A Qualitatively New Effect in Corporative Finance: Abnormal Dependence of Cost of Equity of Company on Leverage

Qualitatively new effect in corporative finance is discovered: decreasing of cost of equity ke with leverage L. This effect, which is absent in perpetuity Modigliani–Miller limit, takes place under account of finite lifetime of the company at profit tax rate, which exceeds some value T*. At some ratios between cost of debt and cost of equity the discovered effect takes place at profit tax rate, existing in western countries and Russia. This provides the practical meaning of discussed effect. Its accounting is important at modification of tax low and can change the dividend policy of the company. In paper the complete and detailed investigation of discussed effect, discovered within Brusov – Filatova – Orekhova theory (BFO theory), has been done. It has been shown, that the absence of the effect at some particular set of parameters is connected to the fact, that in these cases T* exceeds 100% (profit tax rate is situated in â€non– financial†region)

Absence of an Optimal Capital Structure in the Famous Tradeoff Theory!

Abstract: Within modern theory of capital structure and capital cost by Brusov-Filatova-Orekhova the analysis of wide known tradeoff theory has been made. It is shown that suggestion of risky debt financing (and growing credit rate near the bankruptcy) in opposite to waiting result does not lead to growing of weighted average cost of capital, WACC, which still decreases with leverage. This means the absence of minimum in the dependence of WACC on leverage as well as the absence of maximum in the dependence of company capitalization on leverage. Thus, it seems that the optimal capital structure is absent in famous tradeoff theory. The explanation to this fact has been done

A "Golden Age" of the Companies: Conditions of Its Existence

A few years ago we have discovered the effect of the "golden age" of company (Brusov et al. 2015): it was shown for the first time that valuation of the weighted average cost of capital, WACC, in the Modigliani - Miller theory (Modigliani et al. 1958; 1963; 1966) is not minimal and valuation of the company capitalization is not maximal, as all financiers supposed up to this discovery: at some age of the company its WACC value turns out to be lower, than in Modigliani - Miller theory and company capitalization V turns out to be greater, than V in Modigliani - Miller theory. It was shown that, from the point of view of cost of attracting capital there are two types of dependences of weighted average cost of capital, WACC, on the company age n: monotonic descending with n and descending with passage through minimum, followed by a limited growth. In practice there are companies with both types of dependences of WACC on the company age n. In this paper we investigate which companies have the "golden age", i.e. obey the latter type of dependence of WACC on n. With this aim we study the dependence of WACC on the age of company n at various leverage levels within wide spectrum of capital costs values as well as the dependence of WACC on leverage level L at fixed company age n. All calculations have been done within modern theory of capital cost and capital structure BFO by Brusov-Filatova-Orekhova (Brusov et al. 2011a,b,c,d,e; 2012 a,b; 2013 a,b,c; 2014 a,b; Filatova et al. 2008). We have shown that existence of the "golden age" of company does not depend on the value of capital costs of the company, but depends on the difference between equity k0 and debt kd costs. The "golden age" of company exists at small enough difference between k0 and kd costs, while at high value of this difference the "golden age" of company is absent: curve WACC(n) monotonic descends with n. For the companies with the "golden age" curve WACC(L) for perpetuity companies lies between curves WACC(L) for company ages n=1 and n=3, while for the companies without the "golden age" curve WACC(L) for perpetuity companies is the lowest one. In previous paper (Brusov et al. 2015) we have found also a third type of WACC(n) dependence: descending with passage through minimum, which lies below the perpetuity limit value, then going through maximum followed by a limited descending. We called this effect "Kulik effect". In this paper we have found a variety of "Kulik effect": descending with passage through minimum of WACC, which lies above the perpetuity limit value, then going through maximum followed by a limited descending. We call this company age, where WACC has a minimum, which lies above the perpetuity limit value, "a silver age" of the company. Because the cost of attracting capital is used in rating methodologies as discounting rate under discounting of cash flows, study of WACC behavior is very important for rating procedures. The account of effects of the "golden (silver) age" could change the valuation of creditworthiness of issuers. Remind that, since the "golden age" of company depends on the company's capital costs, by controlling them (for example, by modifying the value of dividend payments, that reflect the equity cost), company may extend the "golden age" of the company, when the cost to attract capital becomes a minimal (less than perpetuity limit), and capitalization of companies becomes maximal (above than perpetuity assessment) up to a specified time interval. We discuss the use of opened effects in developing economics

Rating: New Approach

The paper suggests a new approach to rating methodology, key factors of which are: 1) The adequate use of discounting of financial flows virtually not used in existing rating methodologies, 2) The incorporation of rating parameters (financial "ratios") into the modern theory of capital structure (Brusov-Filatova-Orekhova (BFO) theory) (Brusov P, Filatova T, Orehova N, Eskindarov M, 2015) (for beginning into its perpetuity limit). This on the one hand allows use the powerful tools of this theory in the rating, and on the other hand it ensures the correct discount rates when discounting of financial flows. We discuss also the interplay between rating ratios and leverage level which can be quite important in rating. All these create a new base for rating methodologies

