Credit Ratings and Capital Structure

Abstract:     
This paper examines the impact of credit ratings on capital structure decisions. I find that firms near a change in credit rating issue (retire) annually up to 1.5% less (more) debt relative to equity as a percentage of total assets than firms not near a change in rating, reflecting managers' desire to obtain upgrades and avoid downgrades of the firm's credit rating. These results are shown to be distinct from financial distress concerns. The results are robust to several model specifications and inclusion of control variables. I further show how credit rating effects complement the pecking order and tradeoff capital structure theories, and find that dummy variables, indicating firms are near a change in rating, remain predictive when nested in previous empirical tests of these theories. The results of this paper do not appear to be explained with traditional theories of capital structure, and thus this paper enhances the capital structure decision theoretical and empirical frameworks. To my knowledge, this is the first paper to show that credit ratings directly affect capital structure decision-making.

Keywords: Capital Structure, Credit Ratings, Leverage, Tradeoff Theory, Pecking Order

JEL Classifications: G32, G20, G28

Working Paper Series