Hsien-hsing Liao Department of Finance National Taiwan University

1. Comments on “How Does Crediting Management behavior Impact Optimal Capital Structure Decision”The 2008 NTUICF Hsien-hsing Liao Department of Finance National Taiwan University

2. Some thoughts about Capital Structure Theories MM • Capital Structure theories: • Trade-off (optimal theory) • Pecking order • Market timing • What is optimal leverage? • Max. VF both VE and VD max.? • If not? Max VE max VF or max VD? • Target a rating  target the cost of debt max VE or VD Firm value Tax benefit Financial distress cost Leverage Existing debt? Un-levered?

3. Major Objective • This paper examines the impact of credit rating management behavior in determining optimal capital structure.

4. Major Contributions(Findings)-1 • This study constructs a firm-value based framework of credit migration with a system of rating transitionmulti-boundaries, and rebuilds the contingent claim model for capital structure. • The model is able to capture three types of empirical behaviors regarding crediting rating management: targeting an initial rating, credit sensitive coupon debt, and targeting a minimum rating.

5. Major Contributions(Findings)-2 • The model is able to capture three types of empirical behaviors regarding crediting rating management: • targeting an initial rating: high  less leveraged • credit sensitive coupon debt  greater leverage • targeting a minimum rating  mean-reversion

6. General comments • Clear research questions; • Seeming solid model development; • Motivation is not clearly stated; • Model implications are not convincing enough

7. General comments • It is a Merton type model. It also shares the drawbacks of the Merton type models. Distribution problems, skewed, volatility smiled, underestimating PD (downgrade) and short maturity debt... • Time homogeneous transition matrix with Markov property • Fixed maturity of corporate debt • No consideration of financial distress costs (except the bankruptcy cost)

8. Specific questions-1 • The first model implication contends that a firm with a high targeting initial rating is underleveraged. I can tell it from figure 2. Actually, I tell the opposite results. BBB AA AAA

9. Specific questions-2 • The second model implication contends that a firm with a rating linked coupon debt has high leverage. • Because of the ignorance of agency and other financial distress costs (except bankruptcy cost), the tax shield benefit exceeds the bankruptcy cost  high leverage results. • In addition, the required rate of returns for the fixed and the rating-linked debt should be different because their credit risks are different. This is due to the difference in the asset payout ratio δ in (1) is different. It is higher for the rating linked debt firm and therefore a slow growth in firm value.