Credit Ratings and Capital Structure

Darren J. Kisgen*
University of Washington
School of Business Administration
Department of Finance and Business Economics

This Draft: April 20, 2004

________________________________________________________________________

* I would like to thank Wayne Ferson, Charles Hadlock, Jonathan Karpoff, Jennifer Koski, Paul Malatesta,
Mitchell Peterson, and especially Edward Rice, as well as seminar participants at Boston College, Indiana
University, Northwestern University, Rice University, University of Pittsburgh, University of Virginia, University of
Washington, West Virginia University, Xavier University, and the 2004 American Finance Association meetings,
for helpful comments. Please address inquiries to Darren J. Kisgen, Doctoral Candidate, University of Washington
School of Business, Department of Finance and Business Economics, Mackenzie Hall Box 353200, Seattle, WA
98195-3200 or e-mail: [email protected].

Credit Ratings and Capital Structure

Abstract
This paper examines whether and to what extent credit ratings directly affect capital structure
decisions. The motivation for this study begins with the observation that corporate financial
managers care about credit ratings. Graham and Harvey (2001) find that credit ratings are the
second highest concern for CFOs when considering debt issuance. The paper outlines discrete
costs and benefits associated with firm credit rating differences, and tests whether concerns for
these costs and benefits directly affect financing decisions. Using two distinct measures, firms are
differentiated as to whether or not they are close to having their debt rating changed. Then
controlling for firm-specific factors, tests examine whether firms that are near a change in rating
issue less debt over a subsequent period when compared to a control group. Results show that
concerns about upgrades or downgrades of bond credit ratings directly affect managers capital
structure decisions. 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. Prior evidence suggests that credit ratings affect asset valuations in the financial
marketplace; this paper takes the next step and analyzes to what extent they are significant in
capital structure decision making.

This paper examines to what extent credit ratings directly affect capital structure decision
making by financial managers. The paper outlines the reasons why credit ratings may be relevant for
managers in the capital structure decision process, and then empirically tests the extent to which
credit rating concerns directly impact managers debt and equity decisions. The paper also examines
how these findings complement existing capital structure theories such as the pecking order and
tradeoff theories, and specifically how credit rating factors can be included in empirical tests of
capital structure theories.
The initial empirical tests of this paper examine whether capital structure decisions are
affected by credit ratings. Using two distinct measures, firms are distinguished as being close to
having their debt downgraded or upgraded versus not being close to a downgrade or upgrade. Then
controlling for firm-specific factors, I test whether firms that are near a change in rating issue less net
debt relative to net equity over a subsequent period when compared to the control group. I find that
concerns about upgrades or downgrades of bond credit ratings directly affect managers capital
structure decision making; 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.
Firms with a credit rating designated with a plus or minus issue less debt relative to equity than firms
that do not have a plus or minus rating, and when firms are ranked within each specific rating (e.g.,
BB-) based on credit quality determinates, the top third and lower third of firms within ratings also
issue less debt relative to equity than firms that are in the middle of their individual ratings.
These results 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 decisionmaking.

The influence of credit ratings on capital structure is economically significant and statistically
robust. The relationship is apparent whether the dependent variable reflects debt and equity
issuances or debt issuance only, and whether control variables are included. The relationship holds
when both an OLS regression approach is used for continuous capital structure dependent variables
and when a logit regression is used to examine binary capital structure choices. The relationship
holds for both large and small firms, and for firms at several credit rating levels.
After the initial tests in the paper establish these facts, subsequent empirical tests nest credit
rating factors into previous capital structure tests, such as those in Fama and French (2002) and
Shyam-Sunder and Myers (1999). Dummy variables, indicating firms are near a change in rating,
remain statistically significant when nested in the capital structure empirical tests of both of these
papers.
The motivation for this study begins with the observation that corporate financial managers
care about credit ratings. Graham and Harvey (2001) find that credit ratings are the second highest
concern for CFOs when considering debt issuance. When asked what factors affect how they choose
the appropriate amount of debt for their firm, Graham and Harvey found that 57.1% of CFOs said
that Our credit rating (as assigned by credit rating agencies) was important or very important.
Financial flexibility was the only category higher, with 59.4%, and therefore credit ratings ranked
higher than many of the factors suggested by traditional capital structure theories (such as the tax
advantage of interest deductibility).
Graham and Harvey also indicate how the survey results support or contradict various capital
structure theories. In this discussion the credit rating result only appears where they argue it might
support the tradeoff theory: credit ratings [concern]can be viewed as an indication of concern
about distress (pg. 211). Molina (2003) argues that to the extent credit ratings are a measure of

financial distress, the large effect of capital structure on ratings helps explain to some extent why
firms are underlevered (as argued by Graham (2000), for example).
The arguments and results of this paper are in most cases distinct from financial distress
arguments. The empirical tests examine firms that are near both upgrades and downgrades, and the
results are apparent in both instances, whereby firms near both an upgrade and downgrade issue less
debt than firms not near a change in rating. This behavior for firms near an upgrade is inconsistent
with distress arguments but consistent with credit rating effects. I also include variables in the
empirical tests that control for the financial condition of the firm to account for distress concerns.
Credit rating effects are also examined for firms at all ratings levels, and the results are consistent
across the ratings spectrum with significant credit rating effects at the AA rating level alone, for
example.
Although this is the first paper to examine the direct effects of credit ratings on capital
structure decisions, significant research has been conducted examining how credit ratings affect stock
and bond valuations. Hand, Holthausen and Leftwich (1992) find statistically significant negative
average excess bond and stock returns upon the announcement of downgrades of straight debt.
Ederington, Yawitz and Roberts (1987) and West (1973) find that credit ratings are significant
predictors of yield to maturity beyond the information contained in publicly available financial
variables and other factors that would predict spreads. Ederington and Goh (1998) show that credit
rating downgrades result in negative equity returns and that equity analysts tend to revise earnings
forecasts sharply downward following the downgrade. They further conclude that this action is a
result of the downgrade itself not to earlier negative information or contemporaneous earnings
numbers. Thus evidence exists that suggests credit ratings are significant in the financial
marketplace; this paper takes the next step and analyzes to what extent they are significant in capital
structure decision making.

The rest of this paper is organized as follows. In Section I, I provide explanations for why
credit ratings might factor into managerial capital structure decisions. In Section II, I detail how
credit rating concerns complement existing theories of capital structure. Section III contains general
empirical tests of the impact of credit ratings on capital structure decisions, and Section IV contains
specific tests that nest credit rating factors into empirical tests of traditional capital structure theories.
Section V concludes.

I. Specific Hypotheses for the Significance of Credit Ratings

The fundamental hypothesis of this paper is that credit ratings are a material consideration for
managers in making capital structure decisions due to discrete costs/benefits associated with different
ratings levels (henceforth referred to as the Credit Rating Capital Structure Hypothesis or CR-CS).
The primary testable implication of CR-CS considered in this paper is that concern for the impact of
credit rating changes directly affects managers capital structure decision-making, whereby firms near
a ratings change will issue less net debt relative to net equity than firms not near a ratings change.
This section describes the specific reasons that credit ratings might be significant in capital structure
decisions.

A. Regulatory Effects
Several regulations on financial institutions and other intermediaries are directly tied to credit
ratings. Cantor and Packer (1994) observe the reliance on ratings extends to virtually all financial
regulators, including the public authorities that oversee banks, thrifts, insurance companies, securities
firms, capital markets, mutual funds, and private pensions.

For example, banks have been restricted from owning junk bonds since 1936 (Partnoy (1999)
and West (1973)), and in 1989, Savings and Loans were prohibited from investing in junk bonds such
that they could not hold any junk bonds by 1994. Regulatory agencies determine capital
requirements for insurance companies and broker-dealers using credit ratings as a scoring system.
Since 1951, insurance companies investments in securities of firms that are rated A or above get a
value of 1, firms that are BBB get a value of 2, BB get a 3, B a 4, any C level gets a 5, and any D
rating gets a 6. In 1975, the SEC adopted Rule 15c3-1 whereby the SEC uses credit ratings as the
basis for determining the percentage reduction in the value (haircut) of bonds owned by brokerdealers for the purpose of calculating their capital requirements (Partnoy (2002)).
To the extent that regulations affect the cost to investors of investing in a particular bond
class, yields on bonds with higher regulatory costs will be higher to compete with bonds that have
lower regulatory costs, ceteris paribus. Also, to the extent that the demand curve for bonds is
downward sloping, placing a restriction on certain investors participating in a particular bond market
will cause the yield to increase in that market. Therefore although a firm itself may not have any
higher risk of default, it may be required to pay a higher interest rate on its debt merely as a result of
its credit rating.

B. Pooling Effects
Credit ratings may provide information on the quality of a firm beyond publicly available
information. Rating agencies may receive significant sensitive information from firms that is not
public, as firms may be reluctant to provide information publicly that would compromise their
strategic programs, in particular with regard to competitors. Credit agencies might also specialize in
the information gathering and evaluating process and thereby provide more reliable measures of the
firms creditworthiness. Millon and Thakor (1985) propose a model for the existence of information

gathering agencies such as credit rating agencies based on information asymmetries. They argue
that credit rating agencies are formed to act as screening agents certifying the values of firms that
approach them. Boot, Milbourn and Schmeits (2003) argue that, rating agencies could be seen as
information-processing agencies that may speed up the dissemination of information to financial
markets.
A credit rating can therefore act as a signal of overall firm quality. Firms would then be
pooled with other firms in the same rating category, where in the extreme all firms within the same
ratings group would be assessed similar default probabilities and associated yield spreads for their
bonds. Thus, even though a firm may be a particularly good BB- for example, its credit spreads
would not be lower than credit spreads of other BB- firms. Firms that are near a downgrade in
rating will then have an incentive to maintain the higher rating. Otherwise, if they are given the
lower rating (even though they are only a marginally worse credit), they will be pooled into the group
of all firms in that worse credit class. Likewise, firms that are near an upgrade will have an incentive
to obtain that upgrade to be pooled with firms in the higher ratings category.
Previous empirical literature has argued that ratings convey information. Elton, Gruber,
Agrawal, and Mann (2001) examine rate spreads on corporate bonds by rating and maturity from
1987-1996 and conclude, bonds are priced as if the ratings capture real information. Ederington,
Yawitz and Roberts (1987) find that credit ratings are significant predictors of yield to maturity
beyond the information contained in publicly available financial variables, and conclude that, ratings
apparently provide additional information to the market.

C. Market Segmentation
Different classes of investors for different markets distinguished by credit rating may create
unique supply and demand characteristics that would result in yield spreads diverging in different

markets. Further, these different groups of investors may have different trading practices that may
increase or decrease the liquidity in these respective markets.
Collin-Dufresne, Goldstein and Martin (2001) argue, the dominant component of monthly
credit spread changes in the corporate bond market is driven by local supply/demand shocks. West
(1973) notes, bonds not in the top four rating categories had yields consistently above those that
were predicted on the basis of earnings variability, leverage, and so forth. This suggests that
spreads on bonds distinguished by credit rating could diverge enough from what is implied by
traditional factors alone to be significant for managers capital structure decisions.
Patel, Evans and Burnett (1998) find that liquidity affects whether junk bonds experience
abnormal positive or negative returns. If firms incur higher interest rates in less liquid markets
distinguished by credit rating, there may be incentives to avoid these ratings levels. Also, at certain
credit rating levels (e.g., junk bond levels) during difficult economic times, a firm may not be able to
raise debt capital (see Stiglitz and Weiss (1981) for an analysis of credit rationing). Firms would
therefore incur additional costs from having that credit rating (they may have to forgo positive NPV
projects due to their inability to finance projects at those times, for example).

