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Debt Finance: Nutshell of Factors

Factors affecting supply for credit

Deregulation gave banks grater flexibility in issuing loans
This may have resulted in a greater volume of loans being extended to corporate borrowers

Factors affecting demand for credit

Several factors suggested are
–      1. Changes in portfolio management practices
–      2. Development of risk management procedures
–      3. Interaction of inflation and tax
–      4. Behavioural aspects

Changes in portfolio management practices

–      The introduction of active portfolio management may have led to increased share turnover, and therefore volatility of share prices
–      Consequently, debt may have been viewed as being comparatively more stable

Development of risk management products
–      Risk management products (derivatives FRAs) allow corporations to hedge their interest rate and exchange rate risk
–      As a result companies may have been able to take on higher levels of debt

Inflation and the tax system
–      Debt is advantaged over equity in periods of high inflation because
ð  Borrowers receive tax deduction for the real cost of borrowing in addition to being compensated for inflation
ð  Inflation erodes the real value of amounts borrowed, with the borrower benefiting where the value of the assets financed by debt increases faster than the rate of inflation

Behavioural aspects
–      High real growth in assets (property, equity) encouraged firms to capitalise assets (via finance)
–      Issuance of new equity (to raise funds) dilutes the claim existing shareholders have on the firm’s cash flows
–      Debt finance is able to be arranged relatively quickly
–      Information asymmetries

Interaction between supply and demand of Debt

Increased debt use is likely to result from changes in both the supply and demand for debt
–      Supply influenced by
ð  Deregulation of banks
ð  Monetary policy of Governing Bank
–      Demand influence by
ð  High inflation rate
ð  Behavioural changes

Credit Rating Agency

Rate the creditworthiness of an obligor with respect to financial obligations
Examples
–      Standards and Poors
–      Moody’s Investors Service
Issue both long and short-term ratings
Rating range from AAA to D
Ratings are provided for companies as well as for individual issues