TITLE:
Application of Brusov-Filatova-Orekhova Theory (BFO Theory) and Modigliani-Miller Theory (MM Theory) in Rating
AUTHORS:
P. N. Brusov, T. V. Filatova, N. P. Orekhova, V. L. Kulik
KEYWORDS:
Brusov-Filatova-Orekhova Theory, Modigliani-Miller Theory, Rating, Rating Methodology, Coverage Ratios, Leverage Ratios, Discounting of Financial Flows, Discount Rate
JOURNAL NAME:
Theoretical Economics Letters,
Vol.8 No.5,
April
9,
2018
ABSTRACT: The paper is devoted to application of Brusov-Filatova-Orekhova
theory (BFO theory) and Modigliani-Miller theory (MM theory) in rating. A
serious modification of both theories in order to use them in rating procedure
has been required. The financial “ratios” (main rating parameters) were
introduced into both these theories. 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. The use of BFO
theory allows applying obtained results for real economics, for companies with
finite lifetime, introduce a factor of time into theory, estimate the
creditworthiness of companies of arbitrary lifetime (or arbitrary age),
introduce the financial flows discounting, using the correct discount rate etc.
Obtained results made possible to use the power of these theories in the rating
and create a new base for rating methodologies, by other words this allows
develop a new approach to methodology of rating, requiring a serious
modification of existing rating methodologies. The article is organized as
follows: In Section 2, we modify for the first time the Modigliani-Miller
theory (perpetuity limit of BFO theory) for rating needs and introduce the
financial “ratios” (a direct and inverse) into this theory. As well we analyze
here the dependence of company’s weighted average cost of capital (WACC) on the
coverage ratios and on the leverage ones. In Section 3, we discuss the method
of evaluation of the discount rate with using one or a few financial “ratios”. In
Section 4, the conclusions concerning the application of perpetuity limit of
the modern theory of capital structure—BFO theory (MM theory) in rating have
been done. In Section 5, we modify for the first time the general version of
BFO theory (for companies of arbitrary age) for rating needs and introduce the
financial “ratios” (a direct and inverse) into this theory. Here we as well
analyze the dependence of company’s weighted average cost of capital (WACC) on
the coverage ratios and on the leverage ones. We make calculations for two
company ages (three and five years) in order to demonstrate that developed
approach could be applied for companies of arbitrary age and to have a possibility
to compare results for companies of different ages. Section 6 is devoted to
conclusions made by the analysis of obtained results. Application of developed
methods to rating is discussed here as well as completely new horizons which
are opening in the rating industry via this investigation.