OCDs can be valued using Binomial Model, Option Pricing Model, Black-Scholes Model, or any other model for valuing derivatives. For now, we will move on to CCDs.
Like any other asset, the value of CCDs would be the present value of future cash flows consisting of,
- Periodical interest income and
- Terminal
For discounting the periodical interest income, the approach discussed for NCDs can be applied mutatis mutandis.
As discussed earlier, discounted Terminal Value in case of NCDs would be amount receivable on redemption, discounted at the appropriate discount rate. However, in case of CCDs, the discounted Terminal Value would be the value of equity at the date of conversion, discounted to the date of valuation, at the appropriate discount date.
For computing the value of equity on the date of conversion using the DCF method following points should be kept in mind:
- The projected cash flows should not consider the interest payments on the CCDs.
- While arriving at the price per share on the conversion date, the Equity Value on the conversion date would have to be divided by number of equity shares outstanding on a fully diluted basis on the conversion date including the number of equities to be allotted for converting the CCDs.
- In case WACC is used for computing the present value of equity on the conversion date, CCDs should be considered as being part of equity and accordingly weights should be assigned.
Ve as a demi-proxy for Convertible Debentures’ Value
Since Convertible Debentures (OCDs as well as CCDs) embody the features of both equity and debt, there have and will always be doubts about what exactly are Convertible Debentures. An attempt to classify them either as an equity or as a debt would be akin to the blind friends of John (It was six men of Indostan | To learning much inclined, who went to see the Elephant (Though all of them were blind) that each by observation| Might satisfy his mind – John Godfrey Saxe). We will never be able to arrive at a consensus because, convertibles are neither cocoons nor butterflies but embody the features both at different times.
Having said that, Convertible Debentures are neither equity pedigrees nor pure debts, but both. They remain a debt instruments upto the date of conversion. Hence, upto the date of conversion, Convertible Debentures carry default risk and from the date of conversion, equity risk i.e.,
VCD = Vd upto the date of conversion + Ve beyond the date of conversion
On the basis of the principle enunciated in the earlier postulate (Privileges, risks and consequently the Value of Debenture (“Vd”) issued by an entity is less than Value of the Equity (“Ve”) of that entity), we know that Ve is always greater than Vd. Since Convertible Debentures are debts for some part of their life, we can safely conclude that as on the on the date of valuation, VCD will always be less than the Ve.
Valuation of Convertible Debentures is relatively tougher than Valuation of Equity because of the lack of sufficient market data about debt instruments considering the shallow nature of the debt instruments’ market in India.
Considering the above conclusion and the ease of valuation, one can explore using value of equity as a demi-proxy for Convertible Debentures’ value. Under this demi-proxy approach, instead of computing the value of Convertible Debenture, value per fully-diluted equity share is computed by making the following additional adjustments:
- Capital representing Convertible Debenture is considered as forming part of equity;
- Tax shield on interest payment upto the date of conversion is additionally considered;
- While arriving at the value per equity share, number of shares is considered on a fully diluted
After computing the value per fully-diluted equity share, it is concluded that the value of the Convertible Debenture would be lower than computed value.
This demi-proxy approach is particularly useful in cases where the requirement is to arrive at the minimum value of the Convertible Debentures rather than the exact value of Convertible Debentures. In the Indian regulatory scenario, following are instances where Regulator is concerned with the minimum value rather than the exact value:
1. Valuation requirement under section 62(1)(c) of the Companies Act, 2013 where the Regulator requires knowing the minimum value at which an instrument can be issued on preferential basis; (Literal interpretation of 62(1)(c) of Companies Act, 2013 hints an exact valuation requirement. However, the intention of the said statute seems to be to prevent allotment of instruments to new shareholders at less than the fair market value and not to prohibit companies from allotment of instruments to new shareholders at a price higher than the fair market value.)
2. Valuation requirement under Rule 21(2)(a) of FEMA (Non-Debt Instruments) Rule, 2019 where the Regulator requires knowing the minimum value at which an equity instrument can be issued to a person resident outside India;
3. Valuation requirement under Rule 21(2)(b) of FEMA (Non-Debt Instruments) Rule, 2019 where the Regulator requires knowing the minimum value at which an equity instrument can be transferred by a person resident in India to a person resident outside
4. Valuation requirement under Rule 11UA(1)(c)(c) of Income Tax Rules, 1962 where the Regulator requires knowing the minimum value at which an unquoted non-equity security can be received by a person.
In the above cases, it would suffice if the value of equity on fully diluted basis is computed with an appropriate disclosure that since the computed value would be higher than the Convertible Debenture Value, allotment / transfer of the Convertible Debenture at the computed value would be above the fair market value of the Convertible Debenture.
The demi-proxy approach would not be suitable to answer the Regulators in cases where the allotment / transfer of the Convertible Debentures is below the equity value on a fully-diluted basis. The demi-proxy approach is also not suitable for 21(2)(c) FEMA (Non-Debt Instruments) Rule, 2019.
Having said that, the demi-proxy approach might be very handy since majority of current valuation assignments require the valuers to justify the lower threshold.
Conclusion: Debentures serve as vital financial instruments for both companies and investors. Understanding their types and valuation methods is crucial for making informed investment decisions and ensuring regulatory compliance. Whether assessing the value of non-convertible debentures based on cash flows or employing the demi-proxy approach for convertible debentures, investors and financial analysts must carefully evaluate the unique characteristics of these instruments. By gaining insights into debentures’ intricacies, stakeholders can navigate the financial markets with confidence and precision.
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