Wednesday, November 08, 2006

Are companies worried about their credit scores?

The first question is do companies have credit ratings 0ut of 800?. Yes but not out of 800. It generally ranges from AAA to Junk, varying by the denomination used by the rating agencies. The credit rating of a corporation is a financial indicator to potential investors of debt securities such as bonds.

In general when we borrow money from banks/ credit cards, the return they expect is very optimal as they are efficient due to prevailing competition in the market. But if we are able to get a partner for the project we are investing in, the partner would/may expect a return more than he would have expected from a similar investment in a bank( a bond, saving account etc), because he thinks you can default but the bank cannot. Also, the debt reduces your Income Tax liability.

The same logic applies to the corporations as well. The corpoartion wish to borrow as much as possible for funding their operations or new projects . But this can be done untill some optimal debt ratio is acheived. Beyond that point the additional agency costs, the bankrupcy risk etc increses you cost of capital required by the shareholders, hence the higher average weighted average cost of capital and hance the lower value of the firm.

According to a director at HVB, in financial distressed situation the operations of the company is to an extent is controlled by a credit agency as well. The negotiation is in best interest for both as creditors receive minimum returns from their claim on assets during divestitures.


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