Do Credit Ratings Matter? Evidence from S&P's 2013 Methodology Revision

Exploiting exogenous variation introduced by a significant change in S&P’s methodology, we show that credit ratings have a first-order causal impact on capital structure and investment decisions. Quantifying debt capacity within a firm’s credit rating (Ratings Capacity) using precise metrics, we show that capital structure is highly sensitive to changes in Ratings Capacity. Credit ratings explain more variation in capital structure changes than other firm-specific determinants. Firms with low adjustment costs and attractive investment opportunities are more responsive to Ratings Capacity. Increased Ratings Capacity causes significant expansion in investment and reductions in share repurchases, suggesting wide impacts on financial policy.