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Dubai Capital Structure and Impact of Credit Rating


This paper aims to discuss the effects of credit rating on capital structure and the borrowing cost. In particular, it is necessary to describe various rating techniques as well as their limitations. Furthermore, it is necessary to show how these credit rating techniques can be applied to a particular company, Dubai Holding.

Overall, credit rating is a way of estimating the credit worthiness of a company, a country or an individual. Normally, it is performed by independent rating agencies whose opinions are taken into consideration by bond market participants. Only a few institutional investors have the resources and expertise necessary to properly evaluate a bond’s credit quality on their own; thus, they have to rely on the rates, issued by credit rating agencies. The credit rating is usually done such as organizations as Duff and Phelps, Inc, Fitch Investors Service, McCarthy, Corporation and others (Kisgen, 2003).

There are various methods that can be used in credit rating; however, the most common technique is credit scoring where earnings before interest and tax is evaluated. Its essence lies in providing a score that will be assigned to the country or corporation and it will be used to analyze the credit worthiness of the institution. When a company is well rated will be able to raise more funds on credit and this will change the capital structure of a company. In other words, good credit rating will help the company to sell their corporate bonds in the market while poor credit rating will make the bond look less unattractive to the investors (Kisgen, 2006).

Credit rating has many limitations, for instance, very often rating agencies put debt obligations into the same category although they may not have the same credit worthiness. Additionally, the rating agencies assign debt into a certain category without considering the credit score of a company in the similar industry in the same country. A uniform rate for company operating in different countries will provide different information.

Literature review

At this point, there are various scholarly views about the efficiency of credit rating techniques and their implications for the organizations. According to Kisgen (2006), credit rating contains vital information which helps the general public to make a more informed investment decision. Evatt (2007) concurs and elaborates this argument by saying that a firm exhibits better financial flexibility when it has a good rating. If the rating is poor a company will have difficulties in raising capital from a market. In their turn, Myers and Marcus (2007) argue that credit rating has direct impact on capital structure of the enterprise. When the rating is poor the company will have difficulty in raising capital in the form of debt from the market. Jordan and Miller (2008) maintain that a change in credit rating directly affects the value of the company’s stock by making it more or less attractive to the investors.

Apart from that, Kisgen (2006) points out that credit rating will help the management predict the capital structure they are most likely to have in the near future. He further argued that a stronger credit rating will mean a good capital structure.

Kisgen (2006) and Cohen (2009) propose similar theories that explain the impact of credit rating on capital structure. The approach, suggested by these scholars is called trade-off theory. According to it, the firm will try to maximize the balance between tax shield and bankruptcy cost. They argue that a firm will move to an optimal capital structure as long as the tax shield and bankruptcy are optimised. This theory ensures the management does not arbitrarily come up with a capital structure which does not consider both bankruptcy and tax shield. However the theory of pecking order postulates that a company will not wish to issue equity in a strong efficient market (Brealey, Myers and Marcus, 2007). The theory explains that a company will issue a bond so long as it is acceptable in the market. This bond can be accepted in the market only if they have a good credit rating (Kisgen 2003).

Cohen (2009) believes that credit rating affects capital structure of a company by determining the cost that is charged. Credit rating is usually turned annually. The cost that is incurred every year is usually considered when issuing the bond.

Jordan and Miller (2008) argue that rating-dependent benefit is material, managers will balance that cost against the traditional costs and benefits implied by the tradeoffs theory. In certain cases, the costs associated with a change in credit rating may then result in capital structures behaviour that is different from that one implied by traditional trade-off theory factors.

According to the trade-off theory, the value of organization is determined primarily by their ability to use debt finance and equity finance in order to keep balance between benefits and costs (Kisgen, 2003)1. It is possible that credit rating effects will be relevant to a firm of any quality, but once again the extent of the effects will depend on how near that firm is to a change in rating2.

It should be noted that firms that are farther away from a downgrade will be less concerned about a small offering of debt; however, these firms will still be concerned about the potential effects of a large debt offering, since a large offering can significantly downgrade their rating (Kisgen, 2006). Likewise, firms that are relatively far from an upgrade may consider a large equity offering to obtain an upgrade; however, they would be less likely to issue smaller equity offerings relative to firms very close to an upgrade. This distinction is significant in the empirical tests of credit rating and capital structure ((Kisgen, 2006).

Discussion and analysis

At this point, it is necessary for us to show how these theoretical frameworks can be translated into practice. The most important sphere of application is risk management.

The risk that a bond issuer may default on its obligations is called default risk. In order to compensate for this default risk companies need promise a higher rate of interest than government bond when borrowing money. Normally, the investors demand a very high default premium, if there is a great change that the enterprise will not be able to meet its financial obligations (Moody’s Corporate Finance, Rating Methodology – Global Homebuilding Industry, 2009).

