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Title: Credit Rating Agencies Problem Markets and Institutions Post by: xcluzive on Nov 29, 2022 1. Question 1: Suppose credit rating is the only thing that determines companies’ debt interest rate. Below is the interest rate associated with each credit rating.
Credit rating Interest rate (https://biology-forums.com/gallery/45/1185391_29_11_22_2_30_26.png) (https://biology-forums.com/index.php?action=gallery;sa=view&id=45978) Consider a company that is issuing a ten-year fixed-rate bond with a principal value of $1 billion today. Throughout this question, ignore the time value of money (i.e., a dollar in the future is worth the same as a dollar today). (a) (1 point) Suppose the company currently has a credit rating of AA. Howmuch interest expense (in dollars) can it save in total over the next ten yearsif its credit rating become AAA? (b) (1 point) Suppose the company currently has a credit rating of BBB. How much additional interest expense (in dollar terms, no need to do compounding) does it incur over the next ten years if its credit rating drops to BB? (c) (1 point) Suppose the company currently has a rating of BB. The company’s management simply wants to maximize firm value (with no concern about morality), and suppose they are considering spending up to $X dollars to bribe the credit rating agency to make the credit rating BBB. Assume that bribing always works and will never be caught. How much, at most, is the company management willing to spend Title: Re: Credit Rating Agencies Problem Markets and Institutions Post by: gmiannotti on Nov 29, 2022 Quote a) How much interest can in save in total over the next 10 years? We would save $50,000,000 ($50 million) in interest expense in total over the next 10 years. Work: interest expense savings = $1 billion*(interest rate on AA – interest rate on AAA)*10 years Interest expense savings = $1 billion*(3.50% - 3.00%)*10 years Interest expense savings = $1 billion*(0.50%)*10 years Interest expense savings = $1,000,000*0.50%*10 Interest expense savings = $1,000,000,000*0.50%*10 Interest expense savings = $5,000,000*10 Interest expense savings = $50,000,000 Thus, we would save $50,000,000 ($50 million) in interest expense in total over the next 10 years. Quote b) How much additional interest expense does it incur if the credit rating drops to BBB? Additional interest expense = $200 million (Additional interest expense = $200,000,000) Work: Additional interest expense = $1 billion*(interest rate on BB – interest rate on BBB)*10 years Additional interest expense = $1 billion*(7.50% - 5.50%)*10 years Additional interest expense = $1 billion*(2%)*10 years Additional interest expense = $1 billion*20% Additional interest expense = $200 million Quote c) How much is the company management willing to spend? Answer) at most the company management is willing to bribe them $200 million This question is connected to part B. If the rating is upgraded from BB to BBB then we would have to pay $200 million less in interest over the next 10 years. Thus at most the company management is willing to bribe them $200 million |