Abstract
This paper analyses the interdependence that exists between capital structure
and credit ratings. Evidence is obtained from financial theories of capital
structure, examining the trade-off theory and the effects of credit rating
considerations on the theorem. The analysis further demonstrates how the
cost of capital for a firm is a direct outcome of its leverage and its credit rating,
which provides an expression for maximizing firm value by minimizing the cost
of capital. Then the recent developments in the field of capital structure theory
are looked at, and the determinants of capital structure are identified. These
factors are then compared to those used in credit rating assignments, which in
turn are obtained through a detailed review of the methodology employed by
credit rating agencies. Most of these underlying determinants are found to be
common or similar, thus verifying the high level of correlation between capital
structure and credit ratings. As a consequence, a relationship could be
defined, which would allow the modification of one of these underlying
elements to produce the desired change in another element, in a controlled
environment.
 

Table of Contents
List  of  Figures.......................................................................................................................I  

List  of  Abbreviations..........................................................................................................I  

I.  Introduction .....................................................................................................................1  

II.  Financial  Theory ...........................................................................................................3  

A.  Trade-­Off  Theory ...................................................................................................................3  
B.  WACC  (Weighted  Average  Cost  of  Capital) ....................................................................9  
C.  Inferences .............................................................................................................................. 14  

III.  Capital  Structure....................................................................................................... 14  

A.  Objectives .............................................................................................................................. 14  
B.  Determinants ....................................................................................................................... 16  
C.  Recent  Developments  in  Capital  Structure  Theory ................................................. 22  

IV.  Credit  Ratings ............................................................................................................ 27  

A.  Methodology ......................................................................................................................... 28  
B.  Ratings  Criteria.................................................................................................................... 31  
C.  Consequences  of  Credit  Ratings ..................................................................................... 33  
D.  Inferences.............................................................................................................................. 34  

V.  Conclusion .................................................................................................................... 35  
 I

 
List  of  Figures  
 
Figure  1:  Classical  Trade-­off  Theory  
Figure  1a:  Tax  Shield   4  
Figure  1b:  Distress  Costs   5  
Figure  1c:  Trade-­off  Curve   5  
 
Figure  2  
Figure  2:  Credit  Rating  Effects  on  Capital  Structure   6  
 
Figure  3:  Trade-­off  Theory  with  Credit  Rating  Adjustments  
Figure  3a:  Tax  Shield   6  
Figure  3b:  Distress  Costs   7  
Figure  3c:  Trade-­off  Curve  with  Credit  Rating  Effects   7  
 
Figure  4:  Trade-­off  Theory  and  WACC  
Figure  4:  Trade-­off  and  WACC  curves   9  
 
Figure  5:  Managerial  Concerns  
Figure  5:  Capital  Structure  Determinants   16  
 
Figure  6:  Credit  Rating  Process  
Figure  6:  Flowchart   29  
 
Figure  7:  Credit  Rating  and  Capital  Structure  Theory  
Figure  7:  Table  of  Comparison   31  

List  of  Abbreviations  

CAPM: Capital Asset Pricing Model

CDS: Credit Default Swaps
CFO: Chief Financial Officer
MMI: Miller-Modigliani Proposition I
MMII: Miller-Modigliani Proposition II
WACC: Weighted Average Cost of Capital
 II

 
 
 

Acknowledgement

I would like to thank Professor Dr. Ulrich Pape and Dipl-Oec Sven
Seehausen for their constant guidance and support throughout the
course of this Masters thesis.

 
 
 
 
 
 

 
 1

I. Introduction
Credit Ratings have a comprehensive impact on Capital Structure decisions
taken by companies, with consequences that effect and are affected by multiple
factors. This paper takes a look at the developments that have occurred in the
area of Capital Structure theory1, with the aim of aggregating and assimilating
these findings to construct a rough framework detailing the determinants of
Capital Structure. Using the evidence provided in the papers by Graham and
Harvey (2001), and Kisgen (2006-09), one can conclude the existence of a
strong correlation between Capital Structure and Credit Ratings. The
interdependence of the two (Capital Structure and Credit Ratings) is examined
with a view to establish that Credit Ratings form a direct and efficient way to
make decisions on leverage; and further the application of this is analyzed in
the context of financial theory, namely the Trade-off theory (and its extension to
the dynamic trade-off theory), Weighted Average Cost of Capital (WACC) and
the Capital Asset Pricing Model (CAPM).

In 2004, Electronic Data Systems (EDS, now acquired by HP) released more
than $1 billion in new shares to avert a ratings downgrade2. Similarly, Reed
Elsevier, an Anglo-Dutch publisher, conducted an equity offering of GBP 824
million to protect its BBB+ credit rating. Also, Rexam, the biggest manufacturer
of beer and soft-drink cans in Europe increased its capital by GBP 350 million,
to improve upon its recently downgraded rating of BBB-, and thereby ensuring
investment-grade status for its bonds3. Further, Thyssen Krupp, Germany’s
largest producer of steel, made a notable disposal of assets in 2009 to preserve
their investment-grade status, supporting the view that managers give
substantial importance to their credit ratings, especially in times of negative
rating momentum4. These examples do substantiate the claim of a relationship
existing between Capital Structure, Credit Ratings and Target ratios, however
the nature of this relationship is subjected to much debate. The cause-effect
1. The developments referred to are the findings presented in papers by Kisgen (2006),
Flannery and Rangan (2005), Goldstein, Ju and Leland (2001), Baker and Wurgler (2002),
Leary and Roberts (2003), and Brahma, Kuehn and Strebulev (2008).
2. Cf. Kisgen (2006)
3. Cf. Anonymous (n.d)
4. Cf. Hippe (2009) in Anonymous (n.d)
 2

links between these elements, as well as the relative importance of the different
factors identified has proved to be difficult to ascertain owing to the high level of
interdependence between the factors, which this paper would be exploring.

Many factors have been identified that are considered relevant when making
Capital structure decisions. These can be grouped into empirical factors, and
those based on surveys. The aspects identified through a survey of CFOs
include such considerations as financial flexibility, credit ratings, cash flow
volatility, availability of internal funds, and level of interest rates5. Whereas,
when taking into account empirical measures of a firm, the size, research and
development expenditure, market to book ratios, stock returns, asset tangibility,
profitability, and marginal tax rates were found to have a high correlation with
leverage levels6.

Credit ratings are opinions on the creditworthiness of an entity, and are publicly
available7. Now, in assigning credit ratings, many of the factors considered in
capital structure decisions feature in the criteria used by rating agencies. These
include profitability, size, market to book ratios, and stability, apart from financial
leverage and solvency ratios8. Further, the level of interest rates for a firm, or its
cost of capital, is then directly influenced by its assigned credit rating9. This
produces a degree of interdependence between capital structure and credit
ratings, which enables the credit rating of a firm to serve as a comprehensive
antecedent to its capital structure.

The effect of credit ratings is also examined on financial theories associated

with capital structure and corporate finance, namely the Trade-off theory and
the Capital Asset Pricing Model (CAPM). These effects are applied to the trade-
off theory in two different capacities, both of which result in a disjointed Firm
value v/s Leverage curve, and accordingly affect the target debt ratio. In the
CAPM, by introducing credit rating effects, the model can be simplified to
represent more directly observable values. The results thereby demonstrate the
extent of information provided by credit ratings, and the simplicity of its
application in financial theory.

