Question

Your friend has recently told you that the federal government effectively subsidizes the use of debt financing (vs. equity fi nancing) for corporations. Do you agree with that statement? Explain.

Answer 1

Federal government does not necessarily always subsidize the use of debt for corporation but in times of economic distress or financial uncertainty the federal government provides loan at very cheap rates to corporation in order to save the company so that large number of unemployment can be avoided or systemic risk which could spread because of the default of one company to others could be reduced. Take the example of 2008 economic crisis, during that the federal government provided billions of dollars to banks in the form of equity as well as debt financing at very low rates so that bank default could be reduced. If banks had defaulted on the deposits to the customer there would have been widespread run on all banks deposit and this would have catastrophic impact on the financial system at that time so federal government has to step in to save those banks. Another time federal government provides subsidized loan to corporation is when it wants to promote economic development in any certain pats of the country where not much development has happened but federal government does not always provides subsidized loan to corporations.