Credit
ratings are essential in that they guarantee that there is an equilibrium in
bond investments. This signifies that maintaining a level of credit ensures
that a firm can issue a commercial paper and also have an unrestricted access
to the bond investor's information. Additionally, the firm will be able to
lessen its disclosure requirements, reduce the investor capital reserve
requirements, and enhance the third-party relationships and to have an access
to Eurobond markets. Accordingly, these benefits are relevant to devising the
firm's optimal leverage, given that it affects the credit rating of any given
firm. Besides, credit rating levels impart benefits at discrete levels of
ratings, indicating that a firm's value progresses at certain levels of
leverage. This paper is a summary of an investigation on how changes in credit
ratings affect a firm's subsequent capital structure decisions.
To
identify the credit rating effects, in particular, tests were administered that
cover lagged changes in a firm's leverage, profitability and a probability of
bankruptcy. Consequently, three additional tests were conducted to identify
whether the observed leverage reduction following a downgrade is specifically a
resultant of a rating change. The first of these subsequent tests includes
control dummy variables for the firm's industry per year. Generally, the second
of the three tests involved the interaction of the dummy variable which are
rating specific but not specific to other shifts in the firm, for instance,
changes in the investment opportunities. The final test centered on the
estimation of credit rating for firms that do not have credit ratings based on
the factors shown in the previous literature to predict the ratings for firms.
The investigation also endeavored to explain the asymmetric capital structure
that is documented following observed downgrades and upgrades.
Tradeoff Theory
The Impact of Discrete
Credit Rating Benefits on Optimal Leverage
High
credit rating levels provide discrete benefits to a firm that is not considered
as gains of lower leverage in the tradeoff theory. Credit ratings resolve if an
investor will be allowed to invest in a given firm's bond or not, as well as
signaling the firm's quality to investors. Additionally, bond covenants require
a change in bond coupon rate at different rating levels. Hence, Tradeoff theory
(henceforth referred to as TT) and
credit rating effects together imply that firms will balance the tradeoff
benefits of higher leverage against
those of lower leverage and the discrete credit rating benefits of lower
leverage (henceforth referred to as TTCR).
Testing the
implications of TTCR
The
following regression is used to test the implications:
NetDIss =α + β Downgrade + β Upgrade +ε
(1)
NetDIss =α + β Downgrade
+ β Upgrade
+φK
+ε (2)
Where NetDIss refers to the measure of a
firm’s Leverage changing capital market decision at time t
In this context, TTCR implies that downgraded firms
are more likely to reduce leverage in the subsequent period compared to
non-downgraded firms. An additional implication is that an
upgrade will not significantly affect subsequent capital structure behavior.
Empirical Tests
Data and Summary statistics:
The sample is collected from all firms with credit
rating in Compustat. Additionally, the sample period for the tests is 1987 to
2003.
Main Empirical Tests
In the empirical tests, the control variables use
include leverage, sales, profitability, market to book ratio and z-score. The
equation (i), as shown above, does not include control variables. Moreover, the
significant downgrade and upgrade results without control variables can be
interpreted as consistent with both credit rating effects and distress on
target leverage effects.
Besides, dummy variables are
consolidated in the test because they tend to capture time variant effects by
each industry. As for tests at individual ratings, the impact of downgrades at
particular rating levels on subsequent leverage decisions was examined. This
was necessary as it provided distinct results for TTCR, given that other
explanations imply uniform reactions to changes in credit rating.
For the individual rating tests,
regressions of the equation (2) and the result indicates that the firms
receiving downgrades to a particular ratings attempt to move back to their
previous rating. This clearly implies that the effects are greater at certain
rating levels, consistent with the implications of the TTCR. Furthermore, the
tests result in an observed general incremental impact of certain rating
levels. For confirmation purposes, yearly tests were conducted to find out
whether the downgrade effect is merely an artifact of business cycle variation.
For instance, the researcher studied the case of Collapse of Drexel Burnham
Lambert ("Drexel"), a case that occurred in 1989 and was resolved in
the year 1990. Nevertheless, the evidence from this test proof difficult to
reconcile with other explanations regarding the downgrade effect f downgrades
on subsequent with the firm’s targeting minimum rating levels.
Conclusion
In conclusion, a firm's capital
structure choice is more affected by whether the firm's credit rating was
downgraded the previous year than by variations in leverage, profitability or
z-score. Consequently, they target merest credit ratings at which regulations
affect investment in a given organization's bonds and at which commercial paper
access is affected. Finally, from the outcome of the research, the effect of
discrete credit rating level benefits on capital structure behavior is
complementary to the trade-off theory of capital structure.
Work Cited Page
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