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

Abstract

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.