Strategic Management and Corporate Finance · Raising of Funds from Debt and Procedural Aspects

Debt Instruments and Sources of Debt Finance

Updated 11 October 2026 · Fact-checked

Debt finance is money a company borrows and must repay with interest, without giving the lender ownership. Main sources are debentures, bonds, term loans, commercial paper and external commercial borrowings. To answer questions, state the instrument, its features, who lends, cost, security and risk, then compare it with equity.

Understand Debt Instruments and Sources of Debt Finance

A company can fund itself in two ways: owners' money (equity) or borrowed money (debt). Debt means a lender gives funds for a fixed period. The company pays interest and returns the principal. The lender does not become an owner and normally has no vote.

The main debt instruments are:

Debentures: instruments issued by a company acknowledging a debt. They carry interest and can be secured or unsecured, convertible or non-convertible, redeemable or irredeemable.
Bonds: in practice a similar debt instrument. The term is used for instruments issued by governments, public sector bodies and large corporates, often unsecured. In Indian exam answers, treat the difference as one of usage, not strict law.
Term loans: loans from banks and financial institutions for a fixed tenor, repaid by instalments, usually secured on assets.
Commercial paper (CP): short-term, unsecured money market instrument issued at a discount and repaid at face value. Only strong, rated companies can use it.
External commercial borrowings (ECB): loans raised by Indian entities from non-resident lenders, regulated under FEMA and RBI directions. They bring foreign currency and exchange rate risk.

Other sources include public deposits, inter-corporate loans, trade credit, working capital loans and lease or hire purchase finance. Each has its own cost, tenor and regulation.

Why use debt at all? Interest is a tax-deductible expense, existing owners keep control, and the cost is usually lower than equity. The price is a fixed obligation. Interest must be paid even in a bad year, and failure to pay can lead to default, enforcement of security and insolvency. That is why debt raises financial risk, while equity does not need fixed payouts.

So the choice depends on purpose, tenor, cost, security available, control, regulatory limits and the company's ability to service the debt. Match long-term assets with long-term funds and short-term needs with short-term funds.

Key rules to remember

Debt vs equity test: Debt = fixed return + repayment + no ownership; Equity = residual return + no repayment + ownership; Use this as the base of every comparison answer.
Effective cost of debt after tax: Kd (after tax) = Interest rate × (1 − tax rate); Applies because interest is deductible. Use the correct tax rate given in the question.
Commercial paper discount yield: Effective return = (Face value − Issue price) ÷ Issue price × (365 ÷ days to maturity); Simple annualised approach. Use the day count given in the question.
Audit Committee role in loans and investments: Section 177(4)(v): scrutiny of inter-corporate loans and investments; The Audit Committee of a listed public company and prescribed companies has this term of reference. It must have at least three directors with independent directors in the majority (section 177(2)).

How to solve Debt Instruments and Sources of Debt Finance questions

Use one method for any theory or case question on debt sources.

1Identify what is asked: a list of sources, features of one instrument, a comparison, or a recommendation for a given company.
2Read the facts: purpose of funds, amount, tenor, company size, rating, assets available, foreign currency need.
3Name the suitable instruments and define each in one line.
4Give features: issuer, lender, tenor, security, interest or discount, convertibility, regulator.
5Compare with equity on ownership, cost, tax, risk, control and repayment.
6Apply the facts: choose the best source and say why others are less suitable.
7Add compliance points: board approval, charge creation, rating, trustee, RBI or FEMA norms where relevant.
8Conclude in one or two lines with your recommendation.

Quickest way: Tenor-purpose-security shortcut

When to use it: When a case gives a company need and asks which debt source to choose, with little time.

Short need of up to one year and a strong rated company: commercial paper or working capital loan.
Medium or long need for assets and assets available as security: term loan or secured debenture.
Need to raise from many investors and be listed: debentures or bonds.
Foreign currency need or overseas lender: ECB, noting exchange risk and FEMA limits.
Close with a one-line debt versus equity trade-off.

