Solution

This instrument has two components – (1) mandatory redemption by the issuer for a fixed amount at a fixed future date, and (2) interest payable at the discretion of the issuer.

The first component is a contractual obligation to deliver cash (for repayment of principal with or without premium, as per terms) to the debenture holder that cannot be avoided. This component of the instrument is a financial liability.

The financial instrument in this case is a debenture issued by X Co. Limited to Y Co. Limited. The debenture has the following features:

1. It is redeemable after 10 years from the date of issue.
2. Interest of 15% p.a. is payable at the discretion of the issuer.
3. The rate of interest is commensurate with the credit risk profile of the issuer.

Based on these features, the debenture can be classified as a financial liability. This is because the holder of the debenture is entitled to receive a fixed rate of return (i.e., interest of 15% p.a.) and the debenture is redeemable at a fixed date in the future.

However, the fact that the interest is payable at the discretion of the issuer makes this debenture different from the previous example of preference shares with mandatory dividend. The issuer has the option to not pay interest if it deems necessary. This means that the holder of the debenture does not have a fixed claim on interest payments, unlike the holder of preference shares.

Furthermore, the fact that the rate of interest is commensurate with the credit risk profile of the issuer indicates that the debenture is a form of debt financing. The rate of interest is likely to be higher if the credit risk of the issuer is perceived to be higher, which is a characteristic of debt instruments.

Therefore, the debenture issued by X Co. Limited to Y Co. Limited is a financial liability and represents a form of debt financing for X Co. Limited.