5. Cf. Harvey and Graham (2001)

6. Cf. Hovakimian, Hovakimian and Tehranian (2003)
7. Cf. Standard and Poor’s (2011)
8. Cf. Kisgen (2006); Minardi, Sanvicente and Artes (2007); Kamstra, Kennedy and Suan (2001)
9. Cf. Flannery, Nikolova and Öztekin (2007)
 3

Recent developments in the field of capital structure theory lay emphasis on the
underlying causes that are significant for capital structure decision-making, such
as the adjustment costs involved (Leary and Roberts – 2003), the proximity of a
firm to an upgrade or downgrade (Kisgen – 2006), and market valuation of the
firm (Baker and Wurgler - 2002). These phenomena are found to be in
conformance with the studiesof the speed of adjustment of debt ratios (Flannery
and Rangan – 2005) and dynamic capital structure adjustments (Goldstein, Ju
and Leland – 2001). Thus, by analyzing the correlation between capital
structure and credit ratings, with the aggregate of these effects included, a
framework is developed showing how credit ratings provide an efficient method
to estimate capital structure.

II. Financial Theory

The two primary theories in the field of finance related to capital structure are
the Trade-off theory and the Pecking order theory. It has been found that these
theories not mutually exclusive, with the Trade-off theory providing the basis for
the issuance or repurchase of debt, and Pecking order factors being major
determinants of the rate of adjustment under trade-off assumptions1. Another
concept closely intertwined with that of capital structure and firm value
maximization is that of the Weighted Average Cost of Capital or WACC. It forms
a vital parameter of financial theory, and is greatly influenced by credit ratings2.
This section examines the effect of credit ratings on the trade-off theory and on
WACC formulations.

A. Trade-Off Theory

The trade-off theory follows from the Modigliani Miller proposition (MMII) with
taxes, by including financial distress costs to the model. The MMII theory
emphasizes the benefits of using leverage in capital structure through the tax
shield (Ts) provided by using debt3. This tax benefit of using debt has been
studied empirically also, and it has been found that the capitalized benefits in

1. Cf. Cotei and Farhat (2009)

2. Cf. Tijdhof (2007)
3. Cf. Ross-Westerfield-Jaffe (2003), Chapter 15
4. Cf. Graham (2000)
 4

the form of tax incentives of using debt financing is 9.7 percent of firm value4.
The value of the tax shield is given as:

Ts= tc x Rd x D

where tc is the corporate tax rate, Rd is the rate of interest charged on the debt,
and D is the amount of debt taken by the firm3. On considering this in isolation
of the costs of financial distress and bankruptcy (associated with higher levels
of leverage), firm value should be maximum for an entirely leveraged capital
structure, since the value of the tax shield is a constantly increasing function of
debt. However when financial distress costs are taken into account, the trade-
off theory is obtained. Costs such as legal and administrative costs of
liquidation or reorganization, indirect costs of loss of sales and contracts, and
agency costs are classified as costs of financial distress5.

By integrating the tax shield and these financial distress costs, an inverted U
curve is obtained on the graph of firm value versus leverage, showing the point
of maximized value for a particular leverage level, which also corresponds with
the point of minimum WACC5. This point denotes the target leverage for the
firm.

To obtain a graphical representation of this theory the following two

assumptions were made: First, the cost of financial distress was taken to be a
parabolic function, since these costs are fairly insignificant at lower levels of
debt; and second, the difference between an unlevered and a completely
levered firm (extremes on the graph) is assumed to be limited, on the basis of
the Miller-Modigliani pie theory (MMI)6.

4. Cf. Graham (2000)

5. Cf. Ross-Westerfield-Jaffe (2003), Chapter 16
6. Cf. Ross-Westerfield-Jaffe (2003), Chapter 15
 5

Tax  Shield  
0.8  
0.7  
0.6  
0.5  
0.4  
Tax  Shield  
0.3  
0.2  
0.1  
0  
0   0.5   1   1.5  
Figure 1a

Distress  Costs  

1.2  
1  
0.8  
0.6   Distress  Costs  
0.4  
0.2  
0  
0   0.5   1   1.5  

Figure 1b
 6

VT  
100.2  

100.1  

100  

99.9  

99.8   VT  

99.7  

99.6  

99.5  
0   0.1   0.2   0.3   0.4   0.5   0.6   0.7   0.8   0.9   1  
Figure 1c

Figures 1: Classical Trade-Off Theory (Author’s Own Representations)

The distress costs (Cd) were modeled as:

Cd= (V x tc x Rd x L^2)/(2 x L0),

where, V is the value of the unlevered firm, L is the amount of debt divided by
the value of the unlevered firm, and L0 is the target leverage. The resulting
value versus leverage graph shows the trade-off curve, maximum at L=L0.

Further, when including the effects of credit ratings on capital structure

decisions, it has been found that discontinuities arise at the boundaries of credit
ratings. This signifies that firms having leverage levels that cause them to be
near a ratings upgrade or downgrade issue on an average 2% lesser debt than
equity irrespective to target leverage7. This alters the trade-off theory by
creating breaks on the curve.

7. Cf. Kisgen (2006)

 7

Figure 2: The Trade-off Theory with Credit Ratings Effects7

A more detailed examination of these effects of credit ratings, by considering

the changes in credit spreads corresponding to different credit ratings8, certain
other factors are identified, which complement the discontinuous trade-off curve
suggested by Kisgen (2006). This formulation incorporates the credit spreads
into the interest rate variable, Rd, thereby producing modified charts for the
three previously presented graphs of tax shield, distress costs, and firm value9.

Tax  Shield  
4.5  
4  
3.5  
3  
2.5  
2   Ts  
1.5  
1  
0.5  
0  
0   0.2   0.4   0.6   0.8   1   1.2  
Figure 3a

7. Kisgen (2006)- The Journal of Finance p.1042

8. Cf. Flannery, Nikolova and Öztekin (2007), and Damodaran (2011)
9. Cf. Kisgen (2006) along with author’s representations
 8

Distress  Costs  
8  
7  
6  
5  
4  
Cd  
3  
2  
1  
0  
0   0.2   0.4   0.6   0.8   1   1.2  
Figure 3b

100.5  

100  

99.5   AAA,AA  
A+  
99   "A,A-­‐"  
BBB,B+  
98.5   B,B-­‐  
CCC  
98   CC:C  
D  

97.5  

97  
0   0.2   0.4   0.6   0.8   1   1.2  
Figure 3c

Figures 3: Trade-Off Theory with Credit Rating Adjustments (Author’s Own

Representation)10

7. Kisgen (2006)- The Journal of Finance p.1042

8. Cf. Flannery, Nikolova and Öztekin (2007), and Damodaran (2011)
9. Cf. Kisgen (2006) along with author’s representations
 9

The gradual and distinct increases in the slopes of the graphs for tax shield and
distress costs testify to the discrete costs of lower credit ratings. The firm value
chart attempts to show the segmented trade-off curve for different credit ratings,
however to observe the effect better, the graph would have to be scaled up.
This has not been provided above to ensure comparability with the previous
representation of the trade-off theory without credit ratings effect.

The benefit of a lower rating is illustrated by a study by Bo, Lensink and

Murinde, which looks at the demand side of investments, and concludes that
the graph of investments versus credit ratings is an inverted U-curve, with most
investments occurring in the lower investment-graded securities. This can be
explained by investors opting for riskier assets providing higher returns within
the bracket of investment-grade securities11. Since the risk of default for
investment graded securities is fairly low, as testified by the shallow portion of
the parabolic distress cost curve (in figure 1b). To add to this, a study by Kisgen
and Strahan shows that lower rated bonds in the category of investment-grade,
show average yields 54 basis points below those expected12. This findingwhen
viewed in conjunction with the dynamics of demand and supply in economic
theory, validatesthe former inference, and vice versa. In other words, the higher
demand for marginally riskier bonds lowers the expected average yields to be
obtained from them.

