Ratings

One of the three main theories which consists of the basis for conducting modification of existing rating methodologies is the theory of Nobel Prize winners Modigliani and Miller (Am Econ Rev 48:261–297, 1958). In this chapter, we describe in short the main results of this theory, the understanding of which is absolutely necessary for the modification of existing rating methodologies.

The Modigliani–Miller theory, discussed in Chap. 3, has a lot of limitations. One of the most important and serious assumptions of the Modigliani–Miller theory is that all financial flows as well as all companies are perpetuity. This limitation was removed by Brusov–Filatova–Orekhova in 2008 (Filatova et al., Bull FU 48:68–77, 2008), who have created BFO theory—the 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 in the West.

In this chapter, we discuss one more limitation of Modigliani–Miller theory: a method of tax on profit payments. Modigliani–Miller theory considers these payments as annuity-immediate while in practice these payments are made in advance and thus should be considered as annuity-due. We generalize the Modigliani–Miller theory for the case of advance tax on profit payments, which is widely used in practice, and show that this leads to some important consequences, which change seriously all the main statements by Modigliani and Miller (Brusov et al., J Rev Global Econ 9:257–268, 2020). The modified Modigliani–Miller theory (MMM theory) is the second of the three main theories which consists of the basis for conducting the modification of existing rating methodologies. In this chapter, we describe in short the main results of MMM theory.

The main theory which consists of the basis for conducting modification of existing rating methodologies is the modern theory of capital cost and capital structure by Brusov–Filatova–Orekhova (BFO theory). In this chapter, we describe the main results of this theory, the understanding of which is absolutely necessary for modification of existing rating methodologies.

Chapters 6–8 and 9–11 suggest a new approach to rating methodology. Chapters 6–8 are devoted to rating of non-financial issuers, while Chaps. 9–11 are devoted to long-term project rating and rating of arbitrary duration projects. The key factors of a new approach are (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 modern theory of capital structure (Brusov–Filatova–Orekhova (BFO) theory) (in Chap. 6 into its perpetuity limit - Modigliani and Miller theory). This on the one hand allows us to use 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 also discuss 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 us to issue more correct ratings of issuers and makes the rating methodologies more understandable and transparent.

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, into two ways: we apply it for rating methodologies 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 this chapter, we use the modified Modigliani–Miller theory (MMM theory) and apply it for rating methodologies 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. During the last couple of years, we have suggested a new approach to rating methodology of non-financial issuers, as well for project rating (for long-term projects as well as for projects of arbitrary duration) (Brusov et al. 2018, Ratings of the investment projects of arbitrary durations: new methodology. J Rev Global Econ 8:437–448, 2019, Modification of the Modigliani–Miller theory for the case of advance payments of tax on profit. J Rev Global Econ 9:257–268, 2020). The key factors of a new approach are: (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 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 payments: for the case of advance payments of tax on profit, which is widely used in practice. Modigliani–Miller theory considers these tax payments as annuity-immediate, while in practice these payments are made in advance and thus should be considered 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 this chapter, 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 is required. The financial “ratios” (main rating parameters) were introduced into MMM theory. The necessity of an appropriate use of financial flows discounting in rating methodologies is discussed. 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 it possible to use the power of this theory in the rating and create a new basis for rating methodologies; in other words, this allows us to develop a new approach to methodology of rating, requiring a serious modification of existing rating methodologies.

In Chaps. 6 and 7, a new approach to rating methodology has been suggested. The key factors of the 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 this chapter, further development of the 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 the BFO theory in order to use it in rating procedure is required. It allows us 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 us to use the powerful tools of the BFO theory in the rating. All these create a new base for rating methodologies.

In this and the next chapter, we describe the modern investment models, created by the authors and well tested in the real economy. These models are used by us for investigating different problems of investments, such as influence of debt financing, leverage level, taxing, project duration, method of financing, and some other parameters on the efficiency of investments and other problems. But we use them in Chaps. 11–13 for modification of methodology of project ratings. In this chapter, we consider the investment models with debt repayment at the end of the project and their application, while in Chap. 10 we consider the investment models with uniform debt repayment and their application.

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 as well as on perpetuity limit (Modigliani and Miller, Am Econ Rev 48:261–297, 1958; Am Econ Rev 53:147–175, 1963; Am Econ Rev 56:333–391, 1966).

