The impact of credit ratings on capital structure

Bora Aktan,Naser Alshakhoori,Şaban Çelik,Yomna Abdulla

doi:10.1108/ijif-03-2018-0028

Abstract

Purpose The purpose of this paper is to empirically investigate the effect of real credit ratings change on capital structure decisions. Design/methodology/approach The study uses three models to examine the impact of credit rating on capital structure decisions within the framework of credit rating-capital structure hypotheses (broad rating, notch rating and investment or speculative grade). These hypotheses are tested by multiple linear regression models. Findings The results demonstrate that firms issue less net debt relative to equity post a change in the broad credit ratings level (e.g. a change from A- to BBB+). The findings also show that firms are less concerned by notch ratings change as long the firms remain the same broad credit rating level. Moreover, the paper indicates that firms issue less net debt relative to equity after an upgrade to investment grade. Research limitations/implications The study covers the periods of 2009 to 2016; therefore, the research result may be affected by the period specific events such as the European debt crisis. Moreover, studying listed non-financial firms only in the Tadawul Stock Exchange has resulted in small sample which may not be adequate enough to reach concrete generalization. Despite the close proximity between the GCC countries, there could be jurisdictional difference due to country specific regulations, policies or financial development. Therefore, it will be interesting to conduct a cross country study on the GCC to see if the conclusions can be generalized to the region. Originality/value The paper contributes to the literature by testing previous researches on new context (Kingdom of Saudi Arabia, KSA) which lack sophisticated comparable studies to the one conducted on other regions of the world. The results highlight the importance of credit ratings for the decision makers who are required to make essential decisions in areas such as financing, structuring or operating firms and regulating markets. To the best of the authors’ knowledge, this is the first study of its kind that has been applied on the GCC region.

Highlights

Making decisions about the capital structure is considered one of the most significant financial decisions in any firm (Haron, 2014; Krichene and Khoufi, 2015; Kumar et al, 2017)
Credit ratings–capital structure (CR-CS) model Kisgen (2006) empirically tested the impact of credit ratings changes on firms’ capital structure decisions. He found that a potential upgrade or downgrade can affect the firm’s subsequent capital structure decisions, and the impact is more momentous on the crossover area between investment grade and speculative grade. He concluded that firms near credit ratings change will issue approximately 1.0 per cent less net debt relative to net equity, and firms will be more concerned with broad ratings change as regulations are generally associated with broad rating levels
The results show that a credit rating upgrade to investment grade is negatively associated with the net debt issuance as suggested by Kisgen (2006) and some other previous studies

Summary

Introduction

Making decisions about the capital structure is considered one of the most significant financial decisions in any firm (Haron, 2014; Krichene and Khoufi, 2015; Kumar et al, 2017). Capital structure decisions are essential to maximize shareholders’ wealth and the firm’s value as it is related to the way the firm finances its operations and long-term investment through a combination of debt and equity (Proençaa et al, 2014; Dasilas and Papasyriopoulos, 2015). A number of studies have been devoted to examining the factors that affect capital structure decisions. Credit ratings are the opinions of rating agencies about the probability that a debt-issuing firm will not meet its debt obligations (Milidonis, 2013). The rating agencies use different lettering systems which summarize their opinions about debtissuing firms. Credit ratings are available free of charge to the public. They help reduce information asymmetry and help uninformed investors to make wise investment decisions. Rating agencies are paid by the firms being rated; such revenue models in the rating business have been debated due to the possible conflict of interest between the desire of the issuers to get favourable ratings and the need of rating agencies to maintain accuracy and integrity in their ratings (Becker and Milbourn, 2011)

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Conclusion