The Brusov–Filatova–Orekhova Theory of Capital Structure

In this chapter, we analyze all existing theories of capital structure (with their advantages and disadvantages) in order to understand all aspects of the problem and make correct management decisions in practice. The role of the capital structure is that the correct determination of the optimal capital structure allows the company’s management to maximize the capitalization of the company and the long-term goal of the function of any company. The review examines the state of the capital structure and capital cost theory from the middle of the last century, when the first quantitative theory was created, to the present. The two main theories, Modigliani–Miller (MM) and Brusov–Filatova–Orekhova (BFO), are discussed and analyzed, as well as their numerous modifications and generalizations. Additionally discussed is the latest stage in the development of the theory of capital structure, which began a couple of years ago and is associated with the adaptation of the two main theories of capital structure (Brusov–Filatova–Orekhova and Modigliani–Miller) to establish the practice of the function of companies. This generalization takes into account the real conditions of the work of the companies. It was noted that taking into account some effects that are present in economic practice (such as variable income, frequent payments of tax on income, advance payments of tax on income, etc.) brings both theories closer, and even the Modigliani–Miller theory, with all its many limitations, becomes more applicable in economic practice. However, it should be remembered that the Modigliani–Miller theory is only true for perpetual companies, while the BFO theory is valid for companies of any age, and from this point of view, they never coincide.

Under the capital structure, one understands the relationship between equity and debt capital of the company. Does capital structure affect the company’s main settings, such as the cost of capital, profit, value of the company and the other, and, if affected, how? Choice of an optimal capital structure, i.e., a capital structure, which minimizes the weighted average cost of capital and maximizes the value of the company, is one of the most important tasks solving by financial manager and the management of a company. The first serious study (and first qualitative study) of capital structure of the company influence on its indicators of activities was the work by Modigliani–Miller (Modigliani and Miller Am Econ Rev 48:261–297, 1958). Until this study, the approach existed (let us call it traditional), which was based on empirical data analysis. The Modigliani–Miller theory and its numerous modifications are discussed.

One of the serious limitations of the Modigliani–Miller theory is the suggestion about perpetuity of the companies. In 2008, Brusov–Filatova–Orekhova (Filatova et al. Bull FU 48:68–77, 2008) have lifted up this limitation and shown, that the accounting of the finite lifetime (finite age) of the company leads to significant changes in all Modigliani–Miller results (Мodigliani and Мiller, Am Econ Rev 48:261–297, 1958; Am Econ Rev 53:147–175, 1963; Am Econ Rev 56:333–391, 1966): capitalization of the company is changed, as well as the equity cost, ke, and the weighted average cost of capital, WACC, in the presence of corporative taxes. Besides a number of qualitatively new effects in corporate finance, obtained in Brusov–Filatova–Orekhova theory (Brusov et al. Appl Financ Econ 21:815–824, 2011a; Res J Econ Bus ICT 2:16–21, 2011b; Res J Econ Bus ICT (UK) 2:11–15, 2011c; Res J Econ Bus ICT 2: 16–21, 2011d; Appl Financ Econ 22:1043–1052, 2012a; J Rev Glob Econ 1:106–111, 2012b; J Rev Glob Econ 2:94–116, 2013a; J Rev Glob Econ 2:183–193, 2013b; Cogent Econ Financ 2:1–13, 2014a; J Rev Glob Econ 3:175–185, 2014b; Brusov and Filatova, Financ Credit 435:2–8, 2011), is absent in Modigliani–Miller theory.

Within modern theory of capital structure and capital cost by Brusov–Filatova–Orekhova (Brusov et al. Appl Financ Econ 21:815–824, 2011a; Res J Econ Bus ICT 2:16–21, 2011b; Res J Econ Bus ICT (UK) 2:11–15, 2011c; Res J Econ Bus ICT 2: 16–21, 2011d; Appl Financ Econ 22:1043–1052, 2012a; J Rev. Glob Econ 1:106–111, 2012b; J Rev. Glob Econ 2:94–116, 2013a; J Rev. Glob Econ 2:183–193, 2013b; Cogent Econ Financ 2:1–13, 2014a; J Rev. Glob Econ 3:175–185, 2014b; Brusov and Filatova, Financ Credit 435:2–8, 2011; Filatova et al. Bull FU 48:68–77, 2008) the analyses of wide known trade-off theory have 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 means that the optimal capital structure is absent in famous trade-off theory. The explanation to this fact has been done.

