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
Recommended Citation
Shah, A. (2024). Pros and cons of debt financing: an objective analysis. CBER Conference. Retrieved from https://ir.iba.edu.pk/esdcber/2024/program/28
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.