In Chap. 13, we consider the application of the investment models with uniform debt repayment to rating methodology.

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., Rating: new approach. J Rev Glob Econ 7:37–62. SCOPUS. https://​doi.​org/​10.​6000/​1929-7092.​2018.​07.​05, 2018c; A “golden age” of the companies: conditions of its existence. J Rev Glob Econ 7:88–103. SCOPUS. https://​doi.​org/​10.​6000/​1929-7092.​2018.​07.​07, 2018d), 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 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 of 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 k₀, 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 (NPV/NOI) (as well as NPV in units of D (NPV/D)) depends only on equity cost k₀, 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) (NPV/NOI) on leverage ratios l_j(as well as on the dependence of NPV (in units of D) (NPV/D) on coverage ratios i_j) at different equity costs k₀, 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.

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” and “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. In our previous chapters, the new approach to the ratings of the long-term investment projects has been developed (Filatova et al., Ratings of the long–term projects: new approach. J Rev Glob Econ 7:645–661, SCOPUS. https://​doi.​org/​10.​6000/​1929-7092.​2018.​07.​59, 2018). The important features of that consideration are the 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 and (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 the 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 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. New approach allows us 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 International Publishing, Switzerland, p 373. https://​www.​springer.​com/​gp/​book/​9783319147314, 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.

Along with the rating of non-financial issuers, considered in Chaps. 6, 7, and 8, 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, the investment model for which is described in Chap. 10. 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 existing project rating methodologies; (2) incorporation of financial ratios into modern investment models created by the authors; (3) use of rating parameters upon discounting; and (4) the determination of the correct discount rate, taking into account financial ratios. We use modern investment model created by the authors (see Chap. 10), 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. 3, 4, and 5.

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 gives the opportunity to switch from using primarily qualitative methods for assessing the effectiveness of investment projects to using mainly quantitative methods for evaluating them.

In Chaps. 14, 15, 16, 17, and 18, we describe new meaningful effects in the modern capital structure theory (BFO theory), which should be accounted in rating methodologies.

It has been shown for the first time that the average weighted cost of capital of a company, WACC, in the theory of Modigliani–Miller (MM) is not minimal, and the estimate of Modigliani–Miller’s capitalization of a company is not maximum, as all financiers have assumed: at some stage in the development of a company, the WACC turns out to be lower than Modigliani–Miller estimates, and company capitalization, V, turns out to be higher than V estimates in the Modigliani–Miller theory.

This and the following chapters conclude that the notions of the results of the Modigliani–Miller theory existing in these aspects turn out to be incorrect. The possibilities of using discovered effects in practice are discussed, in particular, when rating non-financial issuers.

In this chapter, we continue to study the effect of the “golden age” of the company, which we described in Chap. 14. As it was shown for the first time (Brusov et al., Modern corporate finance, investments and taxation. Springer International Publishing, Switzerland, 373 p. monograph. SCOPUS, 2015), the 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 assumed up to this discovery: at some age of the company, its WACC value turns out to be lower than in the Modigliani–Miller theory, and company capitalization V turns out to be greater than V in the 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 decrease with n and decrease 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 investigate which companies have the “golden age,” i.e., obey the latter type of dependence of WACC on n (Brusov, New meaningful effects in modern capital structure theory. J Rev Global Econ 7:104–122. SCOPUS, 2018b). With this aim we study the dependence of WACC on the age of company n at various leverage levels within the wide spectrum of capital cost 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, 2012a, b, 2013a, b, c, 2014a, b; Filatova et al., Weighted average cost of capital in the theory of Modigliani–Miller, modified for a finite life–time company. 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 k₀ and debt k_d costs. The “golden age” of the company exists at small enough difference between k₀ and k_d costs, while at high value of this difference the “golden age” of the company is absent: curve WACC(n) monotonically decreases 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 our paper (Brusov et al. 2015), we have also found a third type of WACC(n) dependence: decrease with passage through minimum, which lies below the perpetuity limit value, then going through maximum followed by a limited decrease. We called this effect “Kulik effect.” In this chapter, we have found a type of “Kulik effect”: decrease with passage through minimum of WACC, which lies above the perpetuity limit value, then going through maximum followed by a limited decrease. 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. Taking account of effects of the “golden (silver) age” could change the valuation of creditworthiness of issuers.