Under condition of proved by us insolvency of well-known classical trade-off theory question of finding of new mechanisms of formation of the company optimal capital structure, different from one, suggested by trade-off theory, becomes very important. One of the real such mechanisms has been developed by us in this Chapter. It is based on the decrease of debt cost with leverage, which is determined by growth of debt volume. This mechanism is absent in perpetuity Modigliani–Miller theory, even in modified version, developed by us, and exists within more general modern theory of capital cost and capital structure by Brusov–Filatova–Orekhova (BFO theory).

It is shown that incorrect estimations of the basic financial parameters of companies, based on the use of the Modigliani–Miller theory lead to an underestimation of the financial risks, the impossibility, or severe difficulties in making appropriate management decisions, which is one of the implicit reasons for the global financial crisis.

In this Chapter, the role of tax shield, taxes, and leverage in the modern theory of the corporative finance is investigated. Modigliani–Miller theory, as well as modern theory of capital cost and capital structure by Brusov–Filatova–Orekhova is considered. It is shown that the equity cost as well as the weighted average cost of capital decreases with the tax rate, while the capitalization increases. The detailed investigation of the dependence of the weighted average cost of capital WACC and the equity cost ke on the tax rate at fix leverage (debt capital fraction wd) and on the leverage level at fix tax rate, as well as the dependence of WACCand ke on company lifetime is made. We have introduced the concept of tax operation 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 tax on profit rate, which exceeds some value T*.At some ratios between cost of debt and cost of equity the discovered effect takes place at tax on profit 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 this Chapter, the influence of inflation on capital cost and capitalization of the company within modern theory of capital cost and capital structure—Brusov–Filatova–Orekhova theory (BFO theory) (Brusov et al. Appl Financ Econ 21:815–824, 2011a; Res J Econ Bus ICT 2:16–21, 2011b; Res J Econ Bus ICT (UK) 2:11–15, 2011c; Res J Econ Bus ICT 2: 16–21, 2011d; Appl Financ Econ 22:1043–1052, 2012a; J Rev Glob Econ 1:106–111, 2012b; J Rev Glob Econ 2:94–116, 2013a; J Rev Glob Econ 2:183–193, 2013b; Cogent Econ Financ 2:1–13, 2014a; J Rev Glob Econ 3:175–185, 2014b; Brusov and Filatova, Financ Credit 435:2–8, 2011; Filatova et al. Bull FU 48:68–77, 2008) and within its perpetuity limit—Modigliani–Miller theory (Modigliani and Мiller, Am Econ Rev 48:261–297, 1958; Am Econ Rev 53:147–175, 1963; Am Econ Rev 56:333–391, 1966) is investigated. By direct incorporation of inflation into both theories, it is shown for the first time, that inflation not only increases the equity cost and the weighted average cost of capital, but as well it changes their dependence on leverage. In particular, it increases growing rate of equity cost with leverage. Capitalization of the company is decreased under accounting of inflation.

The modern capital cost and capital structure theory—Brusov–Filatova–Orekhova (BFO) theory and its perpetuity limit—Modigliani–Miller theory describe the case of the payments of income tax at the end of the year. But in practice companies could make these payments in advance. Recently, the Modigliani–Miller theory has been modified for the case of advanced payments of income tax and has shown that obtained results are quite different from the ones in “classical” Modigliani–Miller theory. In the current chapter, for the first time we modify the Brusov–Filatova–Orekhova (BFO) theory for the case of advanced payments of income tax and show that the impact of the transition to advance payments is much more significant than in the case of a perpetuity limit (the MM theory) and even leads to a qualitatively new effect on the dependence of equity cost on leverage. An important conclusion drawn in this chapter is that the tax shield is very important and the way it is formed (payments at the end of the year or in advance) leads to very important consequences, changing all the financial indicators of the company, such as the cost of raising capital and company value and radically changing the company’s dividend policy.