Ratings of the Long-Term Projects: New Approach

The paper continues create a new approach to rating methodology: in addition to two papers, which have considered the creditworthiness of the non–finance issuers (Brusov et al., 2018c,d), we develop here a new approach to project rating. We work within investment models, created by authors. One of them describes the effectiveness of investment project from perspective of equity capital owners, while other model describes the effectiveness of investment project from perspective of equity capital and debt capital owners.The important features of current consideration as well as in previous studies are: 1) The adequate use of discounting of financial flows virtually not used in existing rating methodologies, 2) The incorporation of rating parameters (financial "ratios"), used in project rating, into considered modern investment models.Analyzing within these investment models with incorporated rating parameters the dependence of NPV on rating parameters (financial "ratios") at different values of equity cost k0, at different values of credit rates kd as well as at different values of leverage level L we come to very important conclusion, that NPV in units of NOI (NPV/NOI) (as well as NPV in units of D ((NPV/D) depends only on equity cost k0, on credit rates kd, on leverage level L as well as on one of the leverage ratios lj (on one of the coverage ratios ij ) and does not depend on equity value S, debt value D and NOI. This means that obtained results on the dependence of NPV (in units of NOI) (NPV/NOI) on leverage ratios lj (as well as on the dependence of NPV (in units of D) (NPV/NOI) on coverage ratios ij) at different equity costs k0, at different credit rates kd, at different leverage levels L carry the universal character: these dependencies remain valid for investment projects with any equity value S, any debt value D and any NOI

Rating Methodology: New Look and New Horizons

In the previous paper a new approach to rating methodology has been suggested. Key factors of a new approach were the following: 1) The adequate use of discounting of financial flows virtually not used in existing rating methodologies, 2) The incorporation of rating parameters (financial "ratios") into the perpetuity limit of modern theory of capital structure (Brusov-Filatova-Orekhova (BFO) theory): for companies with infinite lifetime. In current paper further development of a new approach has been done. We have generalized it for the general case of modern theory of capital structure (Brusov-Filatova-Orekhova (BFO) theory): for companies of arbitrary age. A serious modification of BFO theory in order to use it in rating procedure has been required. It allows to apply obtained results for real economics, where all companies have finite lifetime, introduce a factor of time into theory, estimate the creditworthiness of companies of arbitrary age (or arbitrary lifetime), introduce discounting of the financial flows, using the correct discount rate etc. This allows use the powerful tools of BFO theory in the rating. All these create a new base for rating methodologies

Modern Theory of Capital Cost and Capital Structure by Brusov – Filatova – Orekhova (BFO Theory) for Companies, which Ceased to Exist at the Time Moment n

Modern theory of capital cost and capital structure by Brusov – Filatova – Orekhova (BFO theory), which describes the companies of arbitrary age n in opposite to the perpetuity Modigliani – Miller theory, is applied for companies, which ceased to exist at the time moment n. The required modification of BFO theory has been done in the paper. Formula BFO-2 for calculation of dependences of weighted average cost of capital, WACC, on the company's of lifetime n, on leverage level L and on tax on profit rate t for companies, which ceased to exist at the time moment n has been derived. We analyze these dependences and compare them with the results of classical BFO theory which describes the companies of arbitrary age n. Comparing of results, obtained for companies as remaining in the market (BFO), as well as retired from the market (BFO-2) shows that dependence of the weighted average cost of capital WACC of companies on leverage level L, the company's lifetime (or age) n and the tax on profit rate t are qualitatively similar in nature, while, there are significant quantitative differences in these dependences: WACC for companies ceased to exist, always turns out to be higher than that of the companies that remain on the market (with the same parameters: leverage level L, the company's lifetime (or age) n and the tax on profit rate t, capital costs (equity and debt)), by other words the cost of attracting capital for companies that continue to operate, is always lower. We examine whether the effects, discovered by us within classical BFO theory, are present in its modified form (BFO-2). We have found that within trade off theory there is no an optimal capital structure for BFO-2 case as well as for BFO (as it has been proven by us before), while the qualitatively new effect in corporative finance (decreasing of equity cost with leverage L), existing within classical BFO theory, is absent in BFO-2 case similar to the case of perpetuity companies