D. Third Party Relationships

Credit ratings may materially affect relationships with third parties, including the employees
of the firm, suppliers to the firm, financial counterparties, or customers of the firm. For example,
firms entering into long-term supply contracts may require certain credit ratings from their
counterparty, and entering into swap arrangements may require a certain rating (e.g., AA- or above).
Third party relationship arguments are in some ways similar to arguments made in the financial
distress literature1; however, CR-CS applies to financially strong firms as well, where perhaps a AAA
rating is important for third party relationships versus a AA rating. Additionally, credit rating effects

imply discrete costs associated with a change in rating, whereas the financial distress literature
implies continuous changes in costs as firms increase their probability of bankruptcy.

E. Ratings Triggers
Firms may be concerned about credit ratings since triggers may exist for changes in ratings
(for example, bond covenants may be directly tied to the credit rating of the firm, forcing certain
costly actions to be taken by the firm given a downgrade). Standard and Poors (2002) recently
surveyed approximately 1,000 U.S. and European investment-grade issues and found that 23
companies show serious vulnerability to rating triggers or other contingent calls on liquidity, whereby
a downgrade would be compounded by provisions such as ratings triggers or covenants that could
create a liquidity crisis. For example, Enron faced $3.9 billion in accelerated debt payments as a
result of a credit rating downgrade. Further, the survey showed that at least 20% of the companies
surveyed have exposure to some sort of contingent liability.

F. Managers Utility
Managements own maximization of utility may make credit ratings material for capital
structure decisions (Hirshleifer and Thakor (1992) look at how the incentive for managers to build a
reputation can affect investment decisions for that manager). For example, if a manager wishes to
change jobs, it may be a disadvantage to come from a junk bond rated firm, or it might be an
advantage to have worked at an AAA-rated company. If credit ratings affect a managers reputation,
managers may target a higher credit rating than might be optimal for overall firm value. Negative
credit rating developments may also have negative consequences for a financial manager with regard
to his job security or compensation. Likewise, positive news (e.g., an upgrade to AAA) may be
considered positively in compensation decisions.

II. Credit Ratings in the Context of Existing Capital Structure Theories

This section examines how CR-CS complements current capital structure theories,
specifically the tradeoff and pecking order theories. I set forth empirical implications of these
theories and consider generally how credit rating concerns might be integrated into these models.

A. Tradeoff Theory
The tradeoff theory argues that a value-maximizing firm will balance the value of interest tax
shields and other benefits of debt against the costs of bankruptcy and other costs of debt to
determine an interior optimal leverage for the firm. An implication of the tradeoff theory is that a
firm will tend to move back toward its optimal leverage to the extent that it departs from its optimum
(see Fama and French (2002), for example).
CR-CS states that different credit rating levels have discrete costs/benefits associated with
them. If this cost is material, managers will balance that cost/benefit against the traditional costs and
benefits implied by the tradeoff theory. In certain cases, the costs associated with a change in credit
rating may then result in different capital structure behavior than implied by traditional tradeoff
theory factors. In other cases, the tradeoff theory factors may outweigh the credit rating
considerations.
To illustrate this point, consider the change from investment grade to junk bond status. If
there is no discrete cost related to credit ratings, a firm may face the situation depicted in Figure 1a.
This graph depicts firm value as a function of leverage and illustrates a tradeoff between the benefits
and costs of higher leverage. A firm value-maximizing manager in this situation will choose the
leverage implying a firm value shown as the point T*.

[Include Figure 1 approximately here]

Now consider a firm that faces a discrete cost (benefit) at the change from investment grade
to junk bond status due to credit rating effects. Further assume that the optimal leverage as implied
by the tradeoff theory is a leverage that would have caused the firm to have a high rating within junk
bond ratings (e.g., a BB+ rating). A firm in this position will choose a smaller leverage than implied
by traditional tradeoff theory factors to obtain an investment grade rating. This is depicted in Figure
1b. The benefits from the better rating outweigh the traditional tradeoff theory factor benefits of
remaining at T*, the optimal capital structure considering only traditional tradeoff effects. C* is the
new optimum considering credit rating effects as well. Figure 1b also illustrates how a firm at C*,
near a downgrade, will be less likely to issue debt relative to equity to avoid a downgrade. Likewise,
a firm at the lower rating slightly to the right of C*, near an upgrade to the higher rating, will be
more likely to issue equity relative to debt to obtain the upgrade.
Figures 1c and 1d depict cases where tradeoff theory effects outweigh CR-CS effects, as the
firms are not near the change in credit rating. Figure 1c depicts a firm whose firm value-maximizing
leverage as implied by the tradeoff theory implies a high rating for the firm (e.g., an A rating). If the
only change in credit rating level associated with a discrete cost/benefit is the change to junk bond
status, a firm with a high rating is not affected by that potential credit rating cost. Figure 1d depicts
a firm with an optimal leverage as implied by the tradeoff theory that implies a credit rating that is
low-rated junk (e.g., a CCC- rating). In this case, the firm may chose to stay at that rating because,
although there are benefits to be obtained by achieving an investment grade rating for the firm, the
costs imposed on the firm of moving so far from the tradeoff optimum may be more significant.
Figure 1e shows a more complete depiction of the tradeoff theory combined with credit rating
effects by showing several jumps. Here it is possible that credit rating effects will be relevant for a

10

firm of any quality, but once again depending on how near that firm is to a change in rating. The
graph shows one example where credit rating effects create an optimum that is different from tradeoff
predictions alone. Similar graphs can be depicted where firms choose a different optimum as a result
of any potential credit rating jump (e.g., from AA to A).
Note that firms that are somewhat farther away from a downgrade will have less concern for
a small offering of debt, however these firms will still be concerned about the potential effects of a
large debt offering, since a large offering could create a downgrade for them. Likewise, firms that
are relatively far from an upgrade may consider a large equity offering to get an upgrade, however
they would be less likely to issue smaller equity offerings versus firms that are very close to an
upgrade. This distinction will be significant in the empirical tests of CR-CS.

B. Pecking Order Theory

The pecking order theory argues that firms will generally prefer not to issue equity due to
asymmetric information costs (Myers (1984)). Firms will prefer to fund projects first with internal
funds and then with debt, and only when internal funds have been extinguished and a firm has
reached its debt capacity will a firm issue equity. The pecking order model implies debt will increase
for firms when investment exceeds internally generated funds and debt will fall when investment is
lower than internally generated funds. The pecking order predicts a strong short-term response of
leverage to short term variations in earnings and investment, in contrast to any concern for reverting
to a target level.
CR-CS implies that for some incremental change in leverage, a discrete cost/benefit will be
incurred due to a credit rating change. Assuming that for some level of leverage both CR-CS and
pecking order effects are material, a firm will face a tradeoff between the costs of issuing equity
versus the discrete cost associated with a potential change in credit rating. This conflict will exist

11

most strongly for firms that are near a change in rating - near to an upgrade as well as a downgrade.
Therefore contrary to the implications of the pecking order, in some cases firms that are near an
upgrade may choose to issue equity instead of debt in order to obtain the benefits of a higher rating
and firms that are near a downgrade may avoid issuing debt to prevent the extra costs that result with
a downgrade.

III. Empirical Tests of CR-CS

If discrete costs are associated with a credit rating downgrade and discrete benefits are
associated with upgrades, firms near a change in rating may make different capital structure decisions
compared to other firms with consideration for these costs/benefits. Firms that are close to being
upgraded or downgraded may issue less debt relative to equity (or simply less debt) to avoid a
downgrade or increase the chances of an upgrade (see the Appendix for an illustration). The main
empirical tests examine this implication.
The dependent variable in the regressions that follow is a measure of the amount of debt
and/or equity raised or a binary decision variable indicating a choice between debt and equity. Since
I am concerned with credit ratings, the book values of issued equity and debt are used, as these are
the variables credit rating agencies emphasize (Standard and Poors (2001)). The book value
measures are also under the direct control of managers and therefore directly reflect managerial
decision-making.
CR-CS directly predicts capital structure decisions over a subsequent period based on the
credit rating situation a firm faces at a particular point in time; whereas, CR-CS has less direct
implications regarding the absolute levels of leverage or debt for a company. As such, the dependent
variables in the tests reflect changes in debt and/or equity or a discrete decision to issue equity or

12

issue debt. This is distinct from some tests of capital structure that may imply certain levels of
leverage for a company based on company factors or other measures.
Being close to a ratings change is measured in two ways. For the first measure, I define
Broad Ratings as ratings levels including the minus, middle and plus specification for a particular
rating, e.g., a Broad Rating of BBB refers to firms with ratings of BBB+, BBB and BBB-. I
distinguish firms as near a ratings change if their rating is designated with either a + or a - within
a Broad Rating and not near a ratings change if they do not have a plus or minus modifier within the
Broad Rating (they are in the middle of the Broad Rating). For example, within the Broad Rating of
BB, BB- and BB+ firms are defined to be near a ratings change and firms that are BB are not. Tests
using this measure are designated Plus or Minus tests (or POM tests).
An advantage of the Broad Ratings measure is that it should accurately reflect being near a
change in rating, since the ratings themselves are used to distinguish firms. A disadvantage is that the
distinctions might be too broad, which would reduce the precision of the tests. For example, a
strong BB- firm may not be near a downgrade within the BB Broad Rating and likewise a weak BB+
firm may not be near an upgrade. A second disadvantage is the Broad Ratings measures assumes
managers care more about a change in Broad Rating than a change in a +/- rating. For example,
firms in the middle of a Broad Rating might reasonably be concerned with upgrades or downgrades
to a plus or minus category. This will increase the noise in these tests.
For the second measure, I define Micro Ratings as specific ratings that include a minus or
plus modification if given. Thus the Micro Rating of BBB refers only to BBB firms, as opposed to
BBB+ or BBB-, and the Micro Rating of for example BBB- refers only to BBB-. The second
measure takes firms within each Micro Rating and ranks them within that rating based on the factors
that tend to indicate credit quality. For this, I compute a Credit Score for each firm that assigns a
credit quality value to each firm based on firm data used by rating agencies, such as debt/equity

13

ratios, interest coverage, etc., with weightings determined by regressing ratings on these factors (the
Credit Score is specifically derived in Section III.D).
I separate firms within each Micro Rating into a high third, middle third and low third ranked
by their respective Credit Scores.2 Firms that are in the high or low third of a Micro Rating are then
considered to be near a change in rating whereas the firms in the middle third are not. Tests using
this measure are designated Credit Score tests.
An advantage of this measure is that, if the Credit Scores are measured correctly, the test
group of firms should be very close to a ratings change, which should increase the precision of these
tests. The measure will also account for all potential ratings changes thereby rectifying potential
problems with the previous measure. The disadvantage of this measure is that the measurement of
the Credit Scores will be noisy in themselves, and this may reduce the power of the test 3.
Credit rating dummy variables are created for firms at the end of each calendar year, and the
firms capital structure decision measures are computed for the subsequent 12 months. A
complicating factor in these tests is that debt and equity issuances and reductions have material
transactions costs and as a result capital structure changes are lumpy and sporadic. For example,
there may be several years where managers are not undertaking offerings of any kind for a firm.
Furthermore, the credit rating situation for a firm could change during the middle of a year, making
the credit rating measure at the beginning of the year inaccurate. Lastly, capital structure
transactions also require time to execute, so there may be a significant lag from a decision being
made to the time it appears in the data.
The beginning sample is all firms with a credit rating in Compustat at the beginning of a
particular year. The credit rating used is Standard & Poors Long-Term Domestic Issuer Credit
Rating (Compustat data item no. 280). This rating is the firms corporate credit rating, which is a