Thus the trade-off theory is very susceptible to credit ratings effectsthrough a

number of factors. The two identified here are those ofcredit rating boundary
conditions and due to different credit spreads associated with different credit
ratings, which determine the interest rate commanded by those bonds. Also, the
concept of WACC is closely tied to this theory. WACC, as explained in the
following section, is largely determined by both, credit ratings and debt level,
which again gives evidence to the correlation between capital structure and
credit ratings.

B. WACC (Weighted Average Cost of Capital)

The optimal capital structure of a firm, as depicted by the highest point on the
trade-off curve, corresponds with the lowest point on the WACC curve (shown

11. Cf. Bo, Lensink and Murinde (n.d)

12. Kisgen and Strahan (2009)
 10

below). This part analyzes how optimizing capital structure is intertwined with
the concepts of WACC and CAPM, which in turn are influenced by credit
ratings1.

0.6  

0.5  

0.4  

0.3   WACC  
Value  
0.2  

0.1  

0  
0   0.2   0.4   0.6   0.8   1   1.2  

Figure 4: Trade-Off Theory and WACC (Author’s Own Representation)

To illustrate this relationship, we begin by defining certain variables in addition

to those described in the previous section:

VL: Value of a levered firm

Vu: Value of unlevered firm

D: Debt

E: Equity

Eb: Earnings Before Interest and Tax (EBIT)

Rw: WACC

Re: Return on equity

Ru: Return on unlevered firm

p: Profit or Net Income

The other variables from the previous section retain their original descriptions.

1. Cf. Cohen (2003)

 11

Now, returning to the Miller-Modigliani theorems on capital structure, we begin

with the value of an unlevered firm (Vu) as follows:

E+D*(1-tc)=Vu (1)2

Vu=VL+Ts

Rw=Eb*(1-tc)/VL (2)

Ru=Eb*(1-tc)/Vu (3)

From equations 1,2 and 3, we get,

Re=Ru+(Ru-Rd)*(1-tc)*D/E (4) 3

Thus we get,

Rw=Ru*(1-L*tc) (5)

This equation (5) shows that WACC is a function of leverage (L=D/VL), and is
used in obtaining the WACC curve (shown in the graph above). However this
equation does not take into consideration any risk of default, that is the costs
associated with financial distress, and consequently, credit ratings effects.
Though the equation does provide an elucidatory relationship between the
value of a levered and an unlevered firm, given as:

VL=Vu/(1-L*tc) (6)

Now, to account for the cost of financial distress (risk of default), we consider
signals the market provides about a firm, in terms of its rate of return and share
price. The market does use credit ratings, and especially credit rating changes
as signals of the financial health of a firm, which will be looked at in greater
detail later in the paper. Presently we turn our focus to the CAPM model, which
allocates the term ‘β’ to reflect this information.β is the term used for measuring
the volatility of a firm with respect to that of the market or a particular sector or
index. It is the primary measure of entity specific risk in the CAPM model4. It
follows that since higher leverage is associated with higher risk, and greater
debt levels correspond to lower credit ratings, β should be higher for firms with
2. Cf. Cohen (2001)
3. Cf. Cohen (2003)
4. Cf. Ross-Westerfield-Jaffe (2003), Chapter 10
 12

lower credit ratings. Consequently, a rise in leverage should be accounted for

by an increase in the value of β.

To investigate the impact of debt levels on β, we define three additional

variables, βL as the levered firm β; and βu as the β of the unlevered firm; and Rp
as the market risk premium defined in CAPM:

βL=(Re-Rd)/Rp (7)

When considering an unlevered firm, the rate of return is equal to the return on
equity (Re), if we put debt as zero in equation 4. In which case, using unlevered
rate of return instead of return on equity in equation 6 gives us the β of an
unlevered firm (βu):

βu=(Ru-Rd)/Rp (8)

This equation (8) finally gives us the relationship between levered and
unlevered β as:

β L=β u*(1-tc)/(1-L) (9)5

Using equation 9 in place of βu in the equation 8, we find Ru to be

Ru=Rd+β L*Rp*(1-L)/(1-tc) (10)

Let Ep=β L*Rp*(1-L)/(1-tc)

Hence the unlevered rate of return breaks into the sum of two terms, Rd and Ep.
When considering this in the framework of risk and return, the term Ep signifies
the higher risk, and hence the higher required rate of return for equity (since
Ru=Re, as an unlevered firm is completely composed of equity, with zero
debt).Here Rd is considered equal to the risk-free rate, as a consequence of not
having any debt.However, in the formulation of these equations, no
assumptions have been made on Rd, nor have any constraints been placed on
it. Thus in cases with existing debt levels, Rd would be considered as the risk
adjusted rate of return, which in turn would incorporate the credit spreads linked
to the various credit ratings. Further, the terms βL and Rp are available for

5. Cf. Cohen (2003)

 13

companies (company shares), which makes the computation of this term

relatively straightforward.

By putting this equation (10) into equation 5 we obtain the following relationship:

Rw=Rd*(1-L*tc)+β L*Rp*(1-L)*(1-L*tc)/(1-tc) (11)

Let W1=Rd*(1-L*tc)

And W2=β L*Rp*(1-L)*(1-L*tc)/(1-tc)

W2 here signifies the market risks, where Rp represents the risk premium
commanded by the market, and is a reflection of macroeconomic factors that
have a telling effect on the state of industry and investment. The terms βL and L
in W2 determine the exposure of the organization to these macroeconomic
uncertainties. L or capital structure serves as the control variable for W2. This
equation demonstrates that capital structure decisions have a significant impact
on the risk exposure of a firm, thereby controlling the extent of the effects of
macroeconomic elements on it.

W1 is the factor that accounts for the consequences of the credit rating of a firm.
Apart from additional considerations arising from credit ratings, like those for
companies nearing a rating change6, the term Rd in the expression for W1
encapsulates credit spreads, representing the risk adjusted rate of borrowing for
the firm. Again, here the debt level (L) also factors in. The rate of borrowing (Rd)
for the firm is hence a function of its credit rating, which again is influenced by
the firm’s level of debt.

Combined, W1 and W2provide the WACC for the organization. The WACC for a
company is the rate of return the company is required to provide to its debt and
equity holders in order to raise capital. Thus equation 11 shows that the
required rate of return for the company, barring macroeconomic factors, is
largely dependent on:

• Leverage

• Credit rating and hence credit spread (Rd, the risk-adjusted rate of debt)

• Corporate tax rate

7. Cf. Collin-Dufresne and Goldstein (2001)
8. Cf. Standard and Poors’ (2011)
 14

C. Inferences

On analysis of the financial theories of WACC and the Capital Pricing Model,
and the Trade-off theory, we can see that leverage, and thus capital structure
has a profound impact on the rate at which a corporation can raise capital.
Apart from directly influencing the company’s exposure to macroeconomic risks,
such as recession and global financial crises, it also plays a vital part in
ascertaining the firm’s credit rating (as discussed ahead). The credit rating, in
turn determines the credit spread on the company’s borrowing, and so is a
crucial consideration for managers when taking decisions on capital structure.
Studies have shown that the expected future behavior of a firm’s leverage is an
important determinant of the credit spreads on its long-term liabilities7.
Complementarily, credit ratings have been defined as forward-looking opinions
on the creditworthiness of an entity8. This setting creates a high level of
interdependency between capital structure and credit ratings. This
interdependency is now examined by looking at the underlying proponents that
determine both, capital structure and credit ratings.

