Reading 32- LOS m ～ Q6－7

6.Gervase Jackson is a student in corporate finance class. Jackson is unsure how debt ratings tie into a company’s capital structure and decides to talk to his professor after class. In their discussion, the professor makes the following statements:

Statement 1: The most common way that firms use debt ratings in conjunction with capital structure is to set a certain minimum debt rating that the firm strives to stay above at all times.

Statement 2: A change in debt rating from investment grade to speculative grade will significantly increase the firm’s cost of debt capital.

Are the statements made by Jackson’s professor, respectively, CORRECT?

A)             Yes                                  Yes

B)             Yes                                       No

C)             No                                        Yes

D)             No                                          No

The correct answer was A)

Both of the statements made by Jackson’s professor are correct. Managers generally want to maintain the highest debt rating possible because higher debt ratings will result in lower costs of capital. Managers are aware that a drop in debt rating may increase capital costs, so that is generally something the managers will avoid. Also, a change in debt rating from investment grade to speculative grade is particularly harmful for the firm’s cost of capital because a drop to speculative grade will classify the debt as “junk” which will generally result in a significant increase in capital costs.

7.Which of the following changes in debt ratings is most likely to have the greatest negative impact on a firm’s weighted average cost of capital (WACC)? A change in debt rating from:

A)   AA to A.

B)   BBB to BB.

C)   BB to BBB.

D)   AAA to AA.

The correct answer was B)

Since the cost of capital is tied to debt ratings, many managers have goals for maintaining certain minimum debt ratings when determining their capital structure policies. Lower debt ratings mean higher level of credit risk, and a higher cost of capital. Managers want to avoid drops in bond ratings in any case, but a bond rating drop from investment grade to speculative grade (BBB to BB) tends to cause a significant increase in the cost of debt and the WACC.