Revisiting equity and debt: access to finance and economic inefficiency

This paper compares equity and debt in regard to access to finance and economic inefficiency when moral hazard prevails in the form of hidden effort by a risk-neutral agent (entrepreneur) financed by a risk-neutral principal (financier). Equity finance is considered through an original sharing contract which is shown to be more incentivizing than the sharing contract commonly considered in the related literature. For a determined range of projects’ sizes and entrepreneurs’ wealth, equity and debt are shown to be equally feasible. However, debt is less financially constraining than equity for large projects. In contrast, equity is more accessible to small projects. Besides, it is shown that extending the financial contracting to two periods enhances the access to debt under a necessary incentivizing termination threat (financing non-renewal). The more restrictive this threat, the loosely is the financial constraint on debt. For equity, extending the horizon improves access to finance only for small projects undertaken by sufficiently foresighted entrepreneurs. Finally, the economic inefficiency which results from the termination threat under debt favors equity (from the micro- and macro-perspectives) in the common region of feasible access to finance. In the policy recommendation section, I show that there is a room for governmental interventions to enhance access to finance and to reduce the economic inefficiency of debt.