Abstract
When making investment decisions shareholders don't factor in benefits to firms’ creditors and they have an incentive to underinvest in the presence of risky debt. Our objective is to understand if dynamic investment choices are different when rating sensitivity of debt is introduced and how they are affected by the policy of a rating agency. To this end, we study a dynamic continuous time economy with two agents: a firm and a credit rating agency. Cash flows of the firm follow a diffusion process. The growth rate of the firm’s cash flows is an endogenous investment decision controlled by equity holders. Moreover, the firm has debt in place in the form of rating-sensitive liabilities, which require the firm to pay higher coupons in case of deteriorating creditworthiness. The problem of the equity holders is to choose the investment time and the default time that maximize the equity value of the firm. The rating agency’s objective is to continuously report its accurate assessment of the default probability of the firm in the form of a discrete rating. The interaction between the firm and the rating agency displays strategic complementarities: a lower rating triggers higher interest payments, which leads to faster default, which in turn brings about new downgrades. In solving our model we rely on tools developed for the study of optimal switching and stopping problems as well as on a number of results on first passage times. Our findings suggest that the credit rating agency alters the incentives of the firm to invest. With rating-sensitive debt in place, the firm weighs the cost of investing in a better project with the benefits stemming from reduced debt payments in the case of a higher credit rating. We show that there exist two types of equilibria and we present valuations as well as optimal policies in both cases. Rating sensitivity of debt indeed plays a role in mitigating the stockholder-bondholder conflict. Incentives to invest earlier are created when, by investing, the firm benefits of an upgrade or can avoid a downgrade for a longer time. Depending on the rating policy of the rating agency it can reduce or worsen the underinvestment problem. Too harsh rating policies deter early investments as the investment will not lower costs. Too lenient rating policies also deter early investments as the status quo is not bad enough.