Both main theories of capital cost and capital structure—the Brusov–Filatova–Orekhova (BFO) theory and its perpetuity limit—the Modigliani–Miller theory—consider the payments of tax on profit once per year, while in real economy these payments are made more frequently (semi-annual, quarterly, monthly, etc.). Recently the Modigliani–Miller theory has been generalized by us for the case of tax on profit payments with an arbitrary frequency. Here for the first time we generalized the Brusov–Filatova–Orekhova (BFO) theory for this case. The main purpose of the chapter is to bring the BFO theory closer to economic practice, taking into account one of the features of the real functioning of companies—the frequent payments of tax on profit. We derive modified BFO formulas and show that: (1) all BFO formulas change; (2) all main financial parameters of the company, such as company value, V, the weighted average cost of capital, WACC, and equity cost, ke, depend on the frequency of tax on profit payments. It turns out that the increase in the number of payments of tax of profit per year leads to a decrease in the cost of attracting capital, WACC and increase in the company value, V. At a certain age n of the company and at certain frequency of tax on profit payments p, a qualitatively new anomalous effect takes place: the equity cost, ke(L), decreases with an increase of the level of leverage L. This radically changes the company’s dividend policy, since the economically justified amount of the dividends is equal to the cost of equity. More frequent payments of income tax are beneficial for both parties—for the company and for the tax regulator: for the company, this leads to an increase in the value of the company, and for the tax regulator, earlier payments are beneficial due to the time value of money.

In practice, profit tax payments are (1) made more frequently than annually and (2) can be made in advance. To study the influence of these two factors on the financial indicators of a company, we generalized the Brusov–Filatova–Orekhova (BFO) theory for the case of advance profit tax payments with an arbitrary frequency for the first time. Using modified BFO formulae, we showed that all financial indicators of a company, such as company value, the weighted average cost of capital (WACC) and equity cost (ke), depend on the frequency of the profit tax payments. We found that the WACC increased with the payments and the company value decreased with the payments. This meant that more infrequent payments could be beneficial for the company. The tilt angle of the equity cost (ke(L)) also increased with the payments. Depending on the age of the company, the equity cost either decreased with L for all payment frequencies or increased for some frequencies. We compared the obtained results to those that we described recently for profit tax payments at the end of the financial period and found them to be totally different. We found that in spite of the fact that the WACC decreased with the payments and the company value increased with the payments, the WACC value in this case turned out to be bigger and the company value turned out to be smaller than in the case of advance profit tax payments of any frequency. This underlined the importance of advance profit tax payments. Regulator recommendations were also developed to encourage the practice of advance profit tax payments due to the understanding of the benefits of this for both parties: the companies and the state. A new effect was discovered: the decrease in equity cost with an increase in the level of leverage (L).

To expand the applicability in practice of the modern theory of cost and capital structure, the theory of Brusov–Filatova–Orekhova (BFO), which is valid for companies of arbitrary age, is generalized for the case of variable income. The generalized theory of capital structure can be successfully applied in corporate finance, business valuation, banking, investments, ratings, etc. income. A generalized Brusov–Filatova–Orekhova formula for the weighted average cost of capital, WACC, is derived using a formula in MS Excel, where the role of the discount rate shifts from WACC to WACC-g (here, g is the growth rate) for financially dependent companies and k0-g for financially independent companies is shown. A decrease in the real discount rates of WACC-g and k0-g with g ensures an increase in the company’s capitalization with g. The tilt of the equity cost curve, ke(L), increases with g. Since the cost of equity justifies the amount of dividends, this should change the dividend policy of the company. It turns out that for the growth rate g < g*, the tilt of the curve ke(L) becomes negative. This qualitatively new effect, discovered here for the first time, can significantly change the principles of the dividend policy of the company. The obtained results are compared with the results of the MM theory with variable income.

The Brusov–Filatova–Orekhova (BFO) theory is generalized for the simultaneous account of variable company profit and advance tax on income payments. The generalized BFO formula for the WACC has been derived. The dependence of WACC, discount rate, WACC-g (here g is growth rate), company capitalization, V, the equity cost, ke, on leverage L at various values of g, on debt cost, kd, and on age of the company, n, is studied. It is shown that WACC is no longer a discount rate. This role passes to WACC-g, which decreases with g, while the company’s value increases with g. The tilt of curve k(L) growths with g. It is found that at the growth rate g < g* the tilt of the curve ke(L) is negative. This changes significantly the company’s dividend policy principles. WACC(L) as well as the discount rate, WACC-g, decreases with the increase of debt cost kd. V (L) at all values of kd increases with leverage L, as well V(L) increases with kd. This means that tax shield advantages the decrease of the cost of raising capital. Examining the main financial parameters of the company at the positive (g = 0.2) and negative (g = −0.2) growth rates, we found a huge difference in their behavior. This allows you to explore companies with growing profits and companies with decreasing profits, as well as investigate the financial state of the companies whose profits rise and fall in different periods.