Ratings of The Investment Projects of Arbitrary Durations: New Methodology

In this paper we develop for the first time a new approach to ratings of the investment projects of arbitrary durations, which could be applied to investments of any area of economy and in particular to energy projects.The ratings of such energy projects, as "Turkish stream", "Nord stream-2", energy projects relating to clean, renewable and sustainable energy, as well as relating to pricing carbon emissions (McAleer et al., 2018a,b,c; 2019) could be done using developed here new rating methodologies. In our previous papers the new approach to the ratings of the long–term investment projects has been developed (Filatova et al., 2018). The important features of that consideration are as following: 1) The incorporation of rating parameters (financial "ratios"), used in project rating and playing a major role in it, into modern long–term investment models, 2) The adequate use of discounting of financial flows virtually not used in existing project rating methodologies. Here, for the first time, we incorporate the rating parameters (financial "ratios"), used in project rating, into modern investment models, describing the investment projects of arbitrary durations. This was much more difficult task then in case of the long–term investment projects, considered by us in previous papers. We work within investment models, created by authors. One of them describes the effectiveness of investment project from perspective of equity capital owners, while other model describes the effectiveness of investment project from perspective of equity capital and debt capital owners. New approach allows use the powerful instruments of modern theory of capital cost and capital structure (BFO theory) (Brusov et al., 2015, 2018) and modern investment models, created by the authors and well tested in the real economy to evaluate investment project performance, including energy projects.In our calculations we use Excel technique in two aspects: 1) we calculate WACC at different values of equity costs k0, different values of debt costs kd and different values of leverage level L=D/S, using the famous BFO formula; 2) we calculate the dependences of NPV on coverage ratios as well as leverage ratios at different values of equity costs k0, different values of debt costs kd and different values of leverage level L

Modification of the Modigliani–Miller Theory for the Case of Advance Payments of Tax on Profit

The first serious study (and first quantitative study) of influence of capital structure of the company on its indicators of activities was the work by Nobel Prize Winners Modigliani and Miller. Their theory has a lot of limitations. One of the most important and seriouse assumptions of the Modigliani – Miller theory is that all financial flows as well as all companies are perpetuity. This limitation was lift out by Brusov–Filatova–Orekhova in 2008 (Filatova et al. 2008), who have created BFO theory – modern theory of capital cost and capital structure for companies of arbitrary age.  Despite the fact that the Modigliani–Miller theory is currently a particular case of the general theory of capital cost and capital structure – Brusov–Filatova–Orekhova (BFO) theory – it is still widely used at the West. In current paper we discuss one more limitation of Modigliani – Miller theory: a method of tax on profit payments. Modigliani – Miller theory accounts these payments as annuity–immediate while in practice these payments are making in advance and thus should be accounted as annuity–due. We generalize the Modigliani–Miller theory for the case of advance payments of tax on profit, which is widely used in practice, and show that this leads to some important consequencies, which change seriously all the main statements by Modigliani and Miller. These consequencies are as following: WACC starts to depend on debt cost kd, WACC turns out to be lower than in case of classical Modigliani–Miller theory and thus company capitalization becomes higher than in ordinary Modigliani–Miller theory.We show that dependence of equity cost on leverage level L is still linear, but the tilt angle with respect to L–axis turns out to be smaller: this could lead to modification of the divident policy of the company. Correct account of a method of tax on profit payments demonstrates that shortcomings of Modigliani – Miller theory are dipper, than everybody suggested: the underestimation of WACC really turns out to be bigger, as well as overestimation of the capitalization of the company. This means that systematic risks arising from the use of modified Modigliani – Miller theory (MMM theory) (which is more correct than "classical' one) in practice are higher than it was suggested by the "classical" version of this theory

Application of the Modigliani–Miller Theory, Modified for the Case of Advance Payments of Tax on Profit, in Rating Methodologies

During a couple years we have suggested a new approach to rating methodology of non–financial issuers, as well for project rating. The key factors of a new approach are: 1) The adequate use of discounting of financial flows virtually not used in existing rating methodologies, 2) The incorporation of rating parameters (financial "ratios") into the modern theory of capital structure (Brusov–Filatova–Orekhova (BFO) theory) and into its perpetuity limit. Recently we have generalized the Modigliani and Miller theory for a more realistic method of payments of tax on profit: for the case of advance payments of tax on profit, which is widely used in practice. Modigliani – Miller theory accounts these tax payments as annuity–immediate, while in practice these payments are making in advance and thus should be accounting as annuity–due. We have shown that this generalization leads to some important consequences, which change seriously all the main statements by Modigliani and Miller. In current paper we use the modified Modigliani – Miller theory (MMM theory) and apply it for rating methodologies needs. A serious modification of MMM theory in order to use it in rating procedure has been required. The financial "ratios" were incorporated into MMM theory. The dependence of the weighted average cost of capital (WACC), which plays the role of discount rate, on coverage and leverage ratios is analyzed.  Obtained results make possible to use the power of this theory in the rating and create a new base for rating methodologies