14

current opinion on an issuers overall capacity to pay its financial obligations (Standard and Poors
(2001) SP). Prior to 1998, this was referred to as the firms implied senior-most rating. 4
The sample period is 1986-2001 (1985 is the first year that this rating is available in
Compustat). I also exclude financial companies and utilities (SIC codes 4000-4999 and 6000-6999),
consistent with prior capital structure literature (e.g., Fama and French (2002) and Frank and Goyal
(2003)). I also exclude firm years where the firm has missing data in the fields required regularly in
the calculations of the tests in the paper.5
For the majority of the empirical tests, I exclude large offerings from the sample, generally
defined to be a net offering during the year that exceeds 10% of total assets. The exclusion of large
offerings is made for several reasons. The decision to conduct a large offering is likely to have the
same rating consequences for all firms that is, a change in debt or equity greater than 10% of total
assets is likely to cause a change in rating for all firms, regardless of where they are in the rating. As
a result, there should be no distinction among the different credit rating groups for these types of
offerings so including them would make the results noisier. Also, large offerings might be associated
with acquisitions, reorganizations or changes in management, and it is less likely that credit rating
changes will be significant in these contexts.
Lastly, CR-CS implies that firms not near a change in rating will conduct fewer (more) large
debt (equity) offerings conditional on conducting a (an) debt (equity) offering of any kind than firms
near a change in rating (see the Appendix for a simple model showing this result). This effect could
result in firms near a downgrade, for example, conducting more large debt offerings than firms in the
middle (even though they conducted fewer offerings in total). 6 Since the dependent variable is a
continuous measure of capital issuance, including large offerings could therefore confound the
results.

15

I consider restrictions on both large debt and equity offerings as well as restrictions on large
debt offerings only. Since equity offerings involve larger transactions costs, they happen less
frequently and are on average larger. This characteristic of equity offerings is distinct from changes
in debt that can occur more fluidly. Also, large debt issues as opposed to large equity offerings more
typically accompany some of the events described above, such as reorganizations due to financial
distress (see Asquith, Gertner & Scharfstein (1994)). Thus including large equity offerings may not
have some of the undesirable effects of including large debt offerings.
When both large debt and equity offerings are excluded, this restriction excludes
approximately 16% of firm years, and if only large debt offerings are excluded, this restriction
excludes approximately 14% of the firm years. I conduct robustness checks of these restrictions.
For the empirical tests detailed in this section and the following section, some of the more
commonly used notation is defined as follows (for notational convenience, i and t subscripts are
suppressed for the credit rating dummy variables):

Dit = book long-term debt plus book short-term debt for firm i at time t (Compustat data item no. 9 plus data
item no. 34).
Dit = long-term debt issuance minus long-term debt reduction plus changes in current debt for firm i from
time t to t+1 (Compustat data item no. 111 minus data item no. 114 plus data item no. 301).
LTDit = long-term debt issuance minus long-term debt reduction for firm i from time t to t+1 (Compustat data
item no. 111 minus data item no. 114).
Eit = book value of shareholders equity for firm i at time t (Compustat data item no. 216).
Eit = sale of common and preferred stock minus purchases of common and preferred stock for firm i from
time t to t+1 (Compustat data item no. 108 minus data item no. 115).
Ait = beginning of year total assets for firm i at time t (Compustat data item no. 6).

16

CRPlus = dummy variable (set equal to 1) for firms that have a plus credit rating at the beginning of the period,
as described above.
CRMinus = dummy variable for firms that have a minus credit rating at the beginning of the period, as described
above.
CRPOM = CRPlus + CRMinus = dummy variable for firms that have a minus or plus credit rating at the beginning
of the period, as described above.
CRHigh = dummy variable for firms that are in the top third of their Micro Rating with regard to their Credit
Score at the beginning of the period, as described above.
CRLow = dummy variable for firms that are in the bottom third of their Micro Rating with regard to their Credit
Score at the beginning of the period, as described above.
CRHOL = CRHigh + CRLow = dummy variable for firms that are in the top or bottom third with regard to their
Credit Score at the beginning of the period.
Kit = set of control variables, including Debt/Total Capitalization: Dit/(Dit+Eit) and EBITDA/Total Assets:
EBITDAit/Ait (EBITDA is Compustat data item no. 13)7. The factors are lagged values (calculated at the end
of the previous year, or for the previous year, where appropriate).
NetDIssit8 = (Dit - Eit)/ Ait

A. Summary Statistics

[Include Tables I and II approximately here]

Summary statistics for the sample are shown in Tables I and II. The sample contains 6,906
firm years. Table I shows statistics for debt to total capitalization ratios by credit rating within the
sample, and it also indicates the number of firm years by rating. Table II shows the capital raising
and reducing activity within the sample.

17

The debt to total capitalization ratios have the expected relationships to ratings for
example, the top 4 credit ratings have median debt to total capital ratios ranging from 19% to 33%
whereas the bottom 4 credit ratings have median debt to total capital ratios ranging from 66% to
72%. It appears that the levels for debt to total capitalization for AAA firms are inconsistent when
compared to AA firms, however AAA firms are on average significantly larger than AA firms (AAA
firms have median total assets of $17.1 billion compared to AA firms with median total assets of $5.6
billion), and size is a significant determinate for credit ratings as well as leverage. The variances
within each rating for the debt to total capitalization ratios are generally high, indicating that
although a relation exists between debt to total capitalization and ratings, the potential for differences
within each rating is significant.
Table I indicates the sample seems relatively well distributed by rating. Although the range is
from 65 AA+ firm years to 897 B+ firm years, 10 of the 17 ratings categories have between 250 and
600 firm years. This demonstrates that that the empirical results in this paper will encompass credit
ratings as a whole, not just specific ratings categories.
Within offerings, Table II shows that nearly 40% of the sample raised debt only for the firm
year compared to less than 10% issuing equity only, with an offering defined as a net amount greater
than 1% of total assets. A small number issued both equity and debt (5%), leaving nearly half of the
firm years with no offerings. The propensities are similar for capital reductions, with approximately
30% reducing debt levels only compared to 17% reducing equity levels only. Once again both a debt
and equity reduction is rare (7%), leaving again approximately half of the sample not reducing
capital.
Table II also shows that firms are more likely to use one form of financing (debt or equity)
during the year as opposed to using both debt and equity. For example, conditional on an offering
taking place, approximately 90% of firms will issue debt only or equity only versus issuing both

18

during the year. To the extent firms are following the tradeoff theory and targeting a specific debt to
capitalization level, they are not doing this on an annual basis using both debt and equity offerings. A
firms decision for a particular year appears to be more a decision about whether to issue debt or
equity, not how much of both it should issue during the year.
As debt is the more employed instrument for changing capital levels by firms, I will also
examine the debt decision specifically in the empirical tests.

B. Plus or Minus Tests

In this section, I conduct tests using the Plus or Minus measure, with dummy variables
constructed for firms with a minus or plus credit rating within their Broad Rating. CR-CS implies
that firms with a minus or plus rating will issue less debt relative to equity than firms that are in the
middle. The following three regressions are run to test this hypothesis:

NetDIss it 0 CR POM K it it

(1)

NetDIss it 1CR Plus 2 CR Minus K it it

NetDIss it 3 CR POM it

(2)
(3)

These equations test whether a firms net issuance of debt versus equity for a particular year
is affected by how near that firm is to an upgrade or downgrade in their credit rating at the end of the
previous period. The implication that firms that are near a ratings change will have more
conservative debt financing policies versus firms in the middle, as implied by CR-CS, predicts that i
< 0, i = 0,1,2,3. The null hypothesis is i 0. Results of these regressions are shown in Table III,
where Panel A excludes large offerings and Panel B excludes large debt offerings only.

19

[Include Table III approximately here]

Throughout these tests, the null that firms are indifferent to being near a credit rating change
for capital structure decisions is rejected at the 1% level, with t-statistics on the POM dummy
variable (equation (1) and (3)) ranging from 3.05 to 5.94. The sign for the coefficient is as
predicted as well; firms that are near a change in credit rating are less likely to issue debt relative to
equity than firms in the middle. Note that the null would be accepted for any positive values of the
coefficient, so technically this is a one-sided statistical test and t-statistics will be interpreted as such.
These results support CR-CS.
Equation (2) examines if firms are more sensitive to being near an upgrade versus a
downgrade. In both Panel A and B of Table III, the coefficients on both the plus and minus dummy
variables are statistically significantly negative with t-statistics ranging from 2.22 to -4.74,
consistent with CR-CS. The coefficient on the plus dummy is larger and more significant than the
minus dummy when only large debt offerings are excluded. These results alleviate concern that the
results of these tests are driven by financial distress. The results for firms near an upgrade distinguish
credit rating effects from financial distress arguments, because credit rating concerns have the
opposite implications of financial distress arguments in this test. Credit rating concerns imply firms
near an upgrade will issue less debt relative to equity versus firms that are not near an upgrade,
however since the control group of firms has greater financial distress concerns in these tests,
financial distress arguments would imply firms near an upgrade would be more likely to issue debt.
Equation (3) is a regression without control variables. This test is of interest generally as a
benchmark against future tests in this paper. The value for the coefficient 3 of equation (3) shown in
column 3 of Panel B indicates that firms with a plus or minus rating annually issue approximately
1.5% less debt net of equity as a percentage of total assets (or 1.5% more equity net of debt as a

20

percentage of total assets) than firms in the middle. This indicates that the results are not only
statistically significant, but economically significant as well.
Table IV shows results of equation (1) on a year-by-year basis. Since the sample sizes of
each of the yearly tests are smaller than the overall sample, smaller t-statistics could be expected.
However the results generally also seem to support CR-CS. For 14 out of 16 years the coefficient
on CRPOM is the correct sign, for 5 out of 16 years the coefficient is statistically significant at the 5%
level, and for 8 out of 16 the coefficient is significant at 10%.