Two modifications of the modern theory of the capital cost and capital structure—the theory of Brusov–Filatova–Orekhova (BFO) with variable income are considered: (1) with the payment of income tax at the end of periods and (2) with advance payments of income tax. BFO formulas for the weighted average cost of capital, WACC, for company value, V, were derived for these two cases and within these formulas, a comprehensive analysis of the dependence of WACC, of discount rate, WACC–g (here g is the growth rate), company capitalization, V, the equity cost, ke, on the leverage level L at different values of the growth rate, g, at different values of the cost of debt capital, kd, and at different values of company age, n was carried out.The results for cases (1) and (2) are compared, which allows us to conclude that case (2) is always preferable for both the company and the regulator. This allows for developing recommendations for both parties to expand the practice of advance payments of income tax.

In this chapter, the modern investment models, which will be used in following chapters for investigation of different problems of investments, such as the influence of debt financing, leverage level, taxing, project duration, method of financing, and some other parameters on the efficiency of investments and other problems, are built.

In the previous сhapter, we have established investment models with debt repayment at the end of the project, well proven in the analysis of real investment projects. In practice, however, a scheme of uniform debt repayment during the duration of the project is more extended. In this chapter, we describe new investment models with uniform debt repayment during the duration of the investment project, quite adequately describing real investment projects. Within these models it is possible, in particular, to analyze the dependence of the effectiveness of investment projects on debt financing and taxation. We will work on the modern theory of capital cost and capital structure developed by Brusov–Filatova–Orekhova (Brusov and Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b; Filatova et al. Bull FU 48:68–77, 2008; Brusova 2011) as well as on perpetuity limit (Мodigliani and Мiller Am Econ Rev 48:261–297, 1958; Am Econ Rev 53:147–175, 1963; Am Econ Rev 56: 333–391, 1966).In Chap. 30 we consider the application of the investment models with uniform debt repayment to rating methodology.

Earlier (see in Brusov et al., Generalized Modigliani–Miller theory: applications in corporate finance, investments, taxation and ratings. Springer Nature, Cham, 2022) we have conducted the analysis of the effectiveness of investment projects within the perpetuity (Modigliani–Miller) approximation (Мodigliani and Мiller, Am Econ Rev 48:261–297, 1958; Am Econ Rev 53:147-175, 1963; Am Econ Rev 56:333–391, 1966). In this chapter the analysis of the obtained results on the exploration of efficiency of investment projects of arbitrary duration (within Brusov–Filatova–Orekhova theory (Brusov et al., Appl Financ Econ 21 (11):815–824, 2011a, Res J Econ Bus ICT 2:16–21, 2011b, Res J Econ Bus ICT 2:11–15, 2011c; Appl Finan Econ 22:1043–1052, 2012a, J Rev Glob Econ 1:106–111, 2012b, J Rev Glob Econ 2:94–116, 2013a, J Rev Glob Econ 2:183–193, 2013b, Cogent Econ Finance 2:1–13, 2014a, J Rev Glob Econ 3:175–185, 2014b; Filatova et al., Bull FU 48:68–77, 2008)) is conducted.

Within investment models, developed by Brusov, Filatova, Orekhova earlier (Brusov et al., Appl Financ Econ 21 (11):815–824, 2011a, Res J Econ Bus ICT 2:16–21, 2011b, Res J Econ Bus ICT 2:11–15, 2011c; Appl Financ Econ 22 (13):1043–1052, 2012a, J Rev Glob Econ 1:106–111, 2012b; J Rev Glob Econ 2:94–116, 2013a, J Rev Glob Econ 2:183–193, 2013b; Cogent Econ Finance 2:1–13, 2014a, J Rev Glob Econ 3:175–185, 2014b; Filatova et al., Bullet FU 48:68–77, 2008) the influence of tax on profit rate on effectiveness of long-term investment projects at different debt levels is investigated. It is shown, that increase of tax on profit rate from one side leads to decrease in project NPV, but from other side it leads to decrease in sensitivity of NPV with respect to leverage level. At high leverage level L the influence of tax on profit rate increase on the effectiveness of investment projects becomes significantly less. We come to conclusion, that taxing could be differentiated depending on debt level of investment projects of the company: for projects with high debt level L it is possible to apply a higher tax on profit rate.

