This paper examines the trade-offs faced by creditors of a country with a large debt that cannot attract new voluntary lending. If the country cannot meet its debt service requirements from current income, creditors have two options: finance the country by lending at an expected loss, hoping for eventual repayment, or forgive the debt to reduce it to a level the country can repay. The IMF and US have historically favored financing, but current calls for debt reform often advocate forgiveness. The paper shows that the choice between financing and forgiveness represents a trade-off. Financing gives creditors an option value, as they can benefit if the country performs well. However, debt burdens distort the country's incentives, as the benefits of good performance go largely to creditors. The paper also shows that the trade-off can be improved if both financing and forgiveness are contingent on factors the country cannot control, such as oil prices or world interest rates. The paper discusses the concept of a "debt overhang," where a country's inherited debt is so large that creditors do not expect to be fully repaid. This can lead to a conflict between creditors' individual and collective interests, with free rider problems potentially compromising the ability to achieve desirable new lending. The presence of a debt overhang can distort the debtor's incentives, and reducing the debt through forgiveness may be more effective than providing new money and hoping for better future conditions. The paper presents three examples to illustrate the implications of debt overhang. In the first example, a country with inherited debt faces a liquidity crisis if it cannot repay. In the second example, uncertainty about future resource transfers leads to a trade-off between financing and forgiveness. In the third example, the debtor's incentives are distorted by the debt burden, and creditors may need to provide incentives to encourage adjustment efforts. The paper also discusses the importance of changing the nature of claims to resolve debt overhang. Proposals include converting debt into equity or equity-like claims, or linking repayment to the state of nature. These proposals can help align incentives and reduce the need for forgiveness. The paper concludes that the choice between financing and forgiveness is a trade-off between the option value of a large nominal debt and the incentive effects of a debt that is unlikely to be repaid. Linking repayment to the state of nature can improve this trade-off by increasing the probability that adjustment efforts benefit the country rather than its creditors. This suggests that linking new money and possibly debt relief to measures of economic conditions could be beneficial for both debtors and creditors.This paper examines the trade-offs faced by creditors of a country with a large debt that cannot attract new voluntary lending. If the country cannot meet its debt service requirements from current income, creditors have two options: finance the country by lending at an expected loss, hoping for eventual repayment, or forgive the debt to reduce it to a level the country can repay. The IMF and US have historically favored financing, but current calls for debt reform often advocate forgiveness. The paper shows that the choice between financing and forgiveness represents a trade-off. Financing gives creditors an option value, as they can benefit if the country performs well. However, debt burdens distort the country's incentives, as the benefits of good performance go largely to creditors. The paper also shows that the trade-off can be improved if both financing and forgiveness are contingent on factors the country cannot control, such as oil prices or world interest rates. The paper discusses the concept of a "debt overhang," where a country's inherited debt is so large that creditors do not expect to be fully repaid. This can lead to a conflict between creditors' individual and collective interests, with free rider problems potentially compromising the ability to achieve desirable new lending. The presence of a debt overhang can distort the debtor's incentives, and reducing the debt through forgiveness may be more effective than providing new money and hoping for better future conditions. The paper presents three examples to illustrate the implications of debt overhang. In the first example, a country with inherited debt faces a liquidity crisis if it cannot repay. In the second example, uncertainty about future resource transfers leads to a trade-off between financing and forgiveness. In the third example, the debtor's incentives are distorted by the debt burden, and creditors may need to provide incentives to encourage adjustment efforts. The paper also discusses the importance of changing the nature of claims to resolve debt overhang. Proposals include converting debt into equity or equity-like claims, or linking repayment to the state of nature. These proposals can help align incentives and reduce the need for forgiveness. The paper concludes that the choice between financing and forgiveness is a trade-off between the option value of a large nominal debt and the incentive effects of a debt that is unlikely to be repaid. Linking repayment to the state of nature can improve this trade-off by increasing the probability that adjustment efforts benefit the country rather than its creditors. This suggests that linking new money and possibly debt relief to measures of economic conditions could be beneficial for both debtors and creditors.