[Include Table IV and V approximately here]

B.1. Robustness Checks

Table V shows t-statistics from several regressions that modify certain assumptions from the
previous regressions to gauge the robustness of the results. The two columns of the table represent
large offering restrictions being placed on both debt and equity or debt only. The tests in the first
four rows modify the exclusion of large offerings from the sample. The results show that the findings
are robust to moderate changes on the 10% assumptions both above and below that cutoff. The
results in fact improve when the cutoff is changed to 5%, dramatically for the debt and equity cutoff
sample (from a t-statistic of 3.05 to 4.94). The results are not however robust to the inclusion of
the entire sample for the POM tests, as the coefficient is insignificant in both cases. This is consistent
however with the implications of CR-CS with respect to large and small offerings discussed
previously and modeled in the Appendix.
The remaining tests revert back to the 10% cutoff assumption and modify other assumptions.
The first results include all SIC codes rather than excluding SIC codes 4000-4999 and 6000-6999.
The results are robust to this modification. I also examine large versus small firms by examining

21

separate regressions for firms with total assets greater than $2 billion and less than $2 billion ($2
billion is chosen to split the sample roughly in half). 3 out of the 4 coefficients are statistically
significant, and the fourth is of the correct sign.
The last row shows results from a regression using the firms contemporaneous rating as
opposed to the lagged level. Firms may consider expected ratings more than past ratings in their
decision-making. Furthermore, as mentioned previously, capital structure decisions are lumpy and
credit ratings can change in the middle of a year, so this test may capture effects not captured in my
lagged rating structure. The results using this approach show slightly greater statistical significance
for the dummy variables. Statistically this test is less appealing however due to endogeneity issues.
Additional robustness tests conducted, but not reported in the table, were: logit regressions
(with binary decision variables reflecting both a decision to issue equity only versus debt only and a
decision to issue debt only versus not issuing debt), tests with a dependent variable that reflects net
debt offerings only (Dit/Ait) in place of NetDIssit in equations (1)-(3), and a test of equation (1)
including market to book ratio as an explanatory variable (to reflect potential equity market timing
(see Baker and Wurgler (2002)) or effects of future investment opportunities (see Rajan and Zingales
(1995) and Myers (1977))). The credit rating dummy variables remain statistically significantly
negative in each of these cases as well.
Lastly, a number of additional tests are conducted to evaluate the robustness of the t-statistics
given potential non-independence of observations due to the pooled time series cross-section
regression approach. I calculate Fama and MacBeth (1973) t-statistics as suggested by Fama and
French (2002), I conduct a random effects test, a two-way fixed effects test, and I conduct
regressions that include dummy variables for the firms industry (based on 2-digit SIC code) and for
individual years. The results are not robust to a two-way fixed effects test due to the tests reliance
on time-series credit rating variation within firms to identify the relationship between credit ratings

22

and capital structure. The within firm credit rating variance is not sufficiently large, especially
relative to the between firm variance of the credit rating dummy variables, so the power of that test is
reduced. For all the other tests, the results are robust. Fama and MacBeth t-statistics imply
significance at the 1% level, and coefficients on the Plus or Minus dummy variable in regressions
with random firm effects or with industry and year dummy variables remain negative and significant
at the 1% level.

C. Investment Grade versus Junk Bond Ratings Change

[Include Table VI approximately here]

Several of the explanations for why credit ratings are significant outlined in Section I imply
that credit rating concerns should be most prominent around the change from investment grade to
junk status (i.e., from BBB- to BB+). This section examines this change specifically by introducing
an additional credit rating dummy variable that indicates firms are near that change in rating. This
variable is defined in two ways: firms with a credit rating of BBB- or BB+, and firms with a rating of
BBB, BBB-, BB+ or BB (given the significance of this potential change in rating, firms with BBB
and BB ratings might be concerned with that change in rating as well as firms with a BBB- and BB+
rating). Denoting this additional dummy variable as CRIG/Junk, I conduct the following 2 tests for each
definition:

NetDIss it CR IG / Junk K it it
NetDIssit CRIG / Junk CR POM K it it

23

(4)
(5)

Table VI shows results of these two equations with the 2 different definitions of CRIG/Junk. The
coefficient on CRIG/Junk is negative for both measures in equation (4), with statistical significance at
the 10% level in the first case and 1% level in the second case. For the first measure, CRIG/Junk is not
incrementally significant in equation (5), whereas for the second measure, CRIG/Junk is incrementally
significant (with a t-statistic of 3.93) and it also increases the statistical significance of the
coefficient on CRPOM (from 5.02 to 5.82). Both coefficients in Regression 2 of Panel B imply over
1% less debt relative to equity as a percentage of total assets annually for those firms, suggesting
economic significance as well for both dummy variables.9 The results of this section suggest that
credit ratings are significant for capital structure decisions for firms across ratings levels, and
incrementally more significant at the investment grade to junk credit rating cutoff.

D. Credit Score Tests

In this section, I evaluate the concern for a potential change in Micro Rating. To create
credit rating dummy variables, I compute a Credit Score for each firm and rank firms within each
Micro Rating. To derive the equation to calculate scores, I run a regression of credit ratings on
factors that are thought to predict ratings for firms in my sample. The dependent variable is equal to
1 for a rating of CCC- up to a value of 18 for a rating of AA+ (see Horrigan (1966) for a similar
approach10). The explanatory variables considered are motivated by previous studies predicting
credit ratings and also by the criteria the ratings agencies themselves argue are significant for
determining ratings. Ederington (1985) E states that, while the exact list of independent variables
varies from study to study, measures of (1) leverage, (2) coverage and/or profitability, (3) firm size,
and (4) subordination status, have consistently appeared on the lists of important determinates of
ratings.11 Standard and Poors (2001) SP outlines key criteria for ratings, of which the financial
factors are size, profitability and coverage, capital structure/leverage and asset protection, and cash

24

flow ratios. Reflecting this, I consider the following explanatory variables (with selected cites in
parentheses): Net Income/Total Assets (Pogue and Soldofsky (1969) PS, Kaplan and Urwitz
(1979) KU, Kamstra, Kennedy and Suan (2001) KKS), Debt/Total Capitalization (PS, E, SP),
Debt/Total Capitalization squared (PS), EBITDA/Interest Expense (KU, SP), EBIT/Interest Expense
(SP), (Log of) Total Assets (KKS, SP), and EBITDA/Total Assets (included as an additional measure
of profitability). In a regression including all of these variables, several of the variables were
redundant or had counterintuitive coefficient signs. By systematically dropping the redundant or
non-predictive variables, a regression including only Log of Total Assets, EBITDA/Total Assets and
Debt/Total Capitalization had an adjusted R2 of .631, approximately the same as a regression with all
of the explanatory variables, and the coefficients on each of the variables were the correct sign and
significant. Kamstra, Kennedy and Suan (2001) survey previous credit rating prediction research,
and they find that past studies have ranged in predictability from .565 to .703, with an average of .
618. The results I achieve appear consistent with the success found in previous literature. I use the
coefficients from this parsimonious regression to calculate the Credit Score as follows12:

Credit Score = 1.4501 Log (A) + 11.6702 EBITDA/A 6.0462 Debt/Total Cap.

(7)

The sample used for calculating this Credit Score equation is the same as in the previous
section, however I also exclude any firm whose debt/total capitalization is greater than 1 or less than
zero. These values are outliers that obscure the calculation of the Credit Score equation if included.
Previous studies also often look at ratings of new issues the interest in this paper however is
predicting ratings for existing bonds of firms, so I use all firm ratings across the sample.
I calculate Credit Scores for each firm year with this equation, and I then rank firms within
each Micro Rating into high thirds, middle thirds and low thirds.13 Dummy variables are then

25

constructed from these thirds for inclusion in the test equations. For example, within the Micro
Rating A-, firms with a Credit Score that places them in the high or low third within A- are given a
value of 1 for the dummy variable CRHOL and firms with Credit Scores that place them in the middle
third are assigned a zero for that dummy variable. I also create dummy variables for the individual
high and low categories. I then run the following regressions:14

NetDIss it 0 CR HOL K it it

(8)

NetDIssit 1CR High 2 CR Low K it it

NetDIss it 3 CR HOL it

(9)
(10)

The sample for these tests is as before, although some additional observations are lost since in
some cases the terms required to calculate the Credit Score are missing. As before, initially I also
exclude debt offerings greater than 10% of total assets for the year.
The Credit Score tests examine effects within a specific rating category, as opposed to the
previous section where effects within Broad Ratings were examined. This not only provides an
additional test generally of CR-CS, but it also allows for potential additional inferences regarding the
way in which managers care about credit ratings. That is, managers may be concerned more with
Broad Ratings changes or they may be more concerned with Micro Ratings changes (or both,
depending on the rating level).
The combined high and low dummy variable should mitigate the potential commingling effect
of the financial condition of the firm. That is, the individual variables used to calculate a score are
highly related to the financial condition of the firm, and firms with worse financial condition issue, on
average, less debt relative to equity. This correlation would therefore likely produce a negative
coefficient on the credit dummy for the lower third and a positive dummy for the coefficient on the

26

high third, independent of the credit rating effects I am trying to identify. Including both the high
third and low third within the dummy should negate this effect by offsetting one against the other.
Therefore once again CR-CS predicts that the coefficient 0 in equation (10) will be less than zero, as
those firms closer to a change in rating will be more conservative (issue less debt relative to equity)
with respect to their financing choices.
Another approach to mitigate the effects of the financial condition of the firm is to include
control variables (equation (8)) as in the previous sections. One potential problem with this however
is that the control variables are the same or similar to the variables used in the score calculation. On
the other hand, since the control variables in the regression allow for a linear relationship with the
particular variable and the dependent variable, and the variables in the score calculation enter the
regression only indirectly in the determination of the dummy variable (which by construction is not a
linear relationship), this should not be a problem.
I also conduct the test with the individual high and low dummy variables as well in equation
(9), to see how much the results are driven by one or the other. This test will allow for inferences
regarding whether managers care more about upgrades or downgrades.

[Include Table VII approximately here]

Table VII shows results for the regressions (8)-(10). The first and third regressions of Panel
A show that the coefficient on CRHOL is statistically significantly negative at the 1% confidence level,
with t-statistics of 3.05 and 3.49. The size of the coefficient is similar to the previous section,
where the third regression indicates that firms that are in the high or low third within a particular
credit rating annually issue nearly 1% less net debt minus net equity as a percentage of total assets

27

than firms in the middle. Once again, credit ratings appear both statistically and economically
significant.
The second regression of Panel A shows results with individual high and low dummy
variables. The coefficients on both ratings are negative as predicted by CR-CS, however the
coefficient on CRHigh is not statistically significant whereas the CRLow dummy variable is significantly
negative at the 1% level. As mentioned above, the Credit Score is highly correlated with the financial
condition of the firm, a correlation that implies that coefficient would be positive. Since the two
control variables proxy for financial condition however, these results may indicate that firms are
somewhat more concerned with downgrades than upgrades.
The POM tests excluded large offerings, as firms conducting large offerings would face
similar credit rating effects regardless of where they were within a Broad Rating. For the Credit
Score tests however, this distinction would arguably need to be applied on a smaller scale. The size
of offerings included in the sample would have to be small enough such that firms in the high or low
third would be concerned with an upgrade or downgrade when considering offerings of that size, and
firms in the middle third would not face an upgrade or downgrade if they undertook offerings of that
size. To consider this, I also examine a cutoff of 5%, with results shown in Panel B of Table VII.
The results are similar with this modification. Further, I examine the results including the full sample
for robustness. In this case, unlike the POM tests, the coefficients on the Credit Score factors remain
statistically significantly negative, with t-statistics of 2.32 on the coefficients of CRHOL in both
equation (8) and (10).

E. Results by Rating: Credit Score and POM Tests

[Include Table VIII approximately here]

28

Table VIII shows results of the Credit Score test and POM test by Broad Rating. The power
of these tests is reduced, as the sample sizes are smaller in each test. For both sets of tests, in 5 out
of the 6 ratings categories, the coefficients on the combined dummy variables are of the correct sign.
Credit rating effects persist throughout the ratings spectrum. The Credit Score test in particular
seems consistent across ratings, with 5 out of 6 coefficients significant at the 10% level. Considering
both tests results, the AA and B Broad Rating categories appear most significant.