Within modern theory of capital cost and capital structure by Brusov–Filatova–Orekhova (BFO theory) (Brusov et al., Appl Financ Econ 21(11):815–824, 2011a, Res J Econ Bus ICT 2:16–21, 2011b, Res J Econ Bus ICT (UK) 2:11–15, 2011c, Finance Credit 435:2–8, 2011d, Appl Financ Econ 22 (13):1043–1052, 2012a, J Rev Glob Econ 1:106–111, 2012b, J Rev Glob Econ 2:94–116, 2013a, J Rev Glob Econ 2:183–193, 2013b, Cogent Econ Finance 2:1–13, 2014a, J Rev Glob Econ 3:175–185, 2014b; Filatova et al., Bull FU 48:68–77, 2008) and created within this theory modern investment models influence of growth of tax on profit rate on the efficiency of the investment is investigated. It has been shown that for long-term investment projects, as well as for arbitrary duration projects the growth of tax on profit rate change the nature of the NPV dependence on leverage at some value t*: there is a transition from diminishing function NPV(L) when t < t* to growing function NPV(L). The t* value depends on the duration of the project, cost of capital (equity and debt) values, and other parameters of the project.At high leverage levels, this leads to qualitatively new effect in investments: growth of the efficiency of the investments with growth of tax on profit rate. Discovered effects take place under consideration from the point of view of owners of equity capital as well as from the point of view of owners of equity and debt capital.

In this chapter developed by the authors models on the evaluation of the dependence of the effectiveness of investments on debt financing are applied for the analysis of investments of one of the telecommunication company from the point of view of optimal structure of investment. The analysis revealed that only in 2011, the company’s investment structure was close to the optimal.

New modern investment models are created to be as close as possible to real investment conditions. We consider long-term as well as arbitrary duration models with payments of interest on debt and of tax on income a few times per year (semi-annually, quarterly, and monthly), which could be applied in real economic practice. Their verification will lead to the creation of a comprehensive system of adequate and correct assessment of the effectiveness of the company’s investment program and its investment strategy. One of the most important elements of calculating the effectiveness of investment projects is the assessment of the discount rate, the calculation methods of which are generalized for the real conditions of the implementation of investment projects. We consider the effectiveness of the investment project from two points of view: the equity owners and the owners of equity and debt. NPV for each of these cases is calculated by two different methods: with the separation of credit and investment flows (and thus discounting the flows using two different rates) and without such separation (with discounting of both flows using the same rate, and WACC can be chosen as the rate). Numerical calculations, conducted for four investment models (without flow separation) show that: (1) in the case of considering the effectiveness of an investment project for owners of equity capital, the increase in the number of payments of tax on income and of interest on debt p leads to a decrease in NPV: this means that the effectiveness of an investment project decreases with p; (2) in the case of considering the effectiveness of an investment project for owners of equity and debt capital, the increase in the number of payments of tax on income and of interest on debt p leads to an increase in NPV: this means that the effectiveness of an investment project increases with p. In the former case, companies should pay tax on profit and interest on debt once per year, while in the latter case, more frequent payments are profitable for the effectiveness of investment. Eight innovative investment models created in this paper can assist decision-makers in the optimal design, planning, and control of company investments and the development of a company’s investment strategy.

In this chapter, we study the role of the Central Bank and commercial banks in creating and maintaining a favorable investment climate in the country. Within the framework of modern investment models created by the authors, the dependence of the efficiency of investments on the level of debt financing within a wide range of values of equity costs and debt capital costs under different project terms (long-term projects as well as projects of arbitrary duration) and different investment profitability coefficients β is investigated. The effectiveness of investments is determined by Net Present Value, NPV. The study is conducted within the framework of investment models with debt repayment at the end of the project term.It is found that NPV depends practically linearly on leverage level L, increasing or decreasing depending on profitability coefficient β and credit rate values kd. The cutoff credit rate values kd*, separating the range of increasing NPV(L) from range of decreasing NPV(L), are determined. The Central Bank should keep its key rate at the level which allows commercial banks to keep their credit rates below the cutoff credit rate kd* values in order to create and maintain a favorable investment climate in the country.