The safety of most corporate bonds can be judged from bond ratings provided by Moody’s Standard & Poor’s, or other bond-rating firms. The below lists the possible bond ratings in declining order of quality:

Moody’s Standard & Poor’s Safety
Aaa AAA The strongest rating; ability to repay interest and principal is very strong
Aa AA Very strong like hood that interest and principal will be repaid
A A Strong ability to repay, but some vulnerability to changes in circumstances
Baa BBB Adequate capacity to repay; more vulnerability to changes in economic circumstances
Ba BB Considerable uncertainty about ability to repay
B B Like hood of interest and principal payments over sustained periods is questionable.
Caa CCC Bonds that may already be in default or in danger of imminent default.
C C Little prospect for interest or principal on the debt ever to be repaid.

The bonds that receive the highest Moody’s rating are known as AAA (or “triple A”) bonds. Then come AA (“double A”), A, Baa bonds, and so on.

To better explain the use of credit rating for risk management, we can consider the example of a firm which issues a bond to finance some operations. If credit rating changes before issuing the bond, the company will not be able to raise the fully intended amount but the amount will be reduced. More importantly, the company will be forced to source from equity. This will definitely affect the capital structure that the company intended to have (Kisgen, 2006). A comprehensive and complex system for rating debt securities is established in the world economy. Many financial institutions also develop their own in-house ratings.

Source: Standard&Poor's 2002
Source: Standard&Poor’s 2002

Bond Credit Ratings

The bond credit rating is a composite expression of judgement about the creditworthiness of the bond issuer and the quality of the specific security being rated. A rating measures credit risk where credit risk is the probability of development unfavourable to the interests of creditors. This judgement of creditworthiness is expressed in a series of symbols reflecting degrees of credit risk. Specifically, the top four rating grades from Standard & Poor’s are:

A major reason why debt securities are widely rated while equity securities are not is because there is far greater uniformity of approach and homogeneity of analytical measures in analysing creditworthiness than in analysing future market performance of equity securities. This wider agreement on what is being measured in credit risk analysis has resulted in acceptance of and reliance on published credit ratings for several purposes (Evatt, 2007).

Criteria determining a specific rating are never precisely defined. They involve both quantitative and qualitative factors. Major rating agencies refuse to disclose their precise mix of factors determining ratings. They wish to avoid arguments about the validity of qualitative factors in ratings.

Rating company bonds

While rating an industrial bond issue, the rating agency focuses on the following criteria: issuing company’s asset protection, financial resources, earnings power, management, and specific provisions of the debt. Also important are company size, market share, industry position, cyclical influences, and general economic conditions (Moody’s Corporate Finance, 2009).

Asset protection can be defined to the extent a company’s debt is covered by its assets. One of the measurements for asset protection is the ratio of net tangible asset to long-term debt. For instance, some rating agencies use a rule of thumb where a bond needs a net tangible asset to long-term debt value should constitute 5,1 for AAA rating; 4:1 for AA rating ; 3 to 3:5:1 for an A rating; and 2:5:1 for a BBB rating. Another rule of thumb suggests the long-term debt to total capital ratio should be lower 25 percent for a AAA , near 30 percent for a AA, near 35 percent for an A, and near 40 percent for a BBB rating. Additional factors entering rating agencies’ consideration of asset protection include book value; composition of working capital; the quality and age of property, plant, and equipment; off-balance-sheet financing; and unrecorded liabilities (Brealey, Myres and Marcus, 2007).

Financial resources refer to liquid resources like cash and working capital accounts. Analysis measures include the collection period of receivables and inventory turnover. Their values are assessed relative to industry and absolute standards. Ratings should be based on the analysis of the issuer’s use of both short-term and long-term debt, and their mix (Cohen, 2009).

Future earning power, and the issuer’s cash-generating ability, is an important factor in rating debt securities because the level and quality of future earnings determine a company’s ability to meet its obligations, especially those of a long-term nature. Earning power is usually a more reliable source of protection than assets. One common measure of protection due to earning power is the ratio earnings and fixed charges coverage. A rule of thumb suggests an acceptable earnings to fixed charges ratios is 5:1 to 7:1 for a AAA rating, over 4:1 for a AA rating, over 3:1 for an A rating, and over 2:1 for a BBB rating. Another measure of debt servicing potential is cash flow from operations to long-term debt. A rule of thumb suggests this ratio be over 65 percent for a AAA, 45 to 60 percent for a AA, 35 to 45 percent for an A, and 25 to 30 percent for a BBB rating (Brealey, Myres and Marcus, 2007).

Management’s abilities, foresight, philosophy, knowledge, experience, and integrity are important considerations in rating debt. Through interviews, site visits, and other analyses, their rating agency probe management’s goals, strategies, plans, and tactics in areas like research and development, product promotion, product planning, and acquisitions(Cohen, 2009).

Additionally, one should not overlook such an important criterion as debt provisions that are usually written in the bond indenture. Rating agency analyses the specific provisions in the indenture designed to protect interest of bondholders under a variety of conditions. The rating agencies determine whether stipulations include mortgaging, sinking funds, redemption provisions, and restrictive covenants (Brealey, Myres and Marcus, 2007). The rating agency normally evaluates the extent to which bondholder is protected.

