Credit ratings and firm value

Abstract

A topic of relevance to financial managers is the relation between a credit rating and firm value (VL). The general aim of this paper is to elucidate this relation with a specific objective of helping C corp managers choose an optimal target rating (OTR). To achieve these goals, we use the Capital Structure Model (CSM) to compute a series of firm value (VL) outcomes matched to credit ratings. The maximum VL (max VL), among all VL outcomes, identifies OTR. This identification begins with the matching of credit spreads and ratings by Damodaran (2019) for three firm categories: small, large, and financial service (FS). Given these spreads, we can compute costs of borrowing with these costs needed to compute VL and other numerical outcomes. Besides costs of borrowing, our numerical outcomes are based on other key inputs including US $1,000,000 in before-tax cash flows, C corp tax rates, and a sustainable growth rate. Major findings that guide managers include the following. First, Moody’s A3 is the most common OTR. Second, growth firms generally require higher ranked OTRs. Third, compared to small and large firms, FS firms attain greater max VL values, higher optimal debt-to-firm value ratios (ODVs), and generally lower ranked OTRs. Fourth, relative to small firms, large firms gain less from growth even though they attain greater max VL outcomes. Fifth, only for FS firms can we find outcomes where operational cash flows are better spent on interest payments than retained internally for growth.