In this Chapter and next one we return back to corporate finance in order to describe a very important discovery, made by us recently (Brusov et al., Modern corporate finance, investment and taxation. Springer, New York, 2015a, J Rev Global Econ 4:21–42, 2015b). We investigate the dependence of attracting capital cost on the time of life (age) of company n at various leverage levels, at various values of capital costs with the aim of defining minimum cost of attracting capital. All calculations have been done within modern theory of capital cost and capital structure by Brusov–Filatova–Orekhova (Brusov and Filatova, Finance Credit 435:2–8, 2011; Brusov et al., Appl Financ Econ 21(11):815–824, 2011a, Res J Econ Bus ICT (UK) 2:16–21, 2011b; Res J Econ Bus ICT (UK) 2:11–15, 2011c; Appl Financ Econ 22(13):1043–1052, 2012a, J Rev Global Econ 1:106–111, 2012b, J Rev Global Econ 2:94–116, 2013a, J Rev Global Econ 2:183–193, 2013b, Cogent Econ Finance 2:1–13, 2014a, J Rev Global Econ 3:175–185, 2014b; Filatova et al., Bull FU 48:68–77, 2008; Brusova, Financ Anal Prob Sol 34(76):36–42, 2011).

In this Chapter we continue to study this problem and investigate which companies have the “golden age,” i.e., obey the latter type of dependence of WACC on n (Brusov 2018b). With this aim, we study the dependence of WACC on the age of company n at various leverage levels within a 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., Appl Financ Econ 21(11):815–824, 2011a, Res J Econ Bus ICT 2:16–21, 2011b, Res J Econ Bus ICT (UK) 2:11–15, 2011c, Finance Credit 435:2–8, 2011d, Brusov et al., Appl Financ Econ 22(13):1043–1052, 2012a, J Rev Glob Econ 1:106–111, 2012b; Brusov et al., J Rev Glob Econ 2:94–116, 2013a, J Rev Glob Econ 2:183–193, 2013b, Brusov et al., Cogent Econ Finance 2:1–13, 2014a, J Rev Glob Econ 3:175–185, 2014b; Filatova et al., Bull FU 48:68–77, 2008).We have shown that the 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.

Chapter is devoted to describing the new meaningful effects in capital structure theory, discovered within modern theory of capital cost and capital structure, created by Brusov, Filatova, and Orekhova (BFO theory). These qualitatively new effects are present in general version of BFO theory and absent in its perpetuity limit (Modigliani–Miller theory). BFO theory has changed some main existing principles of financial management. Discovered effects modify our understanding of financial management and dictate some unusual managerial decisions.

In this chapter, a new approach to rating methodology is suggested. Chapters 28 – 30 are devoted to rating of non-financial issuers, while Chaps. 31 and 32 are devoted to investment project rating (Peter Brusov, Tatiana Filatova and Natali Orekhova Ratings: Critical Analysis and New Approaches of Quantitative and Qualitative Methodology 2021, Springer Nature Publishing). 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) (Brusov et al. Modern corporate finance, investment and taxation. Springer, 2015) in Chap. 29 (in this Chapter and in Chap. 30 into its perpetuity limit). This, on the one hand, allows to 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. New approach to ratings and rating methodologies allows to issue more correct ratings of issuers and makes the rating methodologies more understandable and transparent.

In the previous chapter, 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 the 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 to use the powerful tools of BFO theory in the rating. All these create a new base for rating methodologies.

