Modern Corporate Finance, Investments, Taxation and Ratings

One of the main problems in corporate finance is the problem of cost of capital and the impact of capital structure on its cost and capitalization of the companies. To date, even the question of the existence of an optimal capital structure of the companies (at which the company capitalization is maximal, and weighted average cost of capital is minimal) is open. Numerous theories and models, including the first and the only one until recently quantitative theory by Nobel Laureates Modigliani and Miller (MM) (Modigliani and Miller, Am Econ Rev 48:261–297, 1958; Am Econ Rev 53:147–175, 1963; Am Econ Rev 56:333–391, 1966), not only do not solve the problem but also because of the large number of restrictions (such as, e.g., theory of MM) have a weak relationship with the real economy. Herewith the qualitative theories and models, based on the empirical approach, do not allow to carry out the necessary assessment.

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 have shown that the accounting of the finite lifetime (or finite age) of the company leads to significant changes of 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, k _e, 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 and Filatova, Finance Credit 435:2–8, 2011; 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, Appl Financ Econ 22:1043–1052, 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 34:36–42, 2011), are absent in Modigliani–Miller theory.

Within the 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 21:815–824, 2011a, Res J Econ Bus ICT 2:16–21, 2011b, Res J Econ Bus ICT (UK) 2:11–15, 2011c, Appl Financ Econ 22:1043–1052, 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, Modern corporate finance, investment and taxation. Springer, Berlin, 2015, J Rev Global Econ 7:104–122, 2018a, J Rev Global Econ 7:88–103, 2018b, J Rev Global Econ 7:63–87, 2018c, J Rev Global Econ 7:37–622018d; Filatova et al., Bull FU 48:68–77, 2008), an analysis of the widely known trade-off theory has been made. It is shown that suggestion about risky debt financing (and about growth of credit rate near the bankruptcy) in opposite to waiting result does not lead to growth 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 the famous trade-off theory. The explanation to this fact has been done.

Under condition proved by us, insolvency of the well-known classical trade-off theory and question of finding new mechanisms of formation of the company’s optimal capital structure, different from the one suggested by trade-off theory, become very important. One of the real such mechanisms is 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).

Hopes of ending the financial crisis did not materialize. Recent events (the problems of the euro zone, the threat of default in the USA, the collapse of the financial market after a reduction of the credit rating of the USA, debt problems in the world (Europe, USA), etc.) show that the crisis deepened, affecting new areas and taking on a systemic character.

In this chapter, the role of tax shield, taxes, and leverage in the modern theory of corporate finance is investigated. Modigliani–Miller theory and modern theory of capital cost and capital structure by Brusov–Filatova–Orekhova are considered. It is shown that the equity cost, as well as the weighted average cost of capital, decreases with the tax on profit rate, while the capitalization increases. The detailed investigation of the dependence of the weighted average cost of capital (WACC) and the equity cost k _e on the tax on profit rate at fixed leverage (debt capital fraction w _d) and on the leverage level at fixed tax on profit rate, as well as the dependence of WACC and k _e on company lifetime (age), is made. We have introduced the concept of tax operation leverage. For companies with finite lifetime (finite age), a number of important qualitative effects, which have no analogies for perpetuity companies, are found.

Qualitatively new effect in corporative finance has been discovered by the authors: decreasing of equity cost k _e with leverage L. This effect, which is absent in perpetuity Modigliani–Miller limit, takes place on account of finite age of the company at tax on profit rate, which exceeds some value T*.

At some ratios between debt cost and equity cost, the discovered effect takes place at tax on profit rate existing in Western countries and Russia. This provides the practical meaning of the discussed effect. Taking it into account is important for the modification of tax law 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 and Filatova, Finance Credit 435:2–8, 2011; 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, Appl Financ Econ 22:1043–1052, 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 34:36–42, 2011), and within its perpetuity limit, Modigliani–Miller theory (Мodigliani 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 also it changes their dependence on leverage. In particular, it increases the growing rate of equity cost with leverage. Capitalization of the company is decreased under inflation.

