Application of Brusov-Filatova-Orekhova Theory (BFO Theory) and Modigliani-Miller Theory (MM Theory) in Rating

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.