III. Capital Structure

A. Objectives

As demonstrated by the financial theories considered in the previous section,

debt levels are of crucial significance to firms. This is the reason that there is a
voluminous amount of literature on the subject, and has been such an intensely
debated issue over the years. The common thread, however, through all the
developments and theories regarding capital structure is that capital structure
decisions are aimed at maximizing the value of the firm in question. There are
generally two approaches to this issue; first, there is the WACC minimizing
approach, which looks to achieve the lowest possible rate of raising capital, and
thereby maximizing firm value. The second direct approach is more
complicated, examining the discrete costs and benefits obtained from
employing a particular level of leverage. This approach involves an analysis of
the factors affected by the company’s capital structure, which consequently

7. Cf. Collin-Dufresne and Goldstein (2001)

8. Cf. Standard and Poors’ (2011)
 15

have a bearing on firm value. These factors include, fundamentally, the Tax
Shield and the Distress Costs1. The complications arise from the fact that
distress costs aren’t a well-formulated or mapped element; that is, the costs of
financial distress are not directly measurable, and in addition the tax shield is
also a function of the rate of debt for the organization.

Here credit ratings provide an efficient proxy for basing capital structure
decisions upon, in both of those approaches. Credit ratings embody the costs of
financial distress in the form of increased debt rates for increased levels of
leverage; and these credit ratings are designed to account for a wide array of
factors that do or might play a part in affecting the firm’s ability to meet its
financial obligations2.

In this section the underlying elements used for deciding upon debt levels are
scrutinized. These elements can be classified into two categories: one category
includes factors identified in the study by Graham and Harvey (2001) where
they studied responses obtained from 392 completed surveys of Chief Financial
Officers (CFOs) regarding how they took decisions on capital structure and
capital budgeting issues3. The second includes elements identified in journals
through empirical examination, with regression and reverse regression
methodologies being applied4.

Thereafter we analyze recent developments that have taken place in the field of
capital structure theory. These include theorems such as the dynamic capital
structure adjustment theory5, the market timing theory6, the effects of proximity
to a credit rating upgrade or downgrade7 and adjustments post a credit ratings
upgrade or downgrade8, the costs associated with capital structure
adjustments9, and the speed of these adjustments10.

Finally a framework is developed, in the context of this literature identifying the

key elements that are taken into consideration when new capital is to be raised.
1. Cf. Cohen (2003)
2. Cf. Standard and Poor’s (2011)
3. Cf. Graham and Harvey (2001)
4. Cf. Hovakimian,Hovakimian and Tehranian (2003), Rajan and Zingalas (1995), Bauer
(2004), Mittoo and Zhang (2006)
5. Cf. Goldstein, Ju and Leland (2001)
6. Cf. Baker and Wurgler (2002)
7. Cf. Kisgen (2006), Anonymous(n.d)
8. Cf. Kisgen (2009)
9. Cf. Leary and Roberts (2003)
10. Cf. Flannery and Rangan (2005)
 16

This framework serves as an outline encompassing the aforementioned findings

in this area of finance, and provides the basis for studying the correlation
between capital structure and credit ratings.

B. Determinants

1. Manager’s Concerns

The study conducted by Graham and Harvey in 2001was a highly influential

paper on the subject, and has been referred to by a majority of papers in the
same field thereafter. The study was consisted of a survey soliciting responses
from approximately 4,440 companies from which they received 392 completed
surveys, representing a diverse variety of firms and industries. The survey,
which comprised of almost a hundred questions, looked to gain a
comprehensive understanding of the factors managers pay close attention to
when making decisions regarding capital structure and capital budgeting. They
also attempted to identify correlations between the capital structure and capital
budgeting strategies the managers followed for their companies. Further, these
decisions were investigated in the context of firm characteristics, such as size,
P/E ratio, leverage, credit rating, dividend policy, and industry. Managerial
characteristics of the kind of the extent of top management’s stock ownership,
and the age, tenure, and education of the CEO were also taken into account to
examine whether any systemic relationships existed between these and the
financial choices that were made1.

In terms of the elements that played a key role in directing the capital structure
strategy, in descending order of importance were, financial flexibility (cited as
important or very important by about 60 percent of the respondents), credit
ratings (cited important or very important by about 57 percent of the
respondents), earnings and cash flow volatility (cited important or very important
by about 50 percent of the respondents), insufficient internal funds (which is a
reflection of the pecking-order theory, was cited by about 48 percent of the
respondents), level of interest rates (cited as important or very important by
about 47 percent of the respondents), tax benefits of interest deductibility or tax
shield (cited as important or very important by about 45 percent of the

1. Cf. Harvey and Graham (2001)

 17

respondents) , transaction or adjustment costs (cited as important or very

important by about 35 percent of the respondents), equity market valuation
(cited as important or very important by about 33 percent of the respondents),
and comparable firms’ debt levels or average industry leverage (cited as
important or very important by about 25 percent of the respondents)2.

Figure 5: Debt/Capital Structure Policy Determinants2

Of these factors, credit ratings is the second most important factor identified,
and in an indirect capacity it also affects the level of interest rates required of
the companies’ borrowings. An interesting outcome of this study is that four
factors outrank the factor of interest tax savings, which was the primary benefit
of leverage as identified by the Miller Modigliani theorem on capital structure
with taxes (MMII)3. The fairly high significance of transaction costs found in the
analysis lends evidence to the paper by Leary and Roberts (2003) on the
relevance of adjustment costs in making decisions on new capital issuances4.
The relatively high rank of market value of equity, as shown on the figure (figure

2. Cf. Graham and Harvey (2001)

3. Cf. Ross-Westerfield-Jaffe (2003), Chapter 15
4. Cf. Leary and Roberts (2003)
 18

5), testifies to the validity of the market timing theory explored by Baker and
Wurgler in 20025.

This study provides satisfactory validation to the substantial importance placed

upon capital structure in firms. Other relevant findings include the significant
adherence of managers to the trade-off theory, and related adjustments to a
target capital structure. This finding has been argued in some papers, but is
supported by most6. Also, certain differences were identified in the trends of
financing choices made by bigger firms as compared to smaller ones7.
Although, on a holistic revision of the inferences presented in this paper, we can
conclude that this study provides supporting evidence for many of the papers
that have been published on the subject in recent times.

2. Empirical Analysis

An early study on the financial characteristics that determine capital structure

for a firm by Harris and Raviv (1991) came to the consensus that a positive
correlations exists between leverage and fixed assets, non-debt tax shields,
investment opportunities, and firm size, while a negative one is found between
debt level and volatility, advertising expenditure, profitability, and uniqueness of
the offering8. These findings were reformulated by Rajan and Zingalas (1995)
into four factors, the tangibility of assets, market-to-book ratios, firm size, and
profitability9.

