Corporate Financial Policies in Overvalued Debt Markets

Abstract

We investigate the repercussions of credit market mistakes for a firm's borrowing and investment decisions. When credit ratings are relatively optimistic, we find evidence that firms take advantage of inaccuracies by issuing more debt, increasing leverage, rolling over more debt and lengthening maturities. The result goes beyond a wealth transfer and has real investment implications: approximately 75% of the funds raised from debt issuance related to credit rating mistakes was used for capital expenditures and cash acquisitions. In the cross section, credit rating mistakes affect financially constrained firms the most, suggesting that debt overvaluation loosens financial constraints.

Keywords: Debt Misvaluation, Capital Structure, Cash Holdings, Credit Ratings, Debt Issuance, Financial Constraints, Investment, Mergers and Acquisitions, Moody's, Moral Hazard

JEL Classification: G31, G32, G34