Common mistakes in Debt Instruments and Sources of Debt Finance

Treating debentures and bonds as legally different instruments in all cases.
Textbooks stress the difference in usage and students turn it into a rule.
Fix: Say they are similar debt instruments; bonds are the term usually used by governments and large institutions, debentures by companies.
Calling debenture holders owners or shareholders.
Both provide long-term funds.
Fix: Debenture holders are creditors. They get interest whether or not there is profit and usually have no voting rights.
Recommending commercial paper for long-term projects.
CP is cheap, so students favour it.
Fix: CP is short-term and unsecured. Match tenor with the need and use term loans or debentures for long-term assets.
Ignoring exchange rate risk in ECB answers.
Students focus on lower foreign interest rates.
Fix: Always state that repayment is in foreign currency, so rupee depreciation raises the real cost. Mention hedging and RBI conditions.
Comparing debt and equity only on cost.
Cost is the easiest point to remember.
Fix: Cover control, risk, tax shield, repayment obligation and flexibility. Examiners award marks per point.
Applying audit committee rules to every company.
Section 177 is remembered loosely.
Fix: State that the Board of every listed public company and prescribed classes must constitute it, with at least three directors and independent directors in the majority.

Worked examples

Example 1

Meera Textiles Ltd, an unlisted company, needs ₹50 crore to buy machinery with a ten-year life. It has factory land to offer as security. Advise on the suitable source of debt and compare it with equity.

Show the solution

Purpose and tenor: a long-term asset, so long-term funds are needed. Commercial paper is unsuitable as it is short-term.
Suitable sources: a secured term loan from a bank or financial institution, or secured debentures.
Security: factory land can be charged to the lender, which lowers the interest rate.
Cost: interest is tax deductible, so the after-tax cost is below the stated rate.
Control: lenders get no ownership or vote, so existing shareholders retain control.
Risk: fixed instalments must be paid even if profits fall; default can lead to enforcement of the charge.
Compliance: board approval, creation and registration of charge, and loan agreement covenants.
Equity comparison: equity has no repayment burden but dilutes control and is costlier.

Answer: A secured term loan (or secured debentures) is best for a ten-year asset with land as security. It is cheaper and keeps control, but adds fixed repayment obligations, unlike equity.

Example 2

A rated company issues commercial paper of face value ₹1,00,000 at ₹97,500 for 90 days. Find the effective annualised return using 365 days.

Show the solution

Discount = 1,00,000 − 97,500 = ₹2,500.
Return for 90 days = 2,500 ÷ 97,500 = 0.025641, or 2.5641%.
Annualise: 2.5641% × 365 ÷ 90 = 2.5641% × 4.0556.
2.5641 × 4.0556 = 10.40 (approx).

Answer: The effective annualised return is about 10.40%.

Exam tips

For list questions, give each source a one-line definition plus two features. Do not write only names.
Always end comparison answers with a recommendation tied to the facts given.
Keep a ready table-style structure in sentences: ownership, cost, tax, risk, control, repayment for debt vs equity.
For ECB, mention foreign currency, RBI and FEMA framework and exchange risk. Link to the ECB topic for detail.
In calculation questions, show the formula and each step so you earn method marks.

Practice questions from Raising of Funds from Debt and Procedural Aspects

Debt Instruments and Sources of Debt Finance in other exams

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

Debt Instruments and Sources of Debt Finance: frequently asked questions

What are the main sources of debt finance for a company?

The main sources are debentures, bonds, term loans, commercial paper, external commercial borrowings, public deposits and inter-corporate loans. Short-term needs use commercial paper or working capital loans. Long-term needs use term loans and debentures.

What is the difference between debentures and bonds?

Both are debt instruments paying interest and repaying principal. The word debenture is used mainly by companies, while bond is used more by governments, public bodies and large corporates. In exams, state that the distinction is mostly one of usage.

Why is debt cheaper than equity?

Interest is a tax-deductible expense and lenders take less risk because they have a fixed claim and often security. Equity holders accept residual returns and so demand a higher return.

What is an ECB?

An external commercial borrowing is a loan raised by an Indian entity from a non-resident lender, regulated under FEMA and RBI directions. It gives access to foreign funds but carries exchange rate risk.