LOS n: Review the role of debt ratings in capital structure policy.

Q1. 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)   BBB to BB.

B)   AA to A.

C)   BB to BBB.

Q2. 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.

With respect to the statements made by Jackson’s professor:

A)   both are incorrect.

B)   only one is correct.

C)   both are correct.

Q3. Assume that the debt rating given by Standard and Poor’s for Oswald Technologies drops from AAA to BBB. Which of the following reflects the most likely increase in the cost of debt for Oswald Technologies?

A)   500 basis points.

B)   10 basis points.

C)   100 basis points.

Q4. Katherine Epler, a self-employed corporate finance consultant, is preparing a new seminar concerning debt ratings and how they impact capital structure policy. As she is working on her presentation, Epler prepares two presentation slides that contain the following:

Slide 1: Lower debt ratings will increase the cost of debt as well as the cost of equity financing.

Slide 2: Managers will always prefer to have the highest possible debt ratings, all else equal.

With respect to Epler’s slides:

A)   both are incorrect.

B)   only one is correct.

C)   both are correct.

LOS n: Review the role of debt ratings in capital structure policy. fficeffice" />

Q1. 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)   BBB to BB.

B)   AA to A.

C)   BB to BBB.

Correct answer is A)

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.

Q2. Gervase Jackson is a student in corporate finance class. ffice:smarttags" />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.

With respect to the statements made by Jackson’s professor:

A)   both are incorrect.

B)   only one is correct.

C)   both are correct.

Correct answer is C)         

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.

Q3. Assume that the debt rating given by Standard and Poor’s for Oswald Technologies drops from AAA to BBB. Which of the following reflects the most likely increase in the cost of debt for Oswald Technologies?

A)   500 basis points.

B)   10 basis points.

C)   100 basis points.

Correct answer is C)         

Historically, the average spread between AAA rated bonds and BBB rated bonds has been 100 basis points, so 100 basis points is the most likely answer. Note however that the actual spread may fluctuate due to market conditions, and may be wider in recessions.

Q4. Katherine Epler, a self-employed corporate finance consultant, is preparing a new seminar concerning debt ratings and how they impact capital structure policy. As she is working on her presentation, Epler prepares two presentation slides that contain the following:

Slide 1: Lower debt ratings will increase the cost of debt as well as the cost of equity financing.

Slide 2: Managers will always prefer to have the highest possible debt ratings, all else equal.

With respect to Epler’s slides:

A)   both are incorrect.

B)   only one is correct.

C)   both are correct.

Correct answer is C)         

The information on both of Epler’s slides is correct. Lower debt ratings signifies higher risk to both debt and equity capital providers and will cause both to demand higher returns on their investment. Also, managers will always prefer the highest possible debt rating because higher debt ratings will result in lower costs of capital.

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