Here, tangibility of assets refers to the ratio of fixed assets to total assets, which
serves as a measure of the collateral available for the company in case of
defaults thereby reducing the risk of default itself for the lender. The tangibility is
also relevant since the assets under consideration should be marketable, or
should retain a significant part of its value on liquidation. The market-to-book
ratios provide an indication of the growth potential of the firm. It follows that high
growth companies should employ greater levels of equity, which is supported by
both the market timing theory of capital structure10, and the bondholder-
shareholder conflict that makes companies forego positive Net Present Value

5. Cf. Baker and Wurgler (2002)

6 Cf. Hovakimian, Hovakimian and Tehranian (2004)
7 Cf. Harvey and Graham (2001)
8. Cf. Harris and Raviv (1991)
9. Cf. Rajan and Zingalas (1995)
10. Cf. Baker and Wurgler (2002)
 19

(NPV) projects that are not sufficiently high11. The logic behind the firm size
determinant, taken as the natural logarithm of annual sales of the firm, is that
larger companies are less likely to get bankrupt. Lastly, the factor of profitability
is disputed in terms of the correlation being positive and negative. The positive
correlation stems from the assumption that the market for corporate control is
effective, while the argument for the negative correlation follows from the
rationale that managers of highly profitable firms would want to avoid the
interest deductions of debt, which lead to constrained profitability for the firm12.

Added support for the conclusions obtained in the Graham and Harvey (2001)
survey study is found in the paper by Kayhan and Titman (2006), which
analyses parameters such as cash flows, investment expenditure, and stock
price histories to draw inferences for debt ratio rationale. The study categorizes
the determinants of capital structure as: Past profitability, Financial deficits, Past
stock returns, Market timing, Leverage deficit, and Changes in target debt
ratio13.

Here elements from the dynamic capital structure theory suggested by

Goldstein, Ju and Leland (2001) are borrowed and used in formulating the
derived conclusions. It considers the discoveries that relate to the
aforementioned parameters, and finds significant proof of their validity. The past
profitability parameter is measured in light of the observation that highly
profitable firms tend to have lower debt levels; whereas financial deficits refers
to firms with higher financial deficits preferring higher levels of leverage. Past
stock returns and market timing relate to the preference of issuing equity when
equity is valued highly by the markets14. Leverage deficit implies that firms do
target specific debt ratios, and the last parameter accounts for changes in this
target capital structure13, as put forth by the dynamic capital structure theory15.

The results in the paper do pint to the concept of a target capital structure that
firms move towards, though factors like historical stock prices, cash flows,
investment opportunities, and transaction costs may at times cause
considerable deviations from the optimal capital structure13. The study also

11. Cf. Ross-Westerfield-Jaffe (2003), Chapter 16

12. Cf. Rajan and Zingalas (1995)
13. Cf. Kayhan and Titman (2006)
14. Cf. Baker and Wurgler (2002)
15. Cf. Goldstein, Ju and Leland (2001)
 20

makes a reference to the speed of this capital structure adjustment, which was
calculated by Flannery and Hankins (2007) as about 22 percent on average per
year16.

Finally, we consider a paper studying the factors involved in determining a

firm’s target capital structure. The paper focuses on dual issuance, that is, the
issuance of both debt and equity since dual issues offer an opportunity to reset
the firm’s capital structure. Firms following the dynamic trade-off strategy will
choose the amounts of new debt and equity to be issued, such that the
accumulated deviation from the target is offset and the resulting debt ratio is
close to the target. The study uses post-issue leverage levels to analyze the
correlation of different parameters on target leverage. Market performance and
profitability form the basis of this comparison, which is carried out in pairs of,
debt versus dual issue, and dual issue versus equity, and the results are
compared to the behavior predicted by the trade-off theory, the pecking order
theory, and the market timing theory17.

The results obtained by means of this examination reveal that dual issuers’
market-to-book ratio (2.304) is significantly higher than debt issuers’ ratio
(1.595) but is lower than equity issuers’ ratio (2.861). Dual issuers’ stock return
(0.372) is significantly higher than debt issuers’ return (0.184) but is not
significantly different from equity issuers’ return (0.352). The return on assets
(ROA) of an average dual issuer is 0.088, that of an average debt issuer is
0.148, and for an equity issuer it is 0.080. The difference, as such of dual
issuers and equity issuers is not significant, but debt issuers produce
substantially higher returns on their assets17.

Taking firm size into account, again dual issuers and equity issuers tend to
have similar sizes, while debt issuers tend to be larger. Debt issuers and dual
issuers though tend to have similar tangibility of assets, 0.331 for debt issuers
and 0.323 for dual issuers. This figure is significantly larger than that for equity
issuers, which is 0.273 17.

An average dual issuer’s pre-issue leverage ratio is 0.264 and its post-issue
leverage ratio is 0.357. An average debt issuer’s pre-issue leverage ratio is

16. Cf. Flannery and Hankins (2007)

17. Cf. Hovakimian, Hovakimian and Tehranian (2004)
 21

0.254 and its post- issue leverage ratio is 0.367. Though the differences
between debt issuers’ and dual issuers’ ratios are economically small, they are
statistically significant. Equity issuers’ pre and post issue leverage ratios are
significantlylowerat0.166and0.138, respectively. These variations arise primarily
due to sector specific factors. Generally, dual issuers belong to industry sectors
that are less levered than the industries of debt issuers, but have higher
industry averages for debt ratio as compared to equity issuers’ industry
sectors17.

As a consequence of this, debt issuers and dual issuers tend to be more

leveraged than the average level for their sectors, and equity issuers tend to be
underlevered relative to their average industry standard debt ratios17.

These findings all point to the inference that firms do have an optimal capital
structure that they target and pursue. Complementary to this, there are a
number of considerations that influence these adjustments to the optimum. With
regard to the factors that serve as determinants to these capital structure
adjustments, the primary ones are, apart from credit ratings and the associated
interest rate levels, the returns produced by the firm (return on assets, return on
equity, and such measures of profitability) in conjunction with its cost of capital,
the tangibility or marketability of its assets, its market-to-book ratios, firm size,
cash flow volatility, financial deficits, proximity to a rating change, and
adjustment or transaction costs. Some of these findings are relatively new and
will be discussed further in the next section. Returning to equation 11 (page 12)
in the previous part, of these identified factors, βL (the levered beta value used
in accounting for market conditions) in some part reflects market-to-book ratios,
cash flow volatility, and profitability; and βL in turn is correlated with credit
ratings and interest rate levels.

Also many of these identified factors also form determinants for credit rating
assignments, explained in the succeeding part, which gives credence to the
objective of establishing the interdependent relationship between capital
structure and credit ratings.

17. Cf. Hovakimian, Hovakimian and Tehranian (2004)

 22

C. Recent Developments in Capital Structure Theory

1. Proximity of a Firm to a Change in Credit Rating (Boundary Effect)

Kisgen (2006) examines the effect of a firm close to a credit ratings downgrade
or upgrade on its capital structure, and concludes that organizations that are
nearing a change in its credit rating tend to issue approximately 1 percent less
net debt as compared to equity. This phenomena is true for both, companies
nearing a downgrade and those in proximity of an upgrade, and can be
explained by the logic that firms close to a downgrade decrease their leverage
to prevent the impending downgrade and maintain their current credit rating,
while corporations nearing an upgrade issue lesser debt to improve their debt
ratio in order to achieve the upgrade1. In a follow up to this paper, Kisgen
(2009) also analyses the effects on capital structure of a firm post a credit
ratings downgrade or upgrade. In this analysis he finds that on being
downgraded companies issue about 1.5 to 2 percent less net debt relative to
equity. This effect is not, however, noticed in the case of upgraded firms2. This
phenomena is further verified and validated by a paper using different
methodology, which shows that companies close to a credit rating change issue
on average 1.8 percent less net debt relative to equity3.