IV. Incorporating CR-CS into Traditional Capital Structure Tests

A. Shyam-Sunder and Myers (1999) (SSM) Tests

A.1. Pecking Order Test

The SSM test for pecking order asserts that to the extent that a firm has a deficit in funds
(DEF) beyond what can be met by internally generated funds, the deficit will be made up through an
issuance of debt instead of equity. DEF is defined as capital expenditures, dividend payments, the net
increase in working capital and the current portion of long-term debt (at the start of the period) less
operating cash flows, after interest and taxes. Using this variable, the test that they undertake is:
DEFit
LTD it
ab
it
Ait
Ait

(11)

The pecking order theory implies that b is close to 1 and a is equal to zero. Chirinko and
Singha (2000), Frank and Goyal (2002) and others have criticized this test, however my intent is not
to resolve the debate about the model. Of interest is whether the model is enhanced with the
introduction of credit rating considerations, and whether credit rating effects persist in the context of
29

pecking order effects. I therefore proceed with the SSM tests, but I also consider some
modifications suggested by these other papers. To determine if credit rating effects persist in the
context of this pecking order test, I consider the following modified tests:

DEFit
LTDit
ab
0 CRPOM it
Ait
Ait

(12)

DEFit
LTD it
ab
1CRHOL it
Ait
Ait

(13)

As before, the additional term in equation (12) is a dummy variable for if a firm has a plus or
minus within its Broad Rating and equation (13) contains the High or Low Credit Score dummy
variable. If the pecking order model is correct and credit ratings do not matter, the coefficients
should be equal to zero. CR-CS implies coefficients less than zero.
I run these tests using the sample of firms from the previous section, additionally dropping
firm years where a variable that is required for calculating DEF is missing. SSM however use a
sample of only 157 firms, because they want firms to have continuous data available during their
sample period in order to implement other tests. They note however that if they were only testing
the pecking order theory (that is, conducting the test I am interested in here), this restriction would
not be necessary. Since I am only interested in examining pecking order here in the context of credit
ratings, I can extend their sample to include a greater number of firms. Further, Frank and Goyal
(2002) attempt to match the sample from SSM, but are unable to match the exact sample using
several different sets of assumptions. They therefore consider several modifications to the sample
that SSM use, including a broad sample of firms.

30

To maintain consistency with the tests of the previous section, I would also like to exclude
large offerings. However, in this case it would hurt the pecking order results to restrict the sample
only to firms that do not undertake large offerings specifically, since this would allow firms with large
deficits and small debt offerings to be included yet it would exclude firms with large deficits and large
debt offerings, for example. Therefore I also place the restriction on the deficit itself, limiting the size
of the deficit to be less than 10% total assets, as well as limiting the size of the change in long-term
debt to be less than 10%. The dependent variable is the change in debt, so the restriction is placed
on large debt offerings only.15

[Include Table IX approximately here]

Regression 1 of Panel A of Table IX shows results replicating the test from SSM (equation
(11)) with my sample, and the coefficient on the deficit is equal to 0.54 and it is statistically
significant. This value is smaller than the 0.75 coefficient found in SSM, however the sample is much
broader. Frank and Goyal get a coefficient of 0.28 when they use a broader population of U.S. firms
from the period 1971 to 1989. The sample is also different from Frank and Goyal, most significantly
as the time frame is 1986-2001 and the sample is restricted to firms that have credit ratings, so again
the results should be different from theirs. It does appear however that the coefficient in Table IX
matches fairly well within the findings of these previous tests.
Regression 2 of Panel A of Table IX shows results including the POM credit rating dummy
variable only. Although the dependent variable has changed from the previous section to long-term
debt only and the sample is slightly changed given missing data required for calculating the DEF term
and the 10% DEF exclusion, the credit rating variable is still statistically significantly negative with a
t-statistic of -3.87.

31

Regression 3 of Panel A of Table IX shows results including both the POM credit rating
dummy variable and the DEF term, equation (12). This test yields statistical significance for the
dummy variable and the predicted sign. Therefore even when pecking order considerations are
considered, credit ratings remain relevant for managers. The coefficient on DEF is largely unchanged
from Regression 1 to Regression 3, and the R2 from the regression is largely unchanged with the
inclusion of the credit rating dummy variable. Therefore the pecking order test withstands credit
rating effects, and the credit rating variables add only marginal explanatory power to the test.
Panel B of Table IX shows results using the Credit Score based dummy variables. Once
again, CR-CS is supported using this measure for being near a change in rating, as the credit rating
coefficient remains statistically significant when nested in the SSM pecking order test. The t-statistic
for the coefficient 1 on CRHOL in equation (13) is 3.00.
Note that in comparing the CR-CS effects to the traditional effects, there is an important
distinction in the nature of these different tests. The credit rating factors are lagged values and thus
they are predicting future capital raising activity. The SSM pecking order test uses contemporaneous
data in constructing their independent variable DEF, so this variable is not predicting capital raising
activity. As DEF is constructed with contemporaneous data in such a way that it is equal to debt
issued during the period plus equity issued during the period, it is not surprising to see strong
statistical relationships between that factor and debt issued. As the POM and HOL credit rating
factors persist in this context, there again is strong support for CR-CS.
The definition for DEF in the SSM test includes the level of the current portion of long-term
debt, as SSM assume that this must be paid in the next year. Frank and Goyal argue that the current
portion of long-term debt should potentially be excluded as part of DEF. They run tests including it
and excluding it, and they find that empirically the current portion of long-term debt does not belong
in DEF. I also run the tests excluding the current portion of long-term debt in DEF. I obtain results

32

consistent with Frank and Goyal for the test of equation (5.1), whereby both the coefficient and tstatistic on DEF are larger with this modification (not reported). The implications regarding CR-CS
are similar however to the tests using the SSM definition.

A.2. Tradeoff Theory Test

The tradeoff theory implies that there should be no change in leverage from year to year,
regardless of whether the firm is near a change in rating, except to revert back to the target leverage
(holding the companys marginal tax rate and distress costs constant). Proceeding as before, the test
of the tradeoff theory conducted in SSM can also be modified to incorporate potential effects from
credit rating concerns. SSM test the tradeoff theory by running the regression:

( LTD *it LTD it )

LTD it
ab
it
Ait
Ait

(14)

LTD* is the firms target long-term debt level. A difficulty with implementing this test is that
the target debt level is not observed. One approach to estimating the target is to take historical
averages of the debt to total capital ratios (see Taggart (1977), for example), and this is the
predominate approach SSM use. The target debt level is determined by taking an average debt ratio
for each firm for the sample period and multiplying that average by the firms total capital at the
beginning of each year to obtain the target debt level for that particular firm year. SSM show that
this test can result in non-rejection of the model even when the model is false; however, given the
extent of this test in the literature, it is instructive to incorporate the credit rating factors to see the
effects. The tradeoff theory states that b will be greater than zero but less than one (it is less than one
due to transaction costs associated with changing capital levels). This test can be modified with the
introduction of the credit rating factors as follows:
33

( LTD * LTDit )
LTDit
ab
0 CRPOM it
Ait
Ait

(15)

( LTD * LTD it )
LTD it
ab
1CRHOL it
Ait
Ait

(16)

CR-CS implies that firms that are near an upgrade or downgrade may be less willing to
increase their debt levels, even if they are currently below their target levels. However, firms that are
far away from an upgrade or downgrade will be in a better position to increase their debt levels if
they are below their target, since they will be less concerned about a change in rating. Firms that are
above their target will reduce their debt no matter where they are with regard to credit ratings,
however they may be even more inclined to reduce their debt if they are near a change in rating.
Thus CR-CS and the tradeoff theory combined imply the same results for b and a negative value for
0 and 1.
In excluding large offerings in this case, in addition to excluding firm years if the firm has a
debt offering greater than 10% of total assets, to be fair to the tradeoff theory I also exclude firm
years if the difference between the firms debt level and its target debt level is greater than 10%. 16
SSM include a firm only if there is continuous data in which to measure the relevant fundsflow and balance-sheet variables during their entire sample, from 1971 and 1989. I instead include a
firm if it has 3 years of data in which to calculate the relevant variables. Their restriction reduces
their sample to 157, which would make testing credit rating effects difficult considering the
dispersions of firms across ratings. Furthermore, as they point out, their restriction may bias the
sample to large firms with conservative debt ratios, which limits their results.

[Include Table X approximately here]

34

Table X shows results considering POM and HOL dummy variables in the context of the
tradeoff tests. Regression 1 of both Panels shows results of the same test as conducted in SSM,
equation (14). The target adjustment coefficient, b, in my sample is 0.23-0.24 compared to 0.33 in
SSM. My results are for a significantly larger sample and I place restrictions on debt offering size.
For these reasons, the results could differ, but the coefficient from my test seems reasonable
considering the SSM results. The second regression of both Panels shows results from a regression
with the credit rating dummy variables alone, with the modified sample, and the coefficient on the
credit rating dummy is statistically significantly negative in both cases.
Regression 3 of both Panels of Table X nests the credit rating factors into the tradeoff theory
test. The credit rating dummy variables remain statistically significant when nested in this test,
although they only marginally change the R2. The t-statistic for the coefficient 0 on CRPOM in
equation (15) is -3.34, and in equation (16) the t-statistic for the coefficient on CRHOL is 2.77.
These results support CR-CS in the context of the tradeoff theory. Note also again in comparing the
CR-CS factors to the traditional factors, there is an important distinction between the factors. The
SSM tradeoff theory test uses contemporaneous and future data to calculate the target leverage level.
As SSM themselves show, this predisposes this test to perform well. The credit rating factors in
contrast are lagged values, so they are predicting future capital structure activity, which is a more
difficult requirement.

B. Fama and French (2002) (FF) Tests

FF empirically examine the implications on both leverage and dividend decisions of the
tradeoff theory and pecking order models. I focus on the leverage tests they undertake. 17 For these

35

tests, they use partial adjustment models as follows (the i subscripts are suppressed for notational
convenience):

Lt 1 / At 1 Lt / At a b[TLt 1 Lt / At ] cP t 1

(17)

( Lt 1 Lt ) / At a b[TLt 1 Lt / At ] cP t 1

(18)

In this regression, TL is target leverage for a firm and P is a vector of changes in current and
lagged assets (At+1-A t and A t-A t-1) and earnings (ERt+1-ER t and ER t-ER t-1, where ER is defined as
after-tax before-interest earnings). The primary variable FF use in their dependent variable
calculation is leverage, L, defined as total assets minus book equity. This is a different measure of
debt than tests in the previous sections of this paper, as this includes all liabilities, not only long
and/or short-term debt. As this measure of leverage is different from what credit rating agencies use
for determining ratings, this measure is not ideally suited to finding effects of credit ratings compared
to the dependent variables of previous sections. On the other hand, it is related to factors credit
rating agencies use, so it should still allow for some identification of credit rating effects. To further
examine this point however, I modify equation (18) as follows:

Dt / At a b[TLt 1 Lt / At ] cP t 1

(19)

This is similar to their test, however it considers changes in liabilities occurring only as a
result of debt capital market activity. I do not modify equation (17) however; I therefore also
maintain a test with their exact specification.
The pecking order model predicts a strong short-term response of leverage to the variables in
P. The pecking order also predicts that b=0, as firms should not be concerned with moving towards

36

a target leverage level. The tradeoff theory on the other hand predicts that firms will change their
leverage levels such that they move closer to their target levels of leverage, implying b>0. The
tradeoff theory implies that the variables of P are not significant with regard to leverage decisions,
and therefore the tradeoff theory implies c=0.
To estimate equations (17) and (18), FF conduct a two-step cross-sectional regression. Each
year they regress book leverage at time t+1 on variables assumed to determine target leverage, TL.
They then use the fitted values from that equation to proxy for each firms target leverage. The first
stage regression is:

Lt 1 / At 1 0 1Vt / At 2 ETt / At 3TPt 1 4 LogAt 5 RD / At 6 RD _ Dummyt

7 Dp / At t 1

(20)

