March 07, 2006

Credit Ratings : Impact on Equity Markets

Crisil, ICRA, CARE etc all perform some activities that I never knew could help in understanding equity markets. Infact little is known of the help that they do to understand the pricing model for any company. So what is it that these credit agencies do that I found out recently :). While I do not know if this idea makes sense, but yet I shall publish what I think should be right.

Credit Rating Agency - A brief understanding

Assume an unknown company wants to expand its operations but it does not have the funds to do so. The company has a few options. Raise funds in the form of equity or debt. Equity is expensive but debt can help in saving taxes and can ensure that the company performs well as it is forced to service the interest and principal. Further assume that the company decides to raise debt. It faces a new problem. How can the company attract the investor who can be sitting anywhere in the country. Here is where the credit rating agency comes to rescue the company and the investor. A credit agency is a registered entity from SEBI and they help in rating companies to help investors compare companies before investing in their debt securities. Ratings are assigned on different parameters, such as type of industry, growth prospects for the industry, level of competition and most importantly the strength of the balance sheet, profit and loss and cash flow statements. Credit rating agencies assign a Sovereign rating for Government securities as there is no risk of default. The only risk will be on liquidity and this is also on the lower side. However, companies are given different ratings and they range from AAA, AA, A, BBB, BB, B, C and D. There are further + and - ratings within each category. The main aim is to clearly identify the type of risk involved with respect to each security. The investment grade restricts to a B. Anything further is purely risky for the investor. Now all of these are for debt securities, how is it going to impact the equity pricing for the company.

Little more history...

One of the popular methods used for identifying the share prices is by DCF method. A simple method of discounting future cash flows by an appropriate rate, which is normally the WACC, Weighted Average Cost of Capital. Now from where do we get the WACC. Cost of equity can be found using the CAPM.

Eq= Risk free Rate + Beta of the security * Risk Premium

All are freely interpretable and the individual who is optimistic will use lower values for most of the variables and the pessimist will tend to use higher values. The optimist wins when it is a bull market and the pessimist wins in a bear market. Anyways, this handles the equity portion.

Debt is a little easier. You just go to a credit rating agency and he can rate it for you. Normally the objective of a company is to achieve higher ratings as the cost of debt reduces. Each company strives to attain a AAA as it is the cheapest. Rating for a ten year paper can be benchmarked similar to equity.

Debt = Risk free Rate + Risk Premium (Increases for each lower grade)

Voila! you have got the company's WACC. Now we need to identify the cash flows. Again a little searching of the companies record and you will get to know the cash flows for the company. So now we have the cash flows and WACC. Divide the annual cash flows with the WACC and you have the company's price. So, how has the company pricing increase by a credit agency?

Lets take company Z. It is currently trading at Rs. 100 and there are 100 shares outstanding, market capitalisation of Rs. 10,000. Assume that the company has a debt of Rs.3000 and is in 'AA' rating paying 7% risk free rate and a risk premium of 3%. It pays an annual interest payment of Rs. 300 and gets a tax shield of 35%, Rs. 105. If there is a change of rating from AA to AAA, and the rating changes to 7% + 2% risk premium, the company will now pay Rs 270 and gets a tax shield of 94.5. The net savings is Rs. 19.5. Now our assumption is that the company shall maintain the same debt equity ratio. Assuming that it does, and you discount this 19.5/.09 we get a net savings of Rs. 216. This net savings is for the equity investor. Hence the share should appreciate by Rs.2.16 to 102.16. Ah! isn't this simple. How a credit agency can affect the price of the stock.

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