Recently we have modified the theory of Nobel Prize winners Modigliani and Miller (MM theory), which is a perpetuity limit case of the general theory of capital cost and capital structure—Brusov–Filatova–Orekhova theory (BFO theory), into two ways: we apply it for rating methodology needs and later we generalized it for the case of advance payments of tax on profit, which is widely used in practice (MMM theory). In the current chapter, we use the modified Modigliani–Miller theory (MMM theory) and apply it for rating methodology needs. The financial “ratios” (main rating parameters) were introduced into MMM theory. The dependence of the weighted average cost of capital (WACC), which plays the role of discount rate in financial flows discounting in rating methodologies, on coverage and leverage ratios is analyzed. Obtained results will help improve the existing rating methodologies. A couple of years ago, we have suggested a new approach to rating methodology of non-financial issuers, as well as for project rating (for long-term projects as well as for projects of arbitrary duration) (Brusov et al. Modern corporate finance, investments, taxation and ratings. Springer, 2018a; J Rev Glob Econ 7:37–62, 2018b; J Rev Glob Econ 7:88–103, 2018c; J Rev Glob Econ 7:63–829, 2018d; J Rev Glob Econ 7:104–122, 2018e; J Rev Glob Econ 7:360–376, 2018f; Modern corporate finance and investments, monograph. Knorus Publishing House, 2018g; J Rev Glob Econ 8:437–448, 2019; J Rev Glob Econ 9:257–268, 2020b). 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) (Brusov et al. 2011, 2014, 2015; Modern corporate finance, investments, taxation and ratings. Springer, 2018a; J Rev Glob Econ 7:37–62, 2018b; J Rev Glob Econ 7:88–103, 2018c; J Rev Glob Econ 7:63–829, 2018d; J Rev Glob Econ 7:104–122, 2018e; J Rev Glob Econ 7:360–376, 2018f; Modern corporate finance and investments, monograph. Knorus Publishing House, 2018g; J Rev Glob Econ 8:437–448, 2019) and into its perpetuity limit.

In this chapter, we develop for the first time a new approach to ratings of the investment projects of arbitrary durations, applicable 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 could be done using new rating methodologies developed here. In our previous chapters, the new approach to the ratings of the long-term investment projects has been developed (Filatova et al. J Rev Glob Econ 7:645–661, 2018). The important features of that consideration are as follows: (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 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 than in case of the long-term investment projects, considered by us in previous chapters. 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 the perspective of equity capital and debt capital owners. The new approach allows to use the powerful instruments of modern theory of capital cost and capital structure (BFO) theory (Brusov et al. Modern corporate finance, investments and taxation, Springer, Cham, 2015; Modern corporate finance, investments, taxation and ratings, Springer, Cham, 2018a, J Rev Glob Econ 7:37–62, 2018b, J Rev Glob Econ 7:88–103, 2018c, J Rev Glob Econ 7:63–87, 2018d, J Rev Glob Econ 7:104–122, 2018e, J Rev Glob Econ 7:360–376, 2018f, Modern corporate finance and investments, Knorus Publishing House, Moscow, 2018g) and modern investment models, created by the authors and well tested in the real economy to evaluate investment project performance, including energy projects.

Along with the rating of non-financial issuers, considered in previous Chaps. ( 28 , 29 , and 30 ), the rating of investment projects plays an important role in the modern economy and finance. It allows ranking and selection of the most effective investment projects, which is especially important for attracting both foreign and domestic investments. This chapter discusses the rating of investment projects of arbitrary duration with a uniform repayment of debt, investment model for which is described in Chap. 18 . The methodology for rating investment projects has been modified. A fundamentally new approach to the project rating methodology has been developed, the key factors of which are: (1) adequate application of discounting when discounting the financial flows, which is practically not used in the existing project rating methodologies; (2) incorporation of financial ratios into modern investment models created by the authors; (3) use of rating parameters upon discounting; (4) the determination of the correct discount rate, taking into account financial ratios. We use modern investment model created by the authors (see Chap. 18 ), the modern theory of capital cost and capital structure by Brusov–Filatova–Orekhova (BFO) theory, its modification for rating needs, and rating coefficients. Various theories of capital cost and capital structure are described in Chaps. 4 , 5 , and 6 .The developed approach should be applied by rating agencies, both international and national ones, when rating investment projects. The modification of the methodology of the existing project rating systems will improve the accuracy of ratings of investment projects and make them more objective. The use of powerful tools of well-developed theories opens up new opportunities for the rating industry, which gets the opportunity to switch from using primarily qualitative methods for assessing the effectiveness of investment projects to using mainly quantitative methods for evaluating them.

This book changes our understanding of corporate finance, investments, taxation, and rating procedures. It shows that the most used principles of financial management should be changed in accordance with Brusov–Filatova–Orekhova (BFO) theory. Many of the discoveries made within this theory still require interpretations and understanding as well as incorporation into real finance and economy. But it is clear now that without very serious modification of the conceptions of financial management, it is impossible to adequately manage manufacture, investments, taxation, and rating procedures, as well as finance in general.