V is equal to L plus the market value of equity, ET is earnings before interest and taxes, RD is
R&D expenditures, RD_Dummy is a dummy variable set equal to 1 if a firm reports no R&D, Dp is
Depreciation, and TP is the target dividend payout ratio for a firm, calculated from a target payout
regression approach set forth in the paper. FF find however that there is high collinearity between TP
and ET, and as a result including both factors reduces the significance of both. FF conclude that
there is little evidence that TP is related to leverage as it does not remain statistically significant when
both TP and ET are included, whereas ET remains statistically significant. For these reasons, I do
not include TP as a factor in the first stage regression.
FF divide firms into dividend paying and non-dividend paying in both stages of the approach,
as the pecking order model implies that the relationship between leverage and investment may differ
in the two groups; I proceed similarly. FF also conduct tests using market and book values of equity

37

in deriving their dependent variables, but I analyze the book value regressions only as they are more
relevant for credit rating considerations, as discussed previously.
Results of my first stage regressions yield coefficients similar to those found in FF (not
reported). In the second stage regressions, the effects of credit ratings can be tested by including
dummy variables for firms with a plus or minus credit rating or dummy variables for firms with a high
or low Credit Score within their Micro Rating. With these credit rating dummy variables denoted as
CR* (where * = POM or HOL), I examine the following two tests:

Lt 1 / At 1 Lt / At a b[TLt 1 Lt / At ] cP CR* t 1

(21)

Dt / At a b[TLt 1 Lt / At ] cP CR* t 1

(22)

The TL values are those predicted from the first stage regressions. The credit rating
implication in both cases is that <0, while the implications of the tradeoff and pecking order models
remain the same.
The sample for these tests is different given the data requirements for these tests. FF require
that several data variables be available for three consecutive years for each firm year. I also as before
exclude firm years where the firm conducted a large debt offering, defined to be greater than 10% of
total assets.
Instead of using a pooled time-series cross sectional approach, FF employ a statistical
technique similar to that in Fama and MacBeth (1973) (this approach will henceforth be referred to
as FM). They argue this approach provides more robust standard errors.

[Include Table XI approximately here]

38

Table XI shows results of equations (21) and (22) for dividend paying firms with coefficients
and standard errors calculated using FM. Panel A corresponds to equation (21) for both POM and
Credit Score dummy variables, and Panel B corresponds to equation (22) for POM and Credit Score
dummy variables. In all 4 regressions, the credit rating dummy variable coefficients have the
predicted sign, 2 of which are significant at the 5% level. These results support CR-CS in the
context of both pecking order and tradeoff theory factors.
In the equation (21) tests, the coefficients on all six of the FF independent variables are
statistically significant, and are of the same sign as in FF. They also are similar in magnitude to the
coefficients in FF. This indicates that my tests are consistent with their approach and findings. In
equation (22) using a different dependent variable, the lagged changes in assets and earnings are no
longer significant. This suggests that some of their results may not be robust to alternate
specifications of the dependent variable, whereas CR-CS appears somewhat more robust.
For non-dividend paying firms (not reported), the coefficients on the POM dummy variables
with both dependent variables are negative, one of which at the 10% significance level, however the
HOL dummy variable coefficients are positive, but not statistically significant. Consistent with FF, I
also obtain a negative coefficient on the contemporaneous change in investment variable, a result FF
find inconsistent with all other leverage tests.

V. Conclusion

Credit ratings directly affect capital structure decisions by managers. In regressions including
dummy variables that account for a firm being close to a ratings change - both near a Broad Ratings
change and a Micro Ratings change - firms near a credit rating change issue less debt relative to
equity than firms that are not near a ratings change. On an annual basis, firms with a plus or minus

39

rating within their Broad Rating issue approximately 1.5% less net debt minus net equity as a
percentage of total assets than firms that do not have a plus or minus rating. Similarly, firms with
Credit Scores in the high or low third within their Micro Rating issue approximately 1.0% less net
debt minus net equity as a percentage of total assets than firms in the middle of their Micro Rating
with respect to their Credit Score. The results apply both to the potential for an upgrade as well as a
downgrade and are robust to several model specifications and econometric approaches. Managers
appear to be most concerned with ratings changes around the AA and B credit rating levels, as well
as the change from investment grade to junk.
The credit rating dummy variables remain statistically significant when they are nested in the
empirical tests of the tradeoff and pecking order capital structure theories found in Shyam-Sunder
and Myers (1999) and Fama and French (2002). Thus credit rating effects persist in the context of
these other theories. While inclusion of credit rating dummy variables did not materially affect the
implications of these previous tests about their theories, this is not surprising considering the
structure of these previous tests. The previous tests include contemporaneous explanatory variables
for predicting capital structure decisions, whereas the credit rating dummy variables are constructed
without looking ahead. The ability of credit ratings to predict capital structure decisions within these
tests is an arguably stronger result than the ability of the contemporaneous factors from these tests to
maintain predictive ability. Future capital structure research may benefit from accounting for firms
credit rating situations, both to ensure correct inferences in capital structure empirical tests, and also
generally to obtain more comprehensive depictions of capital structure behavior.

Appendix

40

Consider a 1-period financing decision for a firm where the firm has exhausted its internal cash and
therefore must issue outside capital, debt only or equity only (to finance a new project, for example).
Denote the size of the offering as Z, and the financing choice as F (equal to debt (D) or equity (E)).
The value to the firm as a result of the financing including transactions costs, but excluding credit
rating effects, is a function of the size and type of offering: V(F,Z). The probabilities of a credit
rating upgrade or a downgrade given a new offering are PD(F,Z) and PU(F,Z), and the cost/gain from
a change in rating is given by . Assuming risk neutrality, firms will then choose to maximize the
expected value of undertaking an offering: V(F,Z) - PD(F,Z) + PU(F,Z).

Case 1: Consider two firm types: firms of type A are near a downgrade, and firms of type B are not
near a change in rating.18 Assume both firms are considering an offering of size Z, and that if an A
firm issues debt, the probability of a downgrade is equal to 1, whereas for B firms the probability of
an upgrade or downgrade is zero for debt or equity. Thus, for example, a debt offering has a value to
an A firm of VA(D,Z)- whereas for a B firm the value is VB(D,Z). Clearly firms of type A will choose
to issue equity rather than debt in more cases than firms of type B.

Case 2: Consider firms of type A and B, but now assume that debt is the only financing choice they
are considering. Here the firms are considering two sizes of offering, large and small. Assume that A
firms have a probability of a downgrade of 1 for either large or small debt offerings, whereas B firms
undertaking a large debt offering have a probability of 1 for a downgrade, but zero for a small
offering. Assume V values are independently uniformly distributed, from -.5 to .5, for firms within
each type and for each financing choice. Firms will not issue debt if the total value to the firm is less
than zero for both sizes of offerings, thus a firm may choose not to issue debt at all. Therefore, given
values of V(D,L) and V(D,S), a firm of type A will choose the maximum of V(D,L)- , V(D,S)- and
41

zero. Likewise, given values of V(D,L) and V(D,S), a firm of type B will choose the maximum of
V(D,L)- , V(D,S) and zero. The table below depicts the percentages of firms that will choose the
three alternatives for a general value of , and for the example of =0.1.19

Firm Type
A

General Case
Example, =0.1
Debt, Small Debt, Large Do Nothing Debt, Small Debt, Large Do Nothing
32.0%
32.0%
36.0%
( .5) 2
3 2
3 2
8

3 2

8 2 2

3
2

8
2

.5 +.25

42.0%

28.0%

30.0%

For all relevant values of , A firms (near a downgrade) issue fewer small debt offerings than B firms
(32.0% versus 42.0% for =.1), and B firms issue more debt offerings of any kind than A firms
(70.0% versus 64.0% for =.1), implications consistent with Case 1. However, somewhat nonintuitively, CR-CS implies A firms issue more large debt offerings than B firms for all (32.0% versus
28.0% for =.1). Therefore if firm years with large offerings are included in tests of credit rating
effects such as in equation (4.1), a positive credit rating dummy variable coefficient could appear
even though firms near a ratings change issue debt less frequently.20 These implications indicate that
the most effective tests of CR-CS should exclude larger offerings.

Case 3: Now assume firms of type A and B are considering debt or equity offerings of large or small
size. In this case, I allow V to vary uniformly between 0 and 1 implying an offering will be
undertaken (making computations simpler). For B firms, assume the probability of a change in rating
is zero for a small offering of debt or equity, but the probability of a downgrade is 1 for a large debt
offering, and the probability of an upgrade is 1 for a large equity offering. For A firms, the

42

probability of a downgrade is 1 for either a large or small debt offering, whereas the probability of an
upgrade or downgrade given a large or small equity offering is zero. Under these assumptions, firms
will choose different financings in the following percentages by type (these percentages once again
require a value of between 0 and 0.5):

Type
A

Debt , Small
(1 ) 3 (1 ) 4
3

Debt, Large
(1 )3 (1 ) 4

12

1
5
2
4
6

12

7(1 )
(1 )3

12
12
3
4

Equity, Small

Equity, Large

8 6
1

4
12

8 6 3
1

4
12

1
5 3
2
4
6

1
(1 ) 4 7 4

3
12
12

Inspection of these equations reveals that this more general case has the same testing implications as
Case 2.

43

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47

Table I
Sample Summary Statistics - Ratings and Leverage
Means, medians and standard deviations of debt/(debt+equity) by credit rating within the sample, and the number of
firm years (out of the total sample of 6,906 firms years) that had the indicated rating at the beginning of the firm year.
The sample is Compustat firms from 1986 to 2001, excluding firms with SIC codes 4000-4999 and 6000-6999, and
excluding firms with missing values for regularly used variables in the empirical tests of the paper (these include credit
ratings, total assets, debt, and equity). Debt/(debt+equity) is book long-term and short-term debt divided by book longterm and short-term debt plus book shareholders' equity (leverage statistics exclude firms with D/(D+E) greater than 1
or less than zero).

AAA

AA+

AA

AA-

A+

171

65

254

250

454

754

25.9%

19.4%

32.3%

34.2%

38.1%

38.3%

Median

22.7%

18.9%

33.4%

31.7%

37.4%

37.7%

Std Dev.

14.9%

10.0%

16.8%

18.9%

18.9%

15.4%

A-

BBB+

BBB

BBB-

BB+

BB

488

510

562

478

327

495

41.3%

41.3%

46.6%

47.8%

53.2%

53.5%

Median

40.3%

42.1%

45.7%

48.6%

53.1%

53.6%

Std Dev.

14.9%

15.3%

17.4%

18.0%

18.4%

17.6%

BB-

B+

B-

CCC+ or below

606

897

331

122

142

58.1%

63.5%

69.9%

63.1%

64.5%

Median

57.9%

66.2%

72.1%

70.6%

71.4%

Std Dev.

19.3%

22.1%

19.9%

26.7%

29.1%

Number of Firm Years

Debt/(Debt+Equity)
Mean

Number of Firm Years

Debt/(Debt+Equity)
Mean

Number of Firm Years

Debt/(Debt+Equity)
Mean

48

Table II
Sample Summary Statistics - Capital Activity
Number of firm years in the sample with the indicated capital activity. A Debt or Equity Offering
or Reduction is defined as a net amount raised or reduced equal to 1% of total assets or greater
for the calendar year. The sample is Compustat data covering security issuance from 1986 to
2001, and excludes firms with SIC codes 4000-4999 and 6000-6999, and firms with missing
values for regularly used variables in the empirical tests of the paper (these include credit ratings,
total assets, debt, and equity).