The study by Kisgen (2006) included 12,336 firm years, and only includes small
and medium sized debt and equity issuances (defined as 10 percent or less of
total assets), since large sized offerings may produce aberrations in the
phenomena being attempted to be observed. The period for the collected data
was 1986 to 2001, and the statistical tests were performed for two sets of
observations: firstly, the ‘+’ and ‘-‘ graded institutions were compared to the
middle rated ones (for example, A+ and A- rated companies’ offerings were
compared to those by A rated ones), and then within each rating firm from the
top and bottom thirds, as per calculated credit rating scores, were compared to
the firms in the middle third of the rating. Further, the analysis was extended to
cases including financial services and utilities firms, and without including these
firms. The results were found to be more significant for the case not involving
financial services and utilities firms1.

1. Cf. Kisgen (2006)

2. Cf. Kisgen (2009)
3. Cf. Anonymous (n.d)
 23

The observations derived from the study illustrate that firms in the ‘+’ credit
rating category issue, on average when controlling for variables related to
leverage, profitability and size, 0.64 percent less net debt, while those in the ‘-‘
credit rating classification, under the same conditions, issue 0.51 percent less
debt. However, when considering these variables to be incorporated in the
credit rating assignment, and conducting the same tests without the control
variable, and considering both cases as one variable, it is found that firms
having credit ratings in either ‘+’ or ‘-‘ categories, on average issue 1.02 percent
less net debt as compared to equity1.

When the analysis was performed on the firms at the extreme thirds within a
single credit rating, it was found that, on controlling for the same previously
mentioned variables, firms nearing an upgrade issue 0.84 percent less net debt
on average, while those close to a downgrade issue 0.83 percent more equity.
Again, on performing the analysis devoid of the control variables, the firms near
a ratings change issued 0.91percent less debt compared to equity. All
percentages presented were taken as percentages of total assets of the
company, and the results were found to be significant at the 1 percent level1.

2. Dynamic Capital Structure Theory

The formulation of the dynamic capital structure theory by Goldstein, Ju and

Leland (2001) was an important development in the field of capital structure
theory. Prior to this paper, capital structure determinants and the amounts of
debt and/or equity issuances by companies, were considered by most papers to
be static variables. This model considers the EBIT of a company to arrive at the
tax benefits provided by leverage, which as explained by Graham (2000) is a
more direct appraisal of this advantage. Even though the optimal strategy for
capital structure adjustment is implemented over an arbitrarily large number of
restructuring- periods, this study introduces a scaling feature inherent in the
framework that permits simple closed- form expressions to be obtained for
equity and debt prices. When a firm has the option to increase future debt
levels, tax advantages to debt increase significantly, and both the optimal
leverage ratio range and predicted credit spreads are more in line with what is
observed in practice. The one assumption made in the development of this

1. Cf. Kisgen (2006)

 24

concept is that it solely takes into account upward restructuring of leverage, and
also does not account for information asymmetries, asset substitution
(bondholder-shareholder conflicts or agency costs4), and other such particular
limitations, which makes the formulation inaccurate for downward restructuring
of debt5.

3. Market Timing Theory

The market timing theory proposed by Baker and Wurgler in 2002 provides
evidence that firms are more likely to issue equity when their market-to-book
values are high, and are more likely to repurchase equity when the market
values are low. This phenomenon has relevant consequences on the capital
structure of the firm, and suggests that capital structure of a firm is dependent
on previous attempts at “timing the equity markets”. It follows from this that such
a strategy produces benefits for ongoing shareholders as compared to the
entering or exiting ones. The paper also cites the study by Graham and Harvey
(2001) related to managerial considerations in making capital structure
decisions6 as relevant justification of their study7.

Contrary to the inferences drawn from the classical efficient and integrated
capital markets assumed in Miller and Modigliani capital structure theories, the
costs of raising different forms of finance do not vary independent of each other,
and so equity market timing forms an important element in financing policies.
Their analyses show that low leveraged firms were the ones that issued large
offerings of equity when their market values were high, while the highly
leveraged ones do not show this characteristic. They reach the conclusion that
the capital structure of a firm is largely an outcome of previous equity market
timing efforts, and is unrelated to any target capital structure7.

Although market timing does prove to be a consideration of significant

importance to managers in making capital structure decisions6, there is

4. Cf. Ross-Westerfield-Jaffe (2003), Chapter 16

5. Cf. Goldstein, Ju and Leland (2001)
6. Cf. Graham and Harvey (2001)
7. Cf. Baker and Wurgler (2002)
 25

sufficient evidence in capital structure literature that disproves the view that firm
do not target an optimal capital structure8.

4. Adjustment and Transaction Costs

The paper by Leary and Roberts(2003) regarding rebalancing of capital

structure by firms incorporates the presence of costly adjustments in the trade-
off theory and the dynamic capital structure model. The observations in the
study point to companies adhering to a “dynamic trade-off policy in which they
actively rebalance their leverage to stay within an optimal level”8. Other factors
like market equity value and credit ratings do feature in the capital structure
considerations, but the adjustment caused by these elements is drawn out over
time as a result of the adjustment and transaction costs involved. This
occurrence is further highlighted in papers studying the speed of capital
structure adjustments9.

The paper finds that issuance costs for debt on average is 1.09 percent of the
offering while that of equity is 5.38 percent. This implies that equity issuances
will occur less frequently than debt issuances, assuming firms minimize costs.
Second, equity and debt issuance costs contain both a fixed cost and convex
cost component. For similar firms, in terms of size and risk, equity issuance
costs exhibit relatively higher fixed costs and greater convexity than debt
issuances. The greater fixed cost implies that equity issuances will be relatively
larger and less frequent8, to benefit from economies of scale.

The paper concludes that adjustment costs are a factor in capital structure
decisions relating to the raising of new capital, and this is supported by the
finding that corporations undertake capital restructuring efforts fairly infrequently
(annually on average) and in clusters. The examination of costly adjustments in
the context of a dynamic trade-off theory model yields results that are strongly
supportive of a rebalancing effort by firms. However, these results are
inconsistent with the market timing and inertia theories, both of which are

8. Cf. Leary and Roberts (2003)

9. Cf. Flannery and Rangan (2005), and Flannery and Hankins (2007)
 26

predicated in large part on the persistence of the leverage process. It is also

found that firms do indeed respond to equity issuances and equity price shocks
by appropriately rebalancing their leverage. Further, this rebalancing takes
place within two to three years, on average, for equity issuances, and three to
five years for shocks to market equity values8.

With regard to the speed of capital structure adjustments, Flannery and Rangan
(2005) studied whether firms had long-run leverage targets and the rate at
which they adjusted towards this target debt ratio. The paper also recognized
and included partial adjustments towards such a target in stipulating their
findings. The results obtained showed that firms move towards their optimal
capital structure at the rate of 30 percent per year, according to the mean
sample. In addition the paper also showed that market timing and pecking order
effects were economically significant, but their effects were primarily relevant in
the short-run10.

Combining the results of the two aforementioned studies, Flannery and Hankins
(2007) found the rate of adjustment towards the target capital structure to be 22
percent annually. Complementary to these findings, this study also lays stress
upon the influence of firm specific attributes on adjustment costs, and the value
maximization at the target capital structure. Managerial benefits are not shown
to be as significant a factor in the speed of adjustment, possibly reflecting it
being of secondary importance. Overall, the speed of adjustment crystallizes
into a trade-off between the costs and benefits of the adjustment11.

