Do Firms Target Credit Ratings or Leverage Levels - Article Example

Article Summary This article reexamines recent findings on the role played by credit ratings in the marginal financing behaviors of businesses. Credit rating has for a long time been documented as an important determinant of the capital structure policy decisions. Recently, this motivation has been put under empirical scrutiny. The results of the empirical scrutiny indicate that, credit ratings are not the primary concern in making capital structure decisions. The Influence of credit ratings on the capital structure had not been previously formally investigated. The recent interests in this area were influenced by the outcome of a survey paper. The survey listed credit rating as the second most important factor in organization’s capital structure policy decisions. The CR-CS model (credit rating –capital structure), as formulated by Kisgen illustrates that, the capital structure policy of any firm is influenced by its credit ratings (Kisgen, p1325). The model is a general description of the behavior of a subsample of firms. The appeal of the model varies systematically between firms as classified by some firm-level attributes. Those attributes are examined as follows; first, a test of the sensitivity of the active firms to the capital market participation versus inactiveness to capital market participation. Second, the sensitivity of the CR-CS model in firm’s bond ratings. Third, the effect of CR-CS motivation on firms that are active participants in the commercial paper markets as compared to the inactive firms. Last, examination of the capital structure behavior in relation to investment opportunities available (Kisgen, p1325). Reconfirming Kisgen’s findings, firms on the verge of rates change uses less debt financing margin therefore supporting the CR-CS model. However, CR-CS motivation cannot be documented to be systematically related to the attributes above. The major drawback of the model is the fact that, CR-CS model does not apply to all the rating classes. The model, as analyses indicates only holds in B-rated firms. Thus, Kisgen’s initial findings were driven by a subsample of firms with very low ratings. The usage of B-rated firms in support of the model presents a major weakness in the model. B-rated firms are associated with constant financial distresses therefore, their marginal financing behavior is influenced more by their lack of access to the debt market (Kisgen, p1331). Additionally, the model implies that, organizations on the edge of grade rating based on investment and noninvestment should be very sensitive to their marginal financing impact. The results from this article disagree with this notion. Further, the findings indicates that, the model is not necessarily more applicable to firms having external financing needs and those with regular access to the capital markets. Consequently, the results shows that, the model is a poor descriptor of the firm’s determination of their financial decision. This conclusion does not necessarily imply that firms do not include credit rating as an important determinant in their capital structure policy decisions. Literature review Majority of the corporate finance books recognizes credit ratings as a determinant of the capital structure policy decisions. Those books until recently lacked significant formal findings on the influence of the credit ratings. A recent study disclosed that, chief financial officers identified credit ratings to be the second important factor in debt policy decisions (Kisgen, p1330). Formal tests using the CR-CS model were conducted by Kisgen. He argues that, credit ratings is an independent factor on capital structure decisions. He further implies that, firms at the edge of credit rating change issues less debt in relation to equity than firms not near the edge of this change (Kisgen, p1335). The resulting outcome of the model is that, firms at the edge of credit rating change ought to be reluctant in issuing debt. A firm with a positive rating is unlikely to sacrifice the opportunity of moving to a higher credit rating by issuing debt. Firms that make capital structure decisions without considering credit ratings in the long run must make adjustments Hypothesis development The basic thesis of this article is to examine the desire of the firms to maintain a good credit rating and pronouncement of different firms in maintain those credit ratings. Before the survey commences, several attributes of the firms are identified. Those attributes are correlated with the likelihood of the firm to consider credit ratings while making capital structure decisions. Exploration follows to confirm the validity of the CR-CS model as observed in the firm’s systematic marginal financing behaviors in relation to the selected attributes (Kisgen, p1338). If the firms reveals a systematic relation, a confirmation of the role of credit rating influence is achieved. The authors advances the following hypothesis; i. Hypothesis 1: external financing requirements requires the capital market participation. The anticipated firms should have external financing needs and thus participation in the capital market. These firms are more sensitive to the CR-CS model motivation. This subsample of the firms is concerned with the discrete cost jumps as a result of credit ratings (Kisgen, p1340). ii. Hypothesis 2: Effect on bond ratings The CR-CS model indirectly assumes that, firms are concerned with their bond rating category irrespective of the rating. Related hypotheses include; iii. Hypothesis 3: commercial papers. The sensitivity of the CR-CS model to issuers of the commercial papers is conducted. Firms having active participation in the commercial paper market are especially sensitive in maintaining their bond rating. iv. Hypothesis 4: Growth prospects Firms with viable investment opportunities are more likely to maintain a favorable credit ratings. These firms have positive net present value opportunities available. The methodology used to test those hypothesis is an adaption of Kisgen research. The tests are conducted by estimating a regression model. Debt issuance forms the dependent variable while credit ratings forms the dummy variable. The dummy variable illustrates whether a firm is positive or negative in its bond rating. There are other control variables in the regression model (Kisgen, p1342). Results Hypothesis 1 The evidence from this study does not support this hypothesis. The Possible explanation for this outcome is that, firms that are active in the capital market are less concerned with their credit ratings. This due to the ability to raise funds easily for corporate expansion. Hypothesis 2 The results are confounding. The examinations shows instances where CR-CS model is applicable and others where it’s not applicable. Hypothesis 3 Tests shows that, firms issuing commercial papers, the CR-CS model is not their primary descriptor of their behavior. Hypothesis 4 The evidence points out that, the CR-CS model is not moderated by the growth of the firm. Investment opportunities and firm’s decision concerning capital structure policy do not influence each other with credit ratings in mind. Conclusion The evidence as presented by this article discredits Kisgen CR-CS model. Through the analysis of the regression models formulated, the article has proven the inaccuracies in the model. The CR-CS model as the article suggests is only applicable to B-rated firms with low credit rating. The findings from the regression models has demonstrated the significance of credit rating in making the capital structure policy decisions. Finally, the results of the regression model has proven that, credit rating is not the primary consideration in making capital structure decisions. However, the article supports the importance of credit rating in capital structure decisions. Works Cited Kisgen, Darren J. "Do Firms Target Credit Ratings or Leverage Levels?" Journal of Financial and Quantitative Analysis: 1323. Read More