Offerings

Reductions

2,683

38.9%

2,046

29.6%

Equity Only

581

8.4%

1,172

17.0%

Debt and
Equity

368

5.3%

486

7.0%

Neither

3,274

47.4%

3,202

46.4%

Total

6,906

100.0%

6,906

100.0%

Debt Only

49

Table III
Credit Rating Impact on Capital Structure Decisions - Plus or Minus Tests
Coefficients and t-statistics from pooled time-series cross-section regressions of net debt raised for the year
minus net equity raised for the year divided by beginning of year total assets on credit rating dummy variables
and on control variables measured at the beginning of each year. CRPOM is a credit rating dummy variable with a
value of 1 if the firm has either a plus or minus credit rating and equal to zero otherwise. CR Plus and CRMinus are
credit rating dummy variables with a value of 1 if the firm has a plus or minus rating, respectively, and zero
otherwise. The control variables include D/(D+E), book debt divided by book shareholder's equity plus book debt,
and EBITDA/A, previous year's EBITDA divided by total assets. The sample covers security issuance from 1986
to 2001, and excludes firms with SIC codes 4000-4999 and 6000-6999, and firms with missing values for any of
the variables. A large offering is defined as an offering greater than 10% of total assets in the year. t-statistics
are calculated using White's consistent standard errors.

Panel A: Excluding large debt and

equity offerings
1
2
3
Intercept
t-statistic

-0.0173
(-3.76)

CRPOM
t-statistic

-0.0058
(-3.05)

-0.0172
(-3.74)

Panel B: Excluding large debt

offerings only
1
2
3

0.0032
(2.17)

-0.0228
(-2.96)

-0.0078
(-4.01)

-0.0130
(-5.02)

-0.0229
(-2.98)

-0.0153
(-5.94)

CRPlus
t-statistic

-0.0050
(-2.22)

-0.0159
(-4.74)

CRMinus

-0.0068

-0.0097

(-2.97)

(-3.35)

t-statistic
D/(D+E)
t-statistic

-0.0113
(-1.81)

-0.0113
(-1.81)

-0.0175
(-1.97)

-0.0175
(-1.97)

EBITDA/A
t-statistic

0.1831
(9.77)

0.1829
(9.76)

0.2069
(5.41)

0.2077
(5.44)

Adj. R2
N

0.0529
5788

0.0524
5788

0.0451
5969

0.0455
5969

0.0025
5788

50

-0.0023
(-1.30)

0.0052
5969

Table IV
Credit Rating Impact on Capital Structure Decisions - POM t-statistics by Year

t-statistics from cross-sectional regressions by year of net debt raised for the year minus net equity raised for the year
divided by beginning of year total assets on a constant, credit rating dummy variables and control variables measured at
the beginning of each year. CRPOM is a credit rating dummy variable with a value of 1 if the firm has either a plus or minus
credit rating and equal to zero otherwise. CRPlus and CRMinus are credit rating dummy variables with a value of 1 if the firm
has a plus or minus rating, respectively, and zero otherwise. Regression 1 includes the CR POM dummy variable and
Regression 2 includes the CRPlus and CRMinus credit rating dummy variables. The control variables (not shown) are D/
(D+E), book debt divided by book shareholder's equity plus book debt, and EBITDA/A, EBITDA divided by total assets.
The samples exclude firms with SIC codes 4000-4999 and 6000-6999, and firms with missing values for any of the
variables. The sample also excludes a firm year if the firm had a debt offering greater than 10% of total assets in the year.
t-statistics are calculated using Whites consistent standard errors.

1986

1987

1988

1989

1990

1991

1992

1993

1.11

-0.96

-2.80

0.02

-0.74

-1.50

-0.89

-2.53

CRPlus

0.60

-0.51

-2.53

-0.17

0.42

-1.11

-0.84

-2.21

CRMinus

1.61

-1.23

-1.84

0.26

-1.40

-1.58

-0.56

-1.63

1994

1995

1996

1997

1998

1999

2000

2001

-2.70

-2.86

-1.48

-0.33

-0.26

-0.00

-1.40

-2.58

CRPlus

-3.17

-2.25

-1.59

-0.23

-0.18

-0.91

-1.27

-1.61

CRMinus

-1.10

-2.16

-0.66

-0.33

-0.25

1.53

-1.03

-2.76

Regression 1:
CRPOM
Regression 2:

Regression 1:
CRPOM
Regression 2:

51

Table V
Credit Rating Impact on Capital Structure Decisions Robustness Tests

t-statistics for the coefficient on CRPOM from pooled time-series cross-section regressions of net debt raised
for the year minus net equity raised for the year divided by beginning of year total assets on CR POM and on
control variables measured at the beginning of each year. CRPOM is a credit rating dummy variable with a
value of 1 if the firm has either a plus or minus credit rating and equal to zero otherwise. The control
variables include D/(D+E), book debt divided by book shareholder's equity plus book debt, and EBITDA/A,
EBITDA divided by total assets. The sample covers security issuance from 1986 to 2001, and excludes
firms with SIC codes 4000-4999 and 6000-6999 (except where indicated), and firms with missing values for
any of the variables. The two columns correspond to restrictions of the sample whereby the sample
excludes a firm year if the firm has a large debt offering or a large debt or equity offering defined as
indicated. t-statistics are calculated using White's consistent standard errors.

Offering restriction
applied to D&E

Offering restriction
applied to D only

Large offering defined as >10%

N

-3.05
5,788

-5.02
5,969

Large offering defined as >20%

N

-2.04
6,423

-3.54
6,514

Large offering defined as >5%

N

-4.94
4,837

-5.56
5,165

All offering Sizes

N

0.65
6,906

0.65
6,906

-2.76
10,092

-4.82
10,344

Assets greater than $2 billion

N

-2.36
2,864

-2.03
2,890

Assets less than $2 billion

N

-0.52
2,924

-3.38
3,079

Credit Rating measure 1-year forward

N

-3.09
5,788

-5.36
5,969

Large Offering defined as >10% and:

Including all SIC codes
N

52

Table VI
Credit Rating Impact on Capital Structure Decisions Investment Grade to Junk

Coefficients and t-statistics from pooled time-series cross-section regressions of net debt raised for the year
minus net equity raised for the year divided by beginning of year total assets on credit rating dummy variables
and on control variables measured at the beginning of each year. CRPOM is a credit rating dummy variable
with a value of 1 if the firm has either a plus or minus credit rating and equal to zero otherwise. CR IG/Junk is a
credit rating dummy variable with a value of 1 if the firm has a rating of BBB- or BBB+ in Panel A or BBB,
BBB-, BB+ and BB in Panel B. The control variables include D/(D+E), book debt divided by book
shareholder's equity plus book debt, and EBITDA/A, EBITDA divided by total assets. The sample covers
security issuance from 1986 to 2001, and excludes firms with SIC codes 4000-4999 and 6000-6999, and
firms with missing values for any of the variables. The sample also excludes a firm year if the firm had a debt
offering greater than 10% of total assets in the year. t-statistics are calculated using White's consistent
standard errors.

Panel A: BBB-, BB+

1
2

Panel B: BBB, BBB-, BB+, BB

1
2

Intercept
t-statistic

-0.0300
(-4.01)

-0.0228
(-2.96)

-0.0285
(-3.75)

-0.0181
(-2.27)

CRIG/Junk
t-statistic

-0.0066
(-1.62)

-0.0010
(-0.23)

-0.0076
(-2.68)

-0.0114
(-3.93)

CRPOM
t-statistic

-0.0128
(-4.66)

-0.0153
(-5.82)

D/(D+E)
t-statistic

-0.0180
(-1.99)

-0.0175
(-1.96)

-0.0180
(-1.99)

-0.0173
(-1.95)

EBITDA/A
t-statistic

0.2088
(5.48)

0.2068
(5.41)

0.2074
(5.43)

0.2038
(5.29)

Adj. R2
N

0.042
5969

0.045
5969

0.042
5969

0.047
5969

53

Table VII
Credit Rating Impact on Capital Structure Decisions - Credit Score Tests

Coefficients and t-statistics from pooled time-series cross-section regressions of net debt raised for the year minus
net equity raised for the year divided by beginning of year total assets on credit rating dummy variables and on
various control variables measured at the beginning of each year. CRHOL is a credit rating dummy variable with a
value of 1 if the firm's Credit Score is in the high or low third of its Micro Rating. CR High and CRLow are credit rating
dummy variables with a value of 1 if the firm's Credit Score is in the high or low third, respectively, within its Micro
Rating and zero otherwise. The control variables include D/(D+E), book debt divided by book shareholder's equity
plus book debt, and EBITDA/A, EBITDA divided by total assets. The sample covers security issuance from 1986 to
2001, and excludes firms with SIC codes 4000-4999 and 6000-6999, and firms with missing values for any of the
variables. The sample excludes a firm year if the firm had a debt offering greater than the indicated percentage of
total assets in the year. t-statistics are calculated using White's consistent standard errors.

Panel A: Excl. debt offerings > 10%

1
2
3
Intercept
t-statistic

-0.0163
(-2.32)

CRHOL
t-statistic

-0.0081
(-3.05)

-0.0169
(-2.45)

Panel B: Excl. debt offerings > 5%

1
2
3

-0.0065
(-3.08)

-0.0260
(-3.50)

-0.0095
(-3.49)

-0.0079
(-2.84)

-0.0268
(-3.73)

-0.0095
(-3.32)

CRHigh
t-statistic

-0.0021
(-0.72)

0.0003
(0.11)

CRLow
t-statistic

-0.0144
(-4.01)

-0.0168
(-4.38)

D/(D+E)
t-statistic

-0.0333
(-4.30)

-0.0302
(-4.02)

-0.0334
(-4.02)

-0.0299
(-3.74)

EBITDA/A
t-statistic

0.2012
(5.13)

0.1956
(4.96)

0.1715
(4.05)

0.1639
(3.84)

Adj. R2
N

0.0528
5938

0.0548
5938

0.0503
5137

0.0544
5137

0.0017
5938

54

-0.0207
(-9.45)

0.0017
5137

Table VIII
Credit Rating Impact by Broad Rating
t-statistics from pooled time-series cross-section regressions by Broad Rating of net debt raised for the year
minus net equity raised for the year divided by beginning of year total assets on a constant, credit rating dummy
variables and control variables measured at the beginning of each year. Regressions 1 and 2 distinguish
different credit rating dummy variables included the regressions. CR POM is a credit rating dummy variable with a
value of 1 if the firm has either a plus or minus credit rating. CR Plus and CRMinus are credit rating dummy
variables with a value of 1 if the firm has a plus or minus rating, respectively. CR HOL is a credit rating dummy
variable with a value of 1 if the firm's Credit Score is in the high or low third of its Micro Rating. CR High and CRLow
are credit rating dummy variables with a value of 1 if the firm's Credit Score is in the high or low third,
respectively, within its Micro Rating. The control variables (not shown) are D/(D+E), book debt divided by book
shareholder's equity plus book debt, and EBITDA/A, EBITDA divided by total assets. The sample covers security
issuance from 1986 to 2001, and excludes firms with SIC codes 4000-4999 and 6000-6999, and firms with
missing values for any of the variables. The sample also excludes a firm year if the firm had a debt offering
greater than 10% of total assets in the year. t-statistics are calculated using White's consistent standard errors.

