Optimal Target Rating and C Corp Valuation

Abstract

We use data from Damodaran (2019) as inputs in the Capital Structure Model (CSM) to compute firm value (VL) for debt-for-unlevered equity choices. Because each VL is matched to a debt-to-firm value ratio (DV) and a credit rating, the maximum VL (max VL) among all VL outcomes identifies the optimal DV (ODV) and the optimal target rating ( OTR). This identification begins with Damodaran's matching credit spreads with interest coverage ratios (ICRs) and credit ratings. Given this matching, we can compute costs of capital for debt and equity from credit spreads with these costs matched to DVs (through ICRs) and credit ratings. Because Damodaran only recently supplies ICRs for three firm types of small, large, and financial service (FS), this is the first study to use his data (or any data to our knowledge) together with the CSM's levered equity growth rate (gL) to identify OTRs. Given the perpetuity nature of the CSM, we use a gL based on the past seventy years of annual growth in real US GDP. Major findings include the following. Moody's A3 is the most common OTR. Growth firms generally requires higher OTRs. Compared to small and large firms, FS firms have greater max VL outcomes, higher ODVs, and generally lower rated OTRs. Relatively to small firms, large firms gain less from growth even though they attain a greater max VL. Only for FS firms can we find outcomes where operational cash flows are better spent on interest than retained earnings.