Credit ratings can shape corporate financial decisions
On the surface, credit rating agencies simply score a company's financial health. They look at a business's equity and debt and diagnose how risky it is for investors. They slap on a letter grade to show how likely it is to repay its debts.
Credit rating agencies assess a company's financial health by examining its equity and debt, assigning a letter grade to reflect risk. While their assessments often appear straightforward, new research from the University of Texas at Austin reveals they can influence corporate decisions. Cesare Fracassi, an associate professor of finance, and his co-author Gregory Weitzner from McGill University found that when Moody's reclassified certain securities on a company's balance sheet, it prompted them to borrow 22% more.
The reason: the reclassification made the companies appear less risky, allowing for increased borrowing without harming their credit ratings. These companies raised more debt and invested more, even though their financial situation hadn't changed. The study, published in Review of Corporate Finance Studies, highlights how rating agency methodologies can sway business choices and redistribute value among shareholders and debt holders.
For investors, the research suggests relying solely on ratings may not be sufficient; instead, scrutinizing the underlying financials is crucial.
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