AA

BBB

BB

CCC

-2.12

-1.48

-1.87

-1.44

-1.43

1.51

CRHigh

-1.27

0.88

0.16

0.44

-0.35

0.58

CRLow

-2.26

-3.32

-3.23

-2.46

-1.87

2.36

-1.68

-0.48

1.30

-0.72

-3.35

-1.24

CRPlus

0.16

0.10

2.49

0.04

-3.10

-1.07

CRMinus

-2.09

-0.84

-0.27

-1.04

-2.26

-1.13

Panel A: Credit Score Tests

Regression 1:
CRHOL
Regression 2:

Panel B: Plus or Minus Tests

Regression 1:
CRPOM
Regression 2:

55

Table IX
SSM Test of Pecking Order with Credit Rating Factors
Coefficients and t-statistics from pooled time-series cross-section regressions of net long-term debt raised for the year
divided by beginning of year total assets on credit rating dummy variables and on DEF. CR POM is a credit rating
dummy variable with a value of 1 if the firm has either a plus or minus credit rating and equal to zero otherwise.
CRHOL is a credit rating dummy variable with a value of 1 if the firm's Credit Score is in the high or low third of its
Micro Rating. DEF is defined as in Shyam-Sunder and Myers (1999), as capital expenditures plus dividend payments
plus net increase in working capital and the current portion of long-term debt minus operating cash flows after interest
and taxes. The sample covers security issuance from 1986 to 2001, and excludes firms with SIC codes 4000-4999
and 6000-6999, and firms with missing values for any of the variables. The sample also excludes a firm year if the
firm had a debt offering greater than 10% of total assets in the year or if DEF is greater than 10% of total assets for
the year.

Panel A: POM tests

2

Panel B: HOL tests

2

Intercept
t-statistic

-0.0195
(-26.55)

-0.0109
(-7.73)

-0.0166
(-14.17)

-0.0198
(-26.34)

-0.0111
(-7.12)

-0.0166
(-12.81)

DEF
t-statistic

0.5396
(46.61)

0.5384
(46.52)

0.5453
(46.23)

CRPOM
t-statistic

-0.0070
(-3.87)

-0.0047
(-3.15)

CRHOL
t-statistic

Adj. R2
N

0.3130
4767

0.0029
4767

0.5444
(46.17)

0.3150
4767

56

0.3165
4613

-0.0067
(-3.48)

-0.0048
(-3.00)

0.0024
4613

0.3177
4613

Table X
SSM Test of Tradeoff Theory with Credit Rating Factors
Coefficients and t-statistics from pooled time-series cross-section regressions of net long-term debt raised for the year
divided by beginning of year total assets on credit rating dummy variables and on (LTD* - LTD). CR POM is a credit
rating dummy variable with a value of 1 if the firm has either a plus or minus credit rating and equal to zero otherwise.
CRHOL is a credit rating dummy variable with a value of 1 if the firm's Credit Score is in the high or low third of its
Micro Rating. (LTD* -LTD) is defined as in Shyam-Sunder and Myers (1999), as target debt level minus current debt
level divided by total assets. Target debt levels are calculated using historical averages, and the sample includes
firms with at least 3 years of data. The sample covers security issuance from 1986 to 2001, and excludes firms with
SIC codes 4000-4999 and 6000-6999, and firms with missing values for any of the variables. The sample also
excludes a firm year if the firm had a debt offering greater than 10% of total assets in the year or if (LTD* - LTD) is
greater than 10% of total assets for the year.

1
Intercept
t-statistic

-0.0044
(-5.62)

(LTD* - LTD)
t-statistic

0.2255
(27.57)

CRPOM
t-statistic

Panel A: POM tests

2
-0.0060
(-4.73)

-0.0069
(-4.23)

Panel B: HOL tests

2

-0.0013
(-1.10)

-0.0046
(-5.67)

-0.0057
(-3.94)

-0.0016
(-1.16)

0.2243
(27.43)

0.2373
(27.58)

-0.0052
(-3.34)

CRHOL
t-statistic

Adj. R2
N

0.1154
5820

0.0029
5820

0.2357
(27.34)

0.1169
5820

57

0.1198
5581

-0.0077
(-4.35)

-0.0046
(-2.77)

0.0032
5581

0.1209
5581

Table XI
FF Test of Tradeoff and Pecking Order Theories with Credit Ratings - Dividend Paying Firms
Fama and MacBeth time-series cross-section regressions coefficients and t-statistics. Coefficients are means of 16
cross sectional regressions from 1986-2001, and t-statistics are time series standard deviations of the coefficients
divided by 16.5. Dependent variables are change in leverage in Panel A (where L=total assets minus book equity and
A=total assets), and net debt issued divided by total assets in Panel B. CR POM is a credit rating dummy variable with a
value of 1 if the firm has either a plus or minus credit rating and equal to zero otherwise. CR HOL is a credit rating
dummy variable with a value of 1 if the firm's Credit Score is in the high or low third of its Micro Rating. Other
dependent variables include changes in current and lagged Assets and changes in current and lagged Earnings (where
ER denotes after tax earnings). The sample includes firms with dividends at time t-1, and excludes firms with SIC codes
4000-4999 and 6000-6999, firms with missing values for the regression variables, and firm years if the firm had a debt
offering greater than 10% of total assets in the year.

Panel A: Lt+1/At+1 - Lt/At as Dependent

Variable
1
2

CRPOM
t-statistic

-0.0026
(-1.65)

CRHOL
t-statistic

Panel B: Net Debt Issued/At as Dependent

Variable
1
2

-0.0012
(-0.82)
-0.0018
(-0.82)

-0.0039
(-2.36)

TL t+1
t-statistic

0.1407
(5.12)

0.1671
(5.44)

0.0568
(2.82)

0.0561
(2.53)

Lt/At
t-statistic

-0.0640
(-5.29)

-0.0684
(-5.98)

-0.0647
(-4.56)

-0.0667
(-5.34)

(At+1-At)/At+1
t-statistic

0.0747
(3.69)

0.0725
(3.54)

0.1404
(6.91)

0.1423
(6.97)

(At-At-1)/At+1
t-statistic

-0.0402
(-4.10)

-0.0408
(-4.71)

-0.0026
(-0.34)

-0.0032
(-0.39)

(ERt+1-ERt)/At+1
t-statistic

-0.5211
(-9.85)

-0.5302
(-9.78)

-0.2023
(-5.96)

-0.2094
(-6.24)

(ERt-ERt-1)/At+1
t-statistic

-0.2600
(-5.95)

-0.2052
(-5.75)

-0.0193
(-0.57)

-0.0166
(-0.46)

4639

4415

4257

4056

58

Figure 1

(caption on next page)

Panel A: No credit rating level costs/benefits

Panel B: One rating cost, firm near rating change

C*

Firm Value

Firm Value

T*

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

T*

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

Debt/To tal C apital

Debt/Total C apital

Panel C: One rating cost, firm not near change Panel D: One rating cost, firm not near change

Firm Value

T*
Firm Value

T*

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

Debt/Total C apital

Debt/To tal C apital

Panel E: Tradeoff theory and discrete costs/benefits at multiple credit rating levels

T*

Firm Value

C*

0.1

0.2

0.3

0.4

0.5

Debt/Total Capital

59

0.6

0.7

0.8

0.9

Figure 1 Caption

Figure 1 Firm value and optimal capital structure under tradeoff theory and credit rating effects. This
figure illustrates the value of a firm given different levels of leverage, assuming both costs and benefits of leverage
and an interior leverage optimum. Panel A depicts tradeoff theory factors alone; Panels B-E depict cases where
discrete costs/benefits exist for credit rating level differences. T* denotes the optimal value with tradeoff effects
alone, and C* is the optimal value with tradeoff theory and credit rating effects (when C* and T* differ).

60

See Opler and Titman (1994) for a review of this literature.

I also check robustness of this definition by defining firms near a rating change separately as the top and bottom fourths

and as the top and bottom fifths within each rating; neither alternate specification affects the results.
3

For the Plus or Minus measure, 16% of firms defined as near a Broad Rating change experience a Broad Rating change

the subsequent year compared to 8% of firms defined as not near a Broad Rating change, whereas for the Credit Score
measure 23% of firms defined as near a Micro Rating change experience a Micro Rating change the subsequent year
compared to 19% of firms defined as not near a Micro Rating change. Of course, if firms near a change in rating
undertake action to avoid the change in rating, the differences across groups should be diminished.
4

SP states that this rating, generally indicates the likelihood of default regarding all financial obligations of the firm. If

a firm has debt that is determined to be junior to the other debt issues of the company however, the rating could be
notched down from this rating for that issue, but this is limited to a maximum of one notch for investment grade rated
firms (e.g., from AA to AA-) and two notches for junk-bond rated firms (SP). Since this rating is generally published for
all companies that have ratings on any specific issue, more firms have this rating than any other rating (for example, for
the sample of this paper, roughly five times as many firms have this rating in Compustat as compared to a subordinated
credit rating).
5

These are Compustat data item nos, 6, 9, 13, 34, 108, 111, 114, 115, and 216.

The intuition behind this is that if a firm is near a downgrade and has decided to undertake a debt offering, it may as well

make it a large one, since it is likely to be downgraded regardless.

7

See Rajan and Zingales (1995) for a discussion of these control variables.

Note that this variable reflects only changes in capitalization resulting from capital market transactions. This excludes

changes in equity resulting from earnings for the year, as I am interested in capital structure decision making, not changes
in leverage that are a result of firm performance.
9

To further examine these results, I also extended the definition of CRIG/Junk to include all BBB firms and all BB firms. In

this case, the t-statistics for the coefficients on CRIG/Junk were 3.59 and 3.30 for equations (4.4) and (4.5), respectively. In
this case, CRIG/Junk is more significant on its own, but it is less significant when CR POM is included. These results are
generally consistent with the overall findings of this section.
10

Although an extensive literature exists on predicting credit ratings using various involved techniques (see Kamstra,

Kennedy and Suan (2001), Ederington (1985) and Kaplan and Urwitz (1979)), my goal here is simply to obtain a
sufficiently predictive measure within my sample of firms that is also theoretically consistent.
11

While previous studies often include a dummy variable for subordination status, I am looking at senior ratings for

existing bonds in my sample, so this distinction does not apply.

12

The intercept is omitted for purposes of calculating the score, as that will not affect the ranking approach.

13

The ranking uses the entire sample for each Micro Rating, which requires the further assumption that the credit rating

agencies maintain the same requirements for a particular rating throughout the sample period. The alternative would be to
rank on a year-by-year basis, but this would require the (more unrealistic) assumption that the quality distribution of firms
within each Micro Rating is constant over time.
14

Note this approach has a potential errors-in-variables complication, since the measure for the Credit Score is measured

with error. The Credit Scores are not used directly however; they are used to group firms into high and low thirds and
create dummy variables based on these groupings, so the effects of the errors-in-variables complication should be reduced
given this approach.
15

Note also that SSM use only long-term debt, versus long and short-term debt as was used in the tests of the previous

section.
16

Without this additional restriction, firms that were over 10% away from their target might be included, however their

debt offering for the year would have to be less that 10% given the restriction placed on debt offering size.
17

It is left for future research to examine the impact of credit ratings on dividends.

18

Upgrade results follow similarly.

19

The general percentages assume a value of between 0 and 0.5, since for values larger than .5, A firms would never

undertake a project.
20

Under Case 2 assumptions, it can be shown that the coefficient would be positive if the large offering size divided by the

small offering size exceeded the difference in the percentage of small offerings conducted by B versus A firms divided by
the difference in the percentage of large offerings conducted by A versus B firms. In the case of =0.1, this size ratio would
be equal to 2.5).