The main objective of any investor is to ensure the maximum return on investment. During the realization of this goal, at least two major problems appear: the first is in which of the available assets and in what proportions an investor should invest. The second problem is related to the fact that, in practice, as is well known, a higher level of profitability is associated with a higher risk. Therefore, an investor can select an asset with a high yield and high risk or a more or less guaranteed low yield. These two selection problems constitute a problem of investment portfolio formation, the decision which is given by portfolio theory, described in this chapter. We study in detail the portfolio of the two securities (Brusov and Filatova, Financial mathematics for masters, KNORUS, Moscow, 2014, p. 480; Brusov et al., Financial mathematics for bachelor, KNORUS, Moscow, 2010, p. 224, Tasks on financial mathematics for bachelor. KNORUS, Moscow, 2012, p. 285), which represents a more simple case, containing, however, all the main features of more common Markowitz and Tobin portfolios. It appears that when selecting anticorrelated or noncorrelated securities, you can create a portfolio with the risk lower than the risk of any of the securities of portfolio, or even zero-risk portfolio (for anticorrelated securities).

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

In this chapter, we conduct the analysis of 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). Based on the obtained in previous chapter results for NPV (Brusov and Filatova, Finance Credit 435:2–8, 2011; 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, Appl Financ Econ 22:1043–1052, 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 34:36–42, 2011), we analyze the effectiveness of investment projects for three cases:

The dependence of NPV on investment value and/or equity value will be also analyzed. The results are shown in the form of tables and graphs.

In the previous chapter, we have conducted the analysis of 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 and Filatova, Finance Credit 435:2–8, 2011; 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, Appl Financ Econ 22:1043–1052, 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 34:36–42, 2011)] is conducted.

In previous chapters, 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 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, Finance Credit 435:2–8, 2011; 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, Appl Financ Econ 22:1043–1052, 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 34:36–42, 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).

Within investment models, developed by Brusov, Filatova, and Orekhova earlier (Brusov and Filatova, Finance Credit 435:2–8, 2011; 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, Appl Financ Econ 22:1043–1052, 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 34:36–42, 2011), 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 of project NPV, but from other side, it leads to decrease of sensitivity of NPV with respect to leverage level. At high leverage level L, the influence of tax on profit rate increase on 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, in principle, to apply a higher tax on profit rate.

Within the modern theory of capital cost and capital structure by Brusov–Filatova–Orekhova (BFO theory) (Brusov and Filatova, Finance Credit 435:2–8, 2011; 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, Appl Financ Econ 22:1043–1052, 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 34:36–42, 2011) and modern investment models created within this theory, the influence of the 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 changes the nature of the NPV dependence on leverage at some value t*: there is a transition from the diminishing function NPV(L), when t < t*, to the 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.

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 companies for 2010–2012 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.

It is shown for the first time that valuation of weighted average cost of capital (WACC) in the Modigliani–Miller theory (Мodigliani and Мiller, Am Econ Rev 48:261–297, 1958, Am Econ Rev 53:147–175, 1963, Am Econ Rev 56:333–391, 1966) is not minimal and valuation of the company capitalization is not maximal, as all financiers supposed up to now: 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 is shown that, from the point of view of cost of attracting capital, there are two types of dependences of WACC on the age of company n: monotonic descending of WACC with n and descending of WACC with passage through minimum, followed by a limited growth (Brusov et al., Modern corporate finance, investment and taxation, Springer International Publishing, Berlin, 2015a, J Rev Global Econ 4:21–42, 2015b). The companies with the latter type of dependence of WACC on the age of company n can take advantage of the benefits given at a certain stage of development by discovered effect. Moreover, since the “golden age” of company depends on the company’s capital costs, k _e and k _d, by controlling them (e.g., by modifying the value of dividend payments that reflect the equity cost, etc.), the company may extend its “golden age” when the cost to attract capital becomes minimal (less than perpetuity limit) and the capitalization of companies becomes maximal (above than perpetuity assessment) up to a specified time interval. It has been concluded that existing presentations concerning the results of the theory of Modigliani–Miller (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 these aspects are incorrect. We discuss the use of opened effects in economics.

