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Strategic Corporate Finance: Applications in Valuation and Capital Structure by Justin Pettit

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CHAPTER 6

An Executive’s Guide to Credit Ratings

Credit ratings and rating agencies are mentioned only in passing in most business schools and remain one of the most understudied aspects of modern corporate finance. Evolution within the agencies, the emergence of new agencies and agency alternatives, conflicting signals from the agencies, conflicting signals between the agencies and the markets, and several high-profile agency miscalls are all factors that highlight the need for more study in this area.

Though rating agencies have been under fire in recent years, their position as gatekeepers to the capital markets remains firmly in place. Finance executives must determine their optimal capital structure balancing business and financial risk with the need to access capital at a reasonable cost. In doing so, they must determine which ratios matter, how to incorporate industry-specific considerations, the impact of today’s capital market outlook, and how to best manage an increasingly difficult rating climate.

The provision of credit, particularly in the United States, has shifted away from commercial banks to the rated capital markets. Bonds are less frequently purchased by buy and hold investors but traded to optimize portfolio risk/return profiles. The investor base has broadened and diversified (banks have become more cautious about borrowers, and other investors are ready to take risk at attractive terms), making public debt ratings generally more important to issuers than ...

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