Note that, since the “golden age” of the company depends on the company’s capital costs, by controlling them (e.g., by modifying the value of dividend payments, which reflect the equity cost), company may extend the “golden age” of the company, when the cost to attract capital becomes 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 discovered effects in finance, in economics, and, in particular, in rating methodologies.

Inflation is one of the most important indicators taken into account when issuing issuer ratings. It affects the weighted average cost of capital WACC and the cost of equity k₀, which are used (should be used) as the discount rate for discounting financial flows in the ratings. Inflation also affects the dependence of discount rates (WACC and k₀) on the leverage level L. Adequate accounting of inflation will contribute to the issuance of correct issuer ratings.

Taking into account the company’s dividend policy is extremely important in rating when assessing the creditworthiness of issuers. Qualitatively new effect in corporative finance, which could radically change the approach to the formation of the company’s dividend policy, is discovered: decrease of equity cost k_e with leverage level L. This effect, which is absent in perpetuity Modigliani–Miller limit (Мodigliani and Мiller, Am Econ Rev 48:261–297, 1958, Am Econ Rev 53:147–175, 1963, Am Econ Rev 56:333–391, 1968), takes place on account of finite age of the company at tax on profit rate, which exceeds some value T^*(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).

Currently, rating agencies take into account the leverage level L only from the standpoint of assessing financial stability and the risk of bankruptcy. In fact, the leverage level L significantly affects the main financial indicators of the company: the cost of equity k_e and WACC—in other words, the cost of raising capital, which is used (should be used) for discounting of the financial flows in the ratings, as well as for the valuation of the company’s capitalization. Failure to take this influence into account when analyzing financial statements leads to incorrect conclusions and incorrect ratings. Simultaneous accounting of the leverage level L and income taxes may be important in rating: in the BFO theory a whole series of qualitative effects of their mutual influence are discovered.

The studies performed in this monograph provide a new basis for the rating methodology. Rating agencies, both international and national, should apply the developed approach when assessing the creditworthiness of issuers.

The proposed improvement of the rating methodology of existing rating systems will improve the accuracy of generated ratings and make them more objective. Using in rating methods the modern theory of corporate finance allows us to move in the rating industry from using mainly qualitative rating methods to using mainly quantitative methods, which opens up new horizons in ratings of issuers and in methods for determining their creditworthiness.

The proposed fundamentally new approach to the rating methodology includes an adequate application of discounting, which is practically not used in existing rating methodologies when discounting the financial flows; the use of rating parameters upon discounting; and the correct determination of discount rates taking into account financial ratios.

In this chapter based on the results of this monograph, we give some recommendations to international rating agencies (Big Three (Standard & Poor’s, Fitch, and Moody’s), European, and national ones (ACRA, Chinese, etc.)).

In this monograph, new modern methodologies for rating of non-financial issuers and project ratings have been developed, based on the application in ratings of the modern theory of cost and capital structure (BFO theory—Brusov–Filatova–Orekhova theory) and its perpetuity limits (Modigliani–Miller theory (MM theory) and new modified Modigliani–Miller theory (MMM theory)), as well as modern investment models created by authors.

In order to modify and improve existing rating methodologies to increase the objectivity and accuracy of rating assessments, a critical analysis of the methodological and systemic shortcomings of the existing credit ratings of non-financial issuers and project rating has been carried out. The modern theory of capital cost and capital structure (BFO theory) for companies of arbitrary age and its two perpetuity limits (Modigliani–Miller theory and modified Modigliani–Miller theory) have been modified for rating needs. The incorporation of financial indicators used in the rating methodology, both into the BFO theory and into the Modigliani–Miller theory, has been carried out. Within the framework of the modified Brusov–Filatova–Orekhova theory (BFO theory) for rating needs, a complete and detailed study of the dependence of the weighted average cost of capital of WACC, used as the discount rate for discounting financial flows, on the financial ratios used in the rating, on the age of the company, on the leverage level, and on the level of taxation was conducted in a wide range of values of equity cost and debt cost for companies of arbitrary age. This allows us to carry out the correct assessment of the discount rate, taking into account the values of financial ratios.