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What is Subsidized Financing?
Companies in many countries, especially developing countries, may need assistance from the government to sustain and grow. The companies in these countries may be provided with reduced interest on the loans they acquire from the market or investors. These reductions are offered by the governments and are known as subsidies.
Subsidized financing is a mode of financing in which the interest on the loans for sourced funds are paid partially or completely by the government. The subsidized financing process is a way to help companies grow and achieve efficiency in financing. The subsidy in interests of loans are one of the most common processes of subsidized financing.
Subsidized financing is often applied after tax which are discounted at the after tax cost of debt. The idea is to reduce the burden of companies in paying the loans back to investors and thereby get a helping hand to grow and achieve financial efficiency.
If a company sources loans from the market at 15 percent per annum and the subsidy on the interest is 5 percent, then the company will get a tax shield of 5 percent and will have to pay 10 percent interest per annum. The interests are counted on a yearly basis and hence the subsidies are also applied on a yearly basis to the loans.
It is notable that interest tax shields are discounted at the pre-tax cost of debt, while the subsidies are applied on after-tax cost of debt. Therefore, the actual rate of subsidies is applied after-tax so that the actual tax burden is reduced to benefit the maximum to the companies.
Why are the Subsidies Offered?
Companies in developing nations may need assistance from the government to stay competitive in the market. Such companies have to compete with other established companies from developed nations with a better product mix and huge resources at their disposal. The companie from developed countries may be able to offer goods and services at a lower cost due to their quality of acting in scale and having access to cheaper raw materials to produce goods for the market.
In such conditions, the companies in developing nations may need help in terms of financing to stay competitive in the market. They may require assistance in paying the debt back which they had acquired to source raw materials or services from the market. In such cases, financing help from the government can help domestic companies grow and compete with foreign firms.
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