Business Finance · Structure and methods of financing a company

Debt Financing: Bonds, Loans and Debentures Explained

Updated 11 October 2026 · Fact-checked

Debt financing means a company raises money by borrowing, promising to pay interest and repay the capital on fixed terms. Main forms are bank loans, bonds, debentures and convertibles. To answer exam questions, identify the instrument, its security, cost, risk to lender and company, and any covenants.

Understand Debt Financing: Bonds, Loans and Debentures

A company needs long-term money. It can sell shares or it can borrow. Borrowing is debt finance or loan capital. The lender is a creditor, not an owner. The company must pay interest and repay the principal on agreed dates, whether or not it makes a profit.

Debt can be a bank loan from one lender, or a bond sold to many investors. Bonds often trade in a market. In UK-style syllabus language, debentures are loan stock secured on company assets, and unsecured loan stock has no such security. In India, the word debenture is used more loosely, so read the question and say what you assume. The key difference is security, not the name.

Secured debt gives the lender a fixed charge on a specific asset, such as a building, or a floating charge over a changing pool of assets, such as stock. If the company defaults, the lender can enforce the charge. Secured debt is safer for the lender, so it usually carries a lower interest rate. Unsecured debt ranks behind secured creditors on liquidation, so lenders ask for a higher return. Debt ranks ahead of shareholders on winding up.

A convertible bond gives the holder the right, not the obligation, to exchange the bond for ordinary shares on set terms. The holder gets the safety of debt now and a share in upside later. So the coupon is usually lower than on a plain bond. The company risks dilution of existing shareholders if conversion happens.

Lenders protect themselves with covenants. These are promises in the loan agreement. Positive covenants say what the company must do, such as supplying accounts. Negative covenants limit actions, such as extra borrowing, asset sales or dividends above a cap. Breach can make the debt repayable at once. Lenders may also require a sinking fund to build up repayment money.

Debt has advantages. Interest is usually tax-deductible, it is often cheaper than equity, and it does not dilute control. Its risks are fixed payments, higher gearing, covenant limits, refinancing risk at maturity and possible insolvency. Floating-rate debt adds interest rate risk to the company; fixed-rate debt exposes it to opportunity cost if rates fall.

Key rules to remember

Gearing (debt-to-equity): Gearing = Debt ÷ Equity; Another common form is Debt ÷ (Debt + Equity). State which one you use.
Interest cover: Interest cover = Profit before interest and tax ÷ Interest expense; A low value means the company may struggle to meet interest. Lenders often set a minimum in covenants.
Value of a bond: Price = Σ C ÷ (1 + i)^t + R ÷ (1 + i)^n; C is the coupon, R the redemption payment, n the number of periods, i the yield per period.
Conversion ratio: Conversion ratio = Nominal value of bond ÷ Conversion price; This gives the number of shares received per bond.
Conversion value: Conversion value = Conversion ratio × Current share price; Assuming no arbitrage, a convertible's value is at least the greater of its conversion value and its straight bond value.
Post-tax cost of debt (approximate): Kd after tax = Kd × (1 − tax rate); Applies when interest is fully tax-deductible and the company pays tax.

How to solve Debt Financing: Bonds, Loans and Debentures questions

Use this order for most written and MCQ questions on debt finance.

1Identify the instrument: bank loan, bond, debenture, unsecured loan stock or convertible.
2Note the security: fixed charge, floating charge or none. This sets the lender's ranking and the likely interest rate.
3List the cash flows: coupon, interest, redemption date and amount, and any conversion terms.
4If a number is asked, discount the cash flows at the stated yield, or compute the ratio using the exact definition given.
5Discuss risks for both sides: the company (gearing, default, refinancing, covenants, dilution) and the lender (default, inflation, interest rate risk).
6Check the covenants: say which are positive or negative and how they protect the lender.
7State the tax effect and your assumptions, then give a clear conclusion.

Quickest way: Fast debt question routine

When to use it: Use for MCQs and short written parts where you have two to four minutes.

