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The Theory of Finance and the Business Investments: the Business and the Financial Risks

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The managers of the firms take credit rating aspect into consideration at the time of making decisions relating to capital structure. For instance, it was reported by Wall Street Journal (2004) that EDS used the equity route to raise $1 billion in order to avoid and downgrade in its credit ratings. As reported by Barrons (2003) Lear Corp lowered its debt level in order to receive a higher bond rating from the BB-plus from the credit rating agency Standard & Poors. In 2002, it was reported by WSJ that the Fiat company was working towards narrowing down its debt exposure on fears of a possible credit rating downgrade.

In the studies conducted by Graham & Harvey (2001), it has been revealed that credit ratings are considered to be crucial by the company CFO at the time of capital structure determination. Nearly 57% of the CFOs admit that the credit ratings play an important role in the choice of equity and debt. In fact, it has been reported by Graham & Harvey that credit ratings are more crucial than various factors recommended by the traditional theories on a capital structure like interest tax shield.

The level of credit ratings determines whether certain investor groups like pension funds or banks can invest in the bonds issued by the firm. Moreover, the credit ratings give information to the market participants with regard to firm quality thereby influencing their investment behaviour. If the market participants consider ratings to be informative, the firms are grouped on the basis of this rating and therefore any change in the ratings leads to distinct changes in the cost of capital of the firm.

Other than this, a change in the credit rating can trigger events that can result in various costs like a change in the coupon rate of the bond, loss of valuable contract or make commercial paper market inaccessible. The empirical tests conducted by Kisgen evaluate whether the decisions relating to the capital structure are impacted by credit rating concerns. His studies reveal that business entities with a rating of minus or plus like AA- or AA+ issue lesser amount of debt as compared to firms that do not have a rating of minus or plus like AA.

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