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

Abstract

During a couple years we have suggested a new approach to rating methodology of non-financial issuers, as well for project rating. 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) 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: for the case of advance payments of tax on profit, which is widely used in practice. Modigliani -Miller theory accounts these tax payments as annuity-immediate, while in practice these payments are making in advance and thus should be accounting 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 current paper 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 has been required. The financial "ratios" were incorporated into MMM theory. 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 possible to use the power of this theory in the rating and create a new base for rating methodologies.

Capital Structure Theory: Past, Present, Future

“…The fourth stage (2008)(2009)(2010)(2011)(2012)(2013)(2014)(2015)(2016)(2017)(2018)(2019) is the appearance of the Brusov-Filatova-Orekhova (BFO) theory, which removed the main restriction of the Modigliani-Miller (MM) theory associated with the infinite lifetime of a company [16][17][18][19][20][21][22][23]. Additionally, finally, the fifth stage (2019 up to now), which began a couple years ago and is associated with the adaptation of the two main theories of the capital structure (Brusov-Filatova-Orekhova and Modigliani-Miller) to the established financial practice of the company's functioning by taking into account the real conditions of their work [105][106][107][108][109][110][111][112][113][114].…”

“…Brusov et al, [105][106][107][108][109][110][111][112][113][114] discuss another limitation of the Modigliani-Miller theory: the method of paying income tax. The Modigliani-Miller theory accounts for these payments as immediate annuities, while in practice these payments are often made in advance and therefore must be accounted for annuities due.…”

“…For rating needs A new approach to rating methodology (for non-financial issuers and for long-term project rating), within both BFO and MM theories has been developed be Brusov et al [17,106]. 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 these theories.…”

Recent Development of Modigliani-Miller Theory

“…Despite the obvious shortcomings of the Modigliani-Miller theory, it is still widely used in the West. Over the past couple of years, we have generalized the Modigliani-Miller theory, taking into account some practical conditions for the functioning of companies: advance payments of income tax; frequent income tax payments; variable profit of the company, etc [5][6][7][8][9]. All this expands the applicability of the Modigliani-Miller theory in real economic practice.…”

“…It has been discovered the qualitatively new effect in corporate finance: at rate g < g* the slope of the curve ke(L) turns out to be negative that could alters the principles of the company's dividend policy significantly. The generalized theory of Modigliani-Miller, taking into account some practical conditions for the functioning of companies: advance payments on income tax [5]; frequent income tax payments [9]; variable profit of the company [9], were applied by us in corporate finance, in investments, in the ratings of non-financial issuers [6] and project ratings and give qualitatively new results.…”