A few years ago, we have discovered the effect of the “golden age” of the company (Brusov et al., Modern corporate finance, investments and taxation, monograph, 1st edn. Springer, Berlin, 2015a, J Rev Global Econ, 4: 21–42, 2015b): it was shown for the first time that valuation of the weighted average cost of capital, WACC, in the 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 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 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 et al., J Rev Global Econ 7:88–103, 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 and Filatova, Finance Credit 435: 2–8, 2011; 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 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, Modern corporate finance, investments and taxation, monograph, 1st edn, Springer, Berlin, 2015a, J Rev Global Econ, 4: 21–42, 2015b, J Rev Global Econ 7:104–122, 2018a, J Rev Global Econ 7:88–103, 2018b, J Rev Global Econ 7:63–87, 2018c, J Rev Global Econ 7:37–62, 2018d; Filatova et al., Bull FU 48: 68–77, 2008).

We have shown that existence of the “golden age” of the company does not depend on the value of capital costs of the company, but depends on the difference between equity k ₀ and debt k _d costs. The “golden age” of company exists at small enough difference between k ₀ and k _d costs, while at high value of this difference, the “golden age” of the 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.

It is found that NPV depends practically linearly on leverage level L, increasing or decreasing depending on profitability coefficient β and credit rate values k _d. The cutoff credit rate values k _d*, 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 allow commercial banks to keep their credit rates below the cutoff credit rate k _d* values in order to create and maintain a favorable investment climate in the country.

The Chaps. 21, 22, and 23 suggest a new approach to rating methodology. Chapters 21 and 22 are devoted to rating of nonfinancial issuers, while Chap. 23 is devoted to long-term project rating. The key factors of a new approach are (1) the adequate use of discounting financial flows virtually not used in existing rating methodologies and (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 International Publishing, Berlin, 2015) (in Chap. 21 into its perpetuity limit). This on the one hand allows use of the powerful tools of this theory in the rating, and on the other hand, it ensures the correct discount rates when discounting 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 and (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 chapter, 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.

The chapter continues to create a new approach to rating methodology: in addition to two previous chapters, which have considered the creditworthiness of the non-finance issuers (Brusov et al., J Rev Global Econ 7:63–87, 2018c; J Rev Global Econ 7:37–62, 2018d), we develop here a new approach to project rating. We work within investment models created by the authors. One of them describes the effectiveness of investment project from the perspective of equity capital owners, while the other model describes the effectiveness of investment project from the 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 financial flows virtually not used in existing rating methodologies and (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 k ₀, at different values of credit rates k _d, as well as at different values of leverage level L, we come to a very important conclusion that NPV in units of NOI (\( \frac{\mathrm{NPV}}{\mathrm{NOI}} \)) [as well as NPV in units of D (\( \frac{\mathrm{NPV}}{D} \))] depends only on equity cost k ₀, on credit rates k _d, on leverage level L, as well as on one of the leverage ratios l _j (on one of the coverage ratios i _j) 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) (\( \frac{\mathrm{NPV}}{\mathrm{NOI}} \)) on leverage ratios l _j [as well as on the dependence of NPV (in units of D) (\( \frac{\mathrm{NPV}}{D} \)) on coverage ratios i _j] at different equity costs k ₀, at different credit rates k _d, and at different leverage levels L carry the universal character: these dependencies remain valid for investment projects with any equity value S, debt value D, and NOI.

This chapter is devoted to description of 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) (Brusov et al., J Rev Global Econ 7:104–122, 2018a). 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.