Ask: secured or unsecured? Secured means lower risk, lower rate.
Ask: does the holder have an option? If yes, it is convertible, so lower coupon.
For a calculation, write coupon and redemption on a timeline and discount once.
For a convertible, compute conversion value and compare it with the redemption or straight bond value.
For covenants, tag each as positive or negative and give its purpose in one line.

Common mistakes in Debt Financing: Bonds, Loans and Debentures

Saying debentures are always unsecured.
Indian usage of the word is loose, and some students mix it with unsecured loan stock.
Fix: In IAI-style answers, treat debentures as secured on assets and unsecured loan stock as unsecured. State your assumption if the question is unclear.
Thinking interest is optional in a poor year.
Students confuse interest with dividends.
Fix: Interest is a legal obligation. Dividends are at the board's discretion. Missed interest is a default.
Calling a convertible a share.
The conversion option hides that it is debt until converted.
Fix: Treat it as debt with an option. Until conversion the holder is a creditor with a fixed coupon.
Forgetting the tax shield on interest.
Students compare pre-tax cost of debt directly with cost of equity.
Fix: Use the post-tax cost of debt when interest is deductible and the company pays tax.
Mixing up positive and negative covenants.
The terms sound like good and bad.
Fix: Positive means the company must do something. Negative means it must not do something.
Using an annual yield on half-yearly coupons.
Rushing through the discounting.
Fix: Match the period to the coupon: use the half-yearly yield and double the number of periods.

Worked examples

Example 1

A company issues a 3-year bond of nominal ₹1,000 paying an annual coupon of 8%. It is redeemed at par. The market yield is 10% per year. Find the price.

Show the solution

Coupon = 8% × ₹1,000 = ₹80 per year.
Discount factors at 10%: year 1 = 0.9091, year 2 = 0.8264, year 3 = 0.7513.
PV of coupons = 80 × (0.9091 + 0.8264 + 0.7513) = 80 × 2.4868 = ₹198.94.
PV of redemption = 1,000 × 0.7513 = ₹751.30.
Price = 198.94 + 751.30 = ₹950.24 using four-decimal factors. With exact factors the price is about ₹950.26.

Answer: The price is about ₹950. It is below par because the coupon is less than the market yield.

Example 2

A convertible bond has nominal ₹1,000 and converts into ordinary shares at a conversion price of ₹250. The share price is now ₹300. The straight bond value is ₹880. What is the conversion value, and is conversion currently worthwhile?

Show the solution

Conversion ratio = 1,000 ÷ 250 = 4 shares per bond.
Conversion value = 4 × ₹300 = ₹1,200.
Compare with the straight bond value of ₹880 and the redemption value of ₹1,000.
Conversion value ₹1,200 is above ₹1,000, so converting gives more than redemption.

Answer: Conversion value is ₹1,200. Conversion is worthwhile at the current share price, since it exceeds the ₹1,000 redemption value and ₹880 straight bond value.

Exam tips

Always say who is protected by each feature: lender or company.
In discussion questions, give both advantages and risks, and link them to gearing and cost.
For bond pricing, match coupon frequency to the yield period.
State the assumption on tax and on the meaning of debenture.

Practice questions from Structure and methods of financing a company

Debt Financing: Bonds, Loans and Debentures in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Debt Financing: Bonds, Loans and Debentures: frequently asked questions

What is the difference between debentures and unsecured loan stock?

A debenture is secured by a fixed or floating charge on company assets. Unsecured loan stock has no such charge, so holders rank lower on liquidation and usually receive a higher interest rate.

What are loan covenants?

They are conditions in a loan agreement that protect the lender. Positive covenants require actions, such as providing accounts. Negative covenants restrict actions, such as extra borrowing or high dividends.

Why do convertible bonds pay a lower coupon?

The holder also gets an option to take shares. That option has value, so the holder accepts a lower coupon in exchange.

Is debt cheaper than equity for a company?

Usually yes. Lenders face less risk than shareholders, and interest is typically tax-deductible. But more debt raises gearing and the risk of default, so the benefit has limits.