Question

Imagine you work for a company that has been planning to open a new factory in France in two years. The president of the company had received an estimate for 300 million Euros for the plant investment. The cost of capital for the investment was assumed to be 10%. You are part of the taskforce that provided the company president with this assessment. However, recently the sovereign credit rating of the country was down-graded by a major transnational credit-rating agency. Now, the company president has concerns about how this might impact the cost of capital and the projected rate of return on the investment.

For your post this week, research the Internet to find resources that discuss how sovereign credit ratings impact the cost of capital. Then, write an e-mail to the company president and post it in the discussion forum. In your e-mail, answer the following question: How might this credit downgrading impact the rate of return for investment for the new plant?

Answer 1

Hi,

I had viewed your estimation plan to open a new factory in France with in two years. So i want to take part in this Analysis and want to share my thoughts.

A sovereign credit rating is the credit rating of a country or sovereign entity.Sovereign credit ratings give investors insight into the level of risk associated with investing in a particular country, including its political risk.

Recently the sovereign credit rating of the country was down-graded by a major transnational credit-rating agency.

So the investors has insight into the economic and political risks associated with investing in a particular country. From a country’s perspective, particularly developing countries, it is often critical to obtain a good sovereign credit rating in order to attract foreign direct investment and funding in external debt markets.

Credit rating agencies play an important role on the financial market. According to previous researches we wanted to check how the country’s credit rating influence on the cost of the capital. At first we take into consideration the new external debt commitments and the maturity of this variable. We have not observed the important relationship between the history of default and this variable. The important and economically justified impact have got the short term issuer credit rating proposed by S&P’s. The maturity on new external debt commitments depends on the country’s credit rating. If the country’s credit standing is better, the analysed variable is higher. If the credit risk is lower, the lower cost of the capital should be paid. Next we analysed the influence of the credit ratings on the lending interest rate, deposit interest rate, interest rate spread, real interest rate and the premium risk. We observed the different results of estimation for particular variables of capital costs. If the long term issuer rating is higher on one note, the lending interest rate is lower on one percent. The relationship between the short term credit rating and the analysed interest rate is reverse. It is an effect of the reluctance of banks to changes in lending interest rates. As a result interest rates are more sensitive on the long term issuer credit ratings. The deposit rate also responds slowly on the changes in credit rating. We observed the significant influence of the credit rating and history of default on the interest rate spread, but only for the long-time of period. The risk premium on lending is the important determinant only for the Moody’s long – term issuer credit rating. The real interest rate is the significant variable for the estimation process is the S&P’s long – term issuer credit rating. It is observed the negative relationship between the analyzed variables. The received results are important form the investors point of view. Changes in the long and short term country’s credit ratings causes the different results.

One of the key reasons why companies face credit ratings downgrade is because of their deteriorating finances, usually high debt levels. It indicates that the company may not be able to service its debt as per schedule or, in some cases, may even default. ICRA downgraded IDBI Bank’s ratings from AA- to A, due to a substantial fall in the bank’s asset quality—which led to high losses.

Companies with high debt-equity ratio
A high DE ratio indicates that a firm may not be able to service its debt

Firms with poor interest coverage ratio

Higher ICR reflects a higher ability to service debt.

A ratings downgrade hampers the company’s ability to borrow. Lenders may hesitate loaning to such companies and may not even roll-over (refinance) existing debt. “This could in turn impact the future growth plans of the company,”

Usually, a rating downgrade is immediately followed by a fall in the company’s stock price, impacting your equity investments in the short run. Even your debt mutual fund investments can be adversely impacted.

In the case of a company, pay close attention to its debt equity (DE) and interest coverage ratios (ICR). The DE ratio indicates the proportion of the company’s assets that are being financed through debt, while the ICR indicates the ability of a firm to service the debt and repay it as per schedule. A DE ratio of one is considered optimal. While the higher the ICR, the better is the ability of a borrower to service debt.

“Be careful of betting on highly leveraged stocks on the expectation of a turnaround. In majority of the cases, this turnaround never happens or happens after the investors lose patience and exit,”

Finally credit downgrading definitely shows impact on the rate of return for investment for the new plant So the president of the company should estimate and anticipate the further measures.

So that it can be sustained and earn profits in the market.

Thanks..