8. Cf. Leary and Roberts (2003)

10. Cf. Flannery and Rangan (2005)
11. Cf. Flannery and Hankins (2007)
 27

IV. Credit Ratings

Credit ratings are opinions on the creditworthiness of an entity, which might be
a country, a company or a financial product, as assessed by an impartial body
known as a credit rating agency1. These ratings represent opinions as to the
likelihood that the borrower or issuer will meet its contractual and financial
obligations as they become due2.They don’t serve as investment advice or
recommendations to purchase, hold or sell a security. They also don’t address
market liquidity or volatility risk. Credit ratings are also not meant to be
considered guarantees of credit quality or of future credit risks. They are
opinions that serve as guidelines or benchmarks for investors, providing
information on the probability that the concerned entity would default on its
obligation. They are meant to be forward looking, and try to anticipate the
potential impact of future events. They are also formulated in a way so that
these ratings are comparable and equivalent across regions and industry
sectors1.

Credit rating agencies are central to credit rating assignments. These bodies
assess the credit risk of corporate and government borrowers and issuers of
fixed-income securities by analyzing relevant information available regarding
the issuer or borrower, its market, and its economic circumstances. The
information processed by the credit rating agency, while generally available to
the public, may be costly and time-consuming to collect and analyze. Further,
certain credit rating agencies are also able to obtain non- public information
from borrowers and issuers as part of the rating process2. These agencies
derive their credibility through years of experience in the field of risk
assessment, by way of which they develop a comprehensive knowledge base
on the subject, across industries and geographies.

1. Cf. International Organization of Securities Commissions [IOSCO] (2008)

2. Cf. Poon (2003)
3. Cf. Standard and Poor’s (2008)
 28

A. Methodology

There are a variety of methods employed by corporations when raising new

capital that have an impact on both capital structure and credit ratings. Some of
these means include short-term commercial paper, standard bank loans,
publicly traded bonds, and equity securities. Where a company issues fixed
income securities to be traded on a public market, the issuer would generally
require a credit rating agency to rate these products with the objective of
making them attractive to investors and thereby soliciting investment. In many
cases, potential investors expect an issuer or security to be covered by several
credit rating agencies to obtain a more thorough appraisal of the inherent risks
to the investment. Investors also may operate under guidelines or legal
requirements (covenants) that prohibit the investor from holding a debt security
that is not rated at or above a certain level by one or more credit rating
agencies. An issuer that chooses to have its debt securities rated will contract
with a credit rating agency for the issuance and maintenance of a credit rating.
In some cases, a credit rating agency will undertake to rate an issuer without
first being requested by the issuer to do so1. This is referred to as an unsolicited
rating. Though a study focusing on firms in Japan has lent evidence to the fact
that unsolicited credit ratings are biased downwards, after controlling for
irregularities like the self-selectionbias2.

The analytical framework as described by Standard and Poor’s (2008) divides

the characteristics to be considered into two fundamental categories: business
analysis and financial analysis. The category of business analysis focuses on
elements such as industry characteristics, market positioning, management
effectiveness, and so on. The financial analysis category takes into account
factors like capital structure, cash flow volatility, financial flexibility, profitability,
and financial policy. An examination of these two categories allows the rating
agency to first measure the risks particular to the industry under consideration,
while the financials facilitate a better understanding of the company specific
risks within the industry3.

As part of the industry analysis, key rating factors are identified. These form the

1. Cf. International Organization of Securities Commissions [IOSCO] (2008)

2. Cf. Poon (2003)
3. Cf. Standard and Poor’s (2008)
 29

keys to success and areas of vulnerability. A company’s rating is affected

crucially by its ability to achieve success and avoid pitfalls in its business. The
nature of competition is different for different industries, and depends on the
characteristics of that industry sector. In addition to this diversification factors
are also considered. This means that for businesses that are highly diversified,
each separate business unit is analyzed separately, in context of the key rating
factors identified for that industry, and then the composite of these separate
analyses is formed, factoring in the positive synergies for the diversified
operations3.

The formulation of ratings opinions is generally a well-documented process that

is based on a thorough analysis according to the relevant criteria for most credit
rating agencies. The application of these criteria, which will be delved into in the
proceeding section, are tried to kept transparent, comparable, forward looking
and stable4.

The process followed by Standard and Poor’s, as detailed by Standard and

Poor’s (2010) is as follows4:

In applying these criteria during the ratings process, credit rating agencies
undertake analysis and prepare ratings-related documentation that is then
presented to a rating committee. The large amount of analytical work that
informs the ratings process is packaged in the form of a Ratings Analysis
Methodology Profile (RAMP).

This RAMP covers the rating factors prescribed by the applicable criteria. Based
on the outcome of the quantitative and qualitative analyses performed by the
analytic team, the lead analysts present their view with respect to each of these
ratings factors, which are then considered by the voting members of the rating
committee. At the rating committee meeting, the entire RAMP is reviewed and
discussed and a vote is taken to arrive at the assigned rating.

3. Cf. Standard and Poor’s (2008)

4. Cf. Standard and Poor’s (2010)
 30

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Figure 6: Flowchart of the Rating Process4

4. Cf. Standard and Poor’s (2010)

 31

B. Ratings Criteria

In considering the criteria employed by credit rating agencies, we direct our

focus solely to the financial analysis, without taking into account the business
analysis. This follows from the fact that business analysis relates primarily to a
study of the industry sector, and as such, for the purpose of this paper, is not
pertinent to financial theory in this respect. However, it should be noted that the
credit rating process for organizations follows a strict rigor, thereby allowing
these financial parameters to be assessed in context of industry standards and
conditions.

The financial details significant to credit ratings, as identified by Standard and

Poor’s, are profitability measures of the likes of return on equity (pre tax and
interest), operating income and EBITDA margins, interest coverage
(EBIT/Interest); and capital structure ratios such as debt divided by the book
values of debt and equity, and debt divided by the market capitalization of the
firm. All these ratios are taken in relation to the industry average, so as to
provide an estimation of the firm’s relative competitive position in the industry.
The specific ratios are1:

• Debt/EBITDA

• EBITDA/Interest

• Debt/Market Capitalization

• Debt/(Debt+Book value of Equity) [or VL]

In another paper by Minardi, Sanvicente and Artes, which looks at establishing

a relationship for the cost of debt, credit ratings are taken to be an effective
proxy for the cost of debt for firms. The paper goes on to identify the key factors
that contribute to credit ratings for an organization. The study was conducted on
set of 627 American companies, and the results obtained by applying their
model were tallied against those assigned by professional credit ratings
agencies like Moody’s and Standard and Poor’s. Of these outcomes 96.74
percent of the ratings either tallied or were classified into ratings categories
adjacent to the ones assigned. Thus the key factors identified through this study

1. Cf. Standard and Poor’s (2006)

 32

are as follows2:

• Size [ ln(Total Assets) ]

• Financial Leverage [ Debt/Total Assets ]
• Return on Assets [ Net Income/Total Assets ]
• Volatility

Here, β serves as an appropriate measure of volatility. These identified factors

do feature across papers in existing literature. In addition to the factors
mentioned above, interest coverage (EBIT/Interest) is another factor that is
referred to in certain studies3.