Case study: Dubai Holding

Today, Dubai holding is a company that operates in real property industry of UAE market. In the year 2006 the company proposed consolidation with Emaar led to the downgrading of the credit rating, given to Dubai Holding by Moody; in particular it dropped from A2 to A3 (Gulf news, 2009). From the records the company has, a beta of company is 1.27. The company equity of 14,589,397 and long term debt of 31,458,501 and this gives an equity target of 31.68% and debt target of 68.32%. The cost of capital for the company can be calculated in the following way.

The cost of capital for the company

In order to determine credit rating that will be given to Dubai Holding, it is also necessary to calculate the ratio of capital structure and fixed charge coverage (WACC in 2008)

The ratio of capital structure and fixed charge coverage

The following debt trading will be given different ranges.

After credit rating changed the weighted average cost of capital increased from 8.40% to 9.9%. This means the change increased the rate of raising capital for the company.

Rating debt/category Fixed charge coverage Operations/Total debt Long -term capitalization
AA 4,00-5.25x 60-80% 17-23%
A 3,00-4.30 45-65 22-32
Baa 1.95-3.40 35-55 30-41

Therefore, one will recommend that the credit, which should be given to each rating, should be between 20-40% because operation to total debts for rating category is 17-23% meaning that it is Low Risk Company and have a high fixed coverage charge ratios.

Rating A one will recommend debt range of 15-30% because it is medium risk capital structure. Such rated debentures provide for timely payment of interest and principal, but the changed circumstances in future may affect such debentures as compared to the higher rated debentures (Snider, Stumpp, D’Souza, and Marshella, 2004).

Before determining the credit range of the company, one should consider the following factors: current cash flow position, a dividend policy of the company, and nature of business in the company, other sources of revenue available to the company, and its creditworthiness (Cohen, 2009).

The focus so far has been on Dubai Holding and impact on its capital structure. Dubai Holding capital structure has both bonds and equity. Many corporations also borrow based on their credit rating issued by the company. At the same time, Dubai Holding may borrow by issuing their bonds in other countries. For example, they may issue dollar bonds in London so that they could be sold to investors throughout the world.

There is an important distinction between bonds issued by corporations and those issued by the Dubai. However, there is some chance that corporations may get into financial difficulties and may default ion their bonds. Thus, the payments promised to corporate bondholders, normally represent a best-case scenario. The firm will never pay more than the promised cash flows, but in hard times, it may pay less (Samson, 2009).

Conclusions, implications, and limitations

The paper examined the impact of credit rating on Dubai Capital Structure. The paper found out that credit rating had a negative impact on the capital structure of Dubai Holding. The change of credit rating of the company occurred due to the merger of this organization with Emaar Holdings. In particular, it decreased investors’ confidence in the bonds of the company and raised the default premiums, required by bondholders. This is why the management of this organization should develop strategies for raising their credit rating.

Reference List

Brealey, Richard, Myres, Stewart & Marcus, Alan. (2007). Fundamentals of Corporate Finance. Boston: McGraw-Hill Irwin.

Cohen, Ruben (2009).Hewlett – Packard Capital Structure: Case Study. Web.

Evatt, Burleigh. (2007). Adopt an Optimal Capital Structure to improve shareholders value. Burleigh Evatt Holdings Limited. Web.

Gulf news. (2009). Moody’s downgrades Dubai Holding credit rating. Web.

Jordan, Bradford & Miller, Thomas. (2008). Fundamentals of Investments Valuation and Management. Boston: McGraw-Hill Irwin.

Kisgen, Darren (2006). Credit Rating and Capital Structure. Journal of Finance.

Kisgen, Darren (2003). Credit Rating and Capital Structure. Washington: University of Washington

Moody’s Corporate Finance. (2007). Analytical Considerations in Assessing Conglomerates. Moody’s investor service.

Moody’s Corporate Finance. (2009). Moody’s Financial Metrics Key Ratios by Rating and Industry for European, Middle Eastern and African Non-Financial Corporations. Moody’s investor service.

Moody’s Corporate Finance. (2009). Rating Methodology – Global Homebuilding Industry. Moody’s investor service.

Moody’s Corporate Finance. (2006). Rating Methodology – Global Lodging Industry. Moody’s investor service. .

Moody’s Corporate Finance. (2007).Rating Methodology – Global Lodging Industry. Moody’s Corporate Finance. .

Samson, Solomon. (2009). Corporate Ratings Criteria. Standard & Poor’s Ratings Services. .


No credit rating level costs/benefits
Panel A: No credit rating level costs/benefits
One rating cost, firm near rating change
Panel B: One rating cost, firm near rating change
One rating costs, firm not near change
Panel C: One rating costs, firm not near change
One rating costs, firm not near
Panel D: One rating costs, firm not near. (Kisgen, 2003)
Tradeoffs theory and discrete costs/benefits at multiple credit rating levels
Panel E: Tradeoffs theory and discrete costs/benefits at multiple credit rating levels. (Jordan and Miller, 2008)

Consolidated Balance Sheet


  1. Please, refer to Diagram One in the Appendixes, illustrating the tradeoffs theory
  2. Please, refer to Diagram Two which shows that in some cases rating effects create an optimum that is different from trade-off predictions alone (Jordan and Miller, 2008).