Abstract/Description

Debt financing plays an important role in the modern financial system. It is claimed that the interest rate equilibrates demand and supply in the loanable funds markets and helps in the efficient allocation of financial capital. It is also claimed that interest rates simply break up investment risk to suit the requirements of lenders and users of funds. However, the occurrence of the Global Recession in 2008 due to excessive debt financing in real estate (mortgage loans) and the resemblance of interest rate with usury requires investigation of the other side of debt financing. This paper aims to fill this gap. The four possible demerits of debt financing have been explained. First, the equilibrating role of nominal interest rate becomes doubtful in the presence of other rates such as internal rate of return (IRR) and effective interest rate. Second, there are three parties in a debt contract: lender, borrower and actual payer of debt. Nonetheless, the consent of actual payers of debt is rarely obtained, which is against the free choice theory of market economy. Third, while apportioning risk and return profile of given investment for lenders and borrowers, debt financing adds on the risk side and generates additional risk for the project, called financial risk. Fourth, debt financing induces a firm manager to select large-size projects as compared to small size projects. The reason is that a large size project generates more profit in terms of quantity, even if its internal rate of return is less than that of competing smallersize projects. Taking the supply of financial capital in a country as fixed, this approach of firm’s managers slows down the actual economic growth relative to its potential. The paper suggests that in view of these demerits, equity financing should be encouraged for the larger interest of the people and growth of an economy.

Keywords

Debt financing, nominal interest rate, internal rate of return, net present value, odious debts, financial risk, project evaluation

Location

S2 room, Adamjee building

Session Theme

Institutions and Economics

Session Type

Parallel Technical Session

Session Chair

Anwar Shah, Quaid-i-Azam University

Session Discussant

Adnan Haider, Institute of Business Administration ; Muhammad Sabir, Institute of Business Administration

Start Date

10-12-2024 3:15 PM

End Date

10-12-2024 5:15 PM

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Dec 10th, 3:15 PM Dec 10th, 5:15 PM

Pros and cons of debt financing: an objective analysis

S2 room, Adamjee building

Debt financing plays an important role in the modern financial system. It is claimed that the interest rate equilibrates demand and supply in the loanable funds markets and helps in the efficient allocation of financial capital. It is also claimed that interest rates simply break up investment risk to suit the requirements of lenders and users of funds. However, the occurrence of the Global Recession in 2008 due to excessive debt financing in real estate (mortgage loans) and the resemblance of interest rate with usury requires investigation of the other side of debt financing. This paper aims to fill this gap. The four possible demerits of debt financing have been explained. First, the equilibrating role of nominal interest rate becomes doubtful in the presence of other rates such as internal rate of return (IRR) and effective interest rate. Second, there are three parties in a debt contract: lender, borrower and actual payer of debt. Nonetheless, the consent of actual payers of debt is rarely obtained, which is against the free choice theory of market economy. Third, while apportioning risk and return profile of given investment for lenders and borrowers, debt financing adds on the risk side and generates additional risk for the project, called financial risk. Fourth, debt financing induces a firm manager to select large-size projects as compared to small size projects. The reason is that a large size project generates more profit in terms of quantity, even if its internal rate of return is less than that of competing smallersize projects. Taking the supply of financial capital in a country as fixed, this approach of firm’s managers slows down the actual economic growth relative to its potential. The paper suggests that in view of these demerits, equity financing should be encouraged for the larger interest of the people and growth of an economy.