So, to summarize the determinants of capital structure alongside those

identified for capital structure we arrive at the following table:

Credit Ratings Capital structure

Financial Leverage [Debt/Assets] Credit Ratings

Interest Coverage
Interest Rate Level
[EBITDA/Interest]

Profitability [Net Income/Assets] Profitability

Tangibility of Assets

Debt/Market Capitalization Market-to-Book Ratios

Size [ln(Assets)] Firm Size

Volatility [β] Cash Flow Volatility

Coverage [Debt/EBITDA] Financial Deficits

Proximity to Ratings Change

Adjustment Costs

Figure 7: Comparison of Capital Structure and Credit Ratings Determinants

(Author’s Own Representation)

The table above illustrates the degree of parity between capital structure and
credit ratings, and hence shows the interdependency between the two
concepts. At this point it should be noted here that credit rating determinants
are based on additional factors such as off-balance sheet-financing like

2. Cf. Minardi, Sanvicente and Artes (n.d)

3. Cf. Kisgen (2006)
 33

operating leases, guarantees, transferred receivables, and contingent liabilities;

asset valuation or pricing, and other accounting information of the kind of
inventory valuation and depreciation methods. Apart from these, as mentioned
earlier, credit ratings also account for industry standards, averages, trends and
conditions in the business analysis part of the methodology4.

C. Consequences of Credit Ratings

Credit ratings have a direct influence on the credit spreads associated with
long-term debt issuance5. This effect transfers onto the firm’s cost of raising
equity (as explained by the CAPM model6), and hence affects the WACC for the
firm (stipulated in equation 11 on page 12). There are, however, even more
profound effects of credit ratings, as depicted by Kisgen (2006)7. The paper
demonstrates how credit ratings affect firm value, and thus capital structure
decisions, apart from the direct costs imposed on the firm by way of interest rate
levels.

One major effect of credit ratings is caused by the regulations or covenants

imposed on bond investments by governments and institutions. This is
demonstrated by the fact that banks have been restricted from owning
speculative-grade bonds since 1936, and loans and savings have been
restricted from owning speculative-grade bonds since 1936. Regulations also
affect the liquidity for bonds by rating. If firms incur higher interest rates in less
liquid markets as distinguished by credit rating, there may be incentives to avoid
these ratings levels. Also, since several regulations are specific to the
investment-grade versus speculative- grade designation, regulatory effects are
found to be greatest around this change. Liquidity issues are most significant for
speculative-grade bond rating levels, which further strengthens the previously
formed conclusion7.

Credit ratings also produce signaling effects in financial markets. Since they
form opinions on the creditworthiness and hence the default risks associated
with a firm, based upon a thorough examination of the company and its industry
sector, it provides investors with information regarding parameters of
4. Cf. Standard and Poor’s (2006)
5. Cf. Minardi, Sanvicente and Artes (n.d)
6. Cf. Ross-Westerfield-Jaffe (2003), Chapter 10
7. Cf. Kisgen (2006)
 34

performance such as the relative competitive positioning of the firm, its

managerial effectiveness, and so on. Further, credit rating downgrades signal
greater risks associated to the firm, while upgrades portent to higher stability.
Also, since credit ratings are comparable across regions and industries, firms
with the same credit rating in some measure denote the same firm quality. As a
consequence a good firm with an A- rating would still have similar credit
spreads as that of a bad A- firm. This provides managers with the incentive to
maintain high credit ratings8.

D. Inferences

Thus, a wide array of performance parameters is taken into consideration, and

a comprehensive due diligence process is carried out in assigning firms credit
ratings. Many of these factors are also vital in deciding upon the capital
structure of the firm, and the table in the previous section (figure 7) further
illustrates the correlation that exists between capital structure and credit ratings.
Hence credit ratings, being publicly available and comparable across
geographies and industry sectors, would serve as effective proxies in
determining capital structure determinants, and thereby the ideal capital
structure. Additionally, credit ratings are developed to be forward looking. In this
scenario, firms can use capital structure adjustments to influence determinant
parameters like profitability or volatility, by comparing their debt ratio and
accompanying credit rating with those of a company in the same industry with a
more favorable value of the factor being considered. For example, if a firm
wishes to reduce its cash-flow volatility while attempting to achieve a credit
rating upgrade, it can adjust its level of debt by comparing its relevant ratios to
that of a firm having a higher credit rating, thereby altering its capital structure
accordingly to aid itself in its objective.

Now reconsidering the equation 11 (p. 12), it specifies leverage (L), credit rating
(through the term Rd signifying the firm’s rate of borrowing), volatility (βL), the
corporate tax rate (tc), and the risk premium commanded by the market (Rp) as
the dependent variables in defining the WACC for a firm. Of these variables, the
tax rate (tc) and the volatility (βL) are not directly controllable, and market risk
premium (Rp) is a variable depicting macroeconomic conditions. Further, the
8. Cf. Kisgen (2006)
 35

beta term accounts for volatility, and market equity valuation, which, apart from
being a factor in assigning credit ratings, also plays a part in determining capital
structure, as described further by the market timing theory9. Although credit
rating (and hence Rd) is also not a variable that can be manipulated directly, we
include it in this formulation due to its interdependence with the debt ratio.

When considering capital structure and capital structure literature, all of it is

geared towards optimizing capital structure towards maximization of the firm. As
discussed earlier, firm value maximization corresponds with WACC
minimization10, so by developing a model incorporating the applicable tax rate,
β, and Rp, one can derive optimum capital structures for firms in different credit
ratings, by incorporating the risk adjusted rate of debt in place of Rd and taking
into account adjustment costs.

V. Conclusion
The study finds a high degree of interdependence exists between capital
structure and credit ratings, which enables credit ratings to be used as a proxy
for determinants of capital structure, and thereby can help a firm ascertain and
achieve the optimal capital structure for firm value maximization. This
relationship is adapted from the Gaussian copula formulation developed by
David X. Li11. However, unlike the copula function which relied on historic data
of Credit Default Spreads (CDS), which was only available from the year 2001
onwards, credit ratings are designed to be forward looking, and are based upon
a wide scope of parameters. Also, post the subprime mortgage crisis, rating
agencies have started employing a more rigid and conservative approach to
credit rating assignments; and the criteria used for rating organizations is well
grounded in fundamental parameters used to judge performance. These
elements allow corporations to move towards not only preferred credit ratings or
leverage levels, but even modify the underlying determinants in the favored
direction, by making measured adjustments scaled to the requirements of the
firm.

9. Cf. Baker and Wurgler (2002)

10. Cf. Cohen (2003)
11. Cf Salmon (2009)
 36

Another finding in the form of equation 11 (p. 12), demonstrates the effect of
leverage level and credit rating on the cost of capital for a firm. It provides an
expression for separating the WACC into macroeconomic and market factors,
and leverage and credit ratings factors. This equation further provides a
relationship between macroeconomic risk exposure and debt ratio. Thus, the
equation allows for the minimization of the WACC and hence maximization of
the firm value, for a given credit rating in a given market. Also, closer scrutiny of
the classical capital structure theories reveals a failure to consider the dynamics
associated with the tax-shield and the cost of financial distress, which again
have a significant impact on the optimal capital structure level.

Further research would be required to study the dynamics between capital

structure adjustments and credit rating changes, and the impact this has on the
underlying determinants. These effects would have to be quantified so as to
allow modifications in one variable to cause desired changes in the other. There
is ample evidence testament to the profound impact of capital structure. The
aim of academic research would be to quantify or model these behaviors for
application.
 37

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