Brusov, Filatova, Orekhova, Eskindarov - Modern Corporate Finance, Investments, Taxation and Rating 2018

Peter Brusov · Tatiana Filatova
Natali Orekhova · Mukhadin Eskindarov
Modern Corporate
Finance, Investments,
Taxation and Ratings
Second Edition
Modern Corporate Finance, Investments, Taxation
and Ratings
Peter Brusov • Tatiana Filatova •
Natali Orekhova • Mukhadin Eskindarov
Modern Corporate Finance,

Investments, Taxation and
Ratings
Second Edition
Peter Brusov Tatiana Filatova
Financial University under Financial University under
the Government of Russian Federation the Government of Russian Federation
Moscow, Russia Moscow, Russia
Natali Orekhova Mukhadin Eskindarov

Center of Corporate Finance, Investment, Financial University under
Taxation and Ratings the Government of Russian Federation
The Research Consortium of Universities Moscow, Russia
of the South of Russia
Rostov-on-Don, Russia
ISBN 978-3-319-99685-1 ISBN 978-3-319-99686-8 (eBook)

https://doi.org/10.1007/978-3-319-99686-8
Library of Congress Control Number: 2018955714
© Springer Nature Switzerland AG 2015, 2018

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100th Anniversary of the Financial University
under the Government of Russia Federation
Dedicated to our dear granddaughter Anyuta,

who likes very much to sing and dance,
and to her little sister Sofi
Preface to the Second Edition
In the 3 years since the first edition, new results have been obtained by authors in
corporate finance, investment, and taxation as well as in a new area—ratings and
rating methodologies—within the framework of Brusov, Filatova, and Orekhova
(BFO) theory. Some of them (not all) have been included in the second edition
(Chaps. 19, 20, 21, 22, 23, and 24 have been added).
Among them is the chapter entitled “A golden age of the companies: conditions
of its existence” (Chap. 19). Also, we have found a modification of “Kulik effect”:
descending of WACC with passage through minimum, which lies above the perpe-
tuity limit value, and then going through maximum followed by a limited
descending. We call this company age, where WACC has a minimum, which lies
above the perpetuity limit value, “by a silver age” of the company.
In Chap. 20, we study the role of the Central Bank and commercial banks in
creating and maintaining a favorable investment climate in the country. Within the
framework of modern investment models created by the authors, the dependence of
the efficiency of investments, determined by net present value (NPV), on the level of
debt financing within a wide range of values of equity costs and debt capital costs
under different project terms (long-term projects as well as projects of arbitrary
duration) and different investment profitability coefficients β is investigated. The
study is conducted within the framework of investment models with debt repayment
at the end of the project term. It is found that NPV depends practically linearly on
leverage level L, increasing or decreasing depending on profitability coefficient β
and credit rate values kd. The cutoff credit rate values k∗ d , separating the range of
increasing NPV(L ) from the range of decreasing NPV(L), are determined. The
Central Bank should keep its key rate at the level which allows commercial banks
to keep their credit rates below the cutoff credit rate k ∗
d values in order to create and
maintain a favorable investment climate in the country.
The most significant addition to the second edition is Part IV, devoted to the
discussion of ratings and rating methodologies. The shortcomings of existing rating
methodologies are discussed and analyzed, and a new approach to rating methodol-
ogy has been suggested in Chaps. 21, 22, and 23: Chaps. 21 and 22 are devoted to
vii
viii Preface to the Second Edition
rating of non-financial issuers, while Chap. 23 is devoted to long-term project rating.

The key factors of the 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. 21 into its
perpetuity limit). 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 of financial flows. We discuss also the interplay between rating ratios
and leverage level, which can be quite important in rating. All these create a new
base for rating methodologies.1
The new approach to ratings and rating methodologies allows issue more correct
ratings of issuers, making the rating methodologies more understandable and
transparent.
We call the modified form of BFO theory for rating needs BFO-3 theory. Thus, in
the monograph we describe three modifications of BFO theory:
BFO-1, which is applicable to describe the companies of arbitrary age;
BFO-2, which is applicable to describe companies of arbitrary lifetime when com-
pany ceased to exist at the arbitrary time moment n;
BFO-3, which is applicable for rating needs.
This book is intended for both undergraduate and postgraduate students, students
of MBA program, teachers of economic and financial universities, scientists, finan-
cial analysts, financial directors of company, managers of insurance companies and
rating agencies, officials of regional and federal ministries and departments, and
ministers responsible for economic and financial management.
Kronburg, Moscow, Russia Peter Brusov

23 June 2018
1
The study in Chaps. 21, 22, and 23 was funded by RFBR according to the research project №17-
06-00251A.
Preface
This book describes in detail the modern theory of corporate finance, investment,
and taxation, created by Brusov, Filatova, and Orekhova (BFO theory), which has
replaced the famous theory of capital cost and capital structure by Nobel laureates
Modigliani and Miller. The authors have moved from the assumption of Modigliani–
Miller concerning the perpetuity (infinite time of life) of companies and further
elaborated quantitative theory of valuation of key parameters of financial activities of
companies with arbitrary time of life (of arbitrary age).
Results of modern BFO theory turn out to be quite different from those of
Modigliani–Miller theory. They show that the latter, via its perpetuity, underesti-
mates the assessment of weighted average cost of capital, WACC, and the equity
cost of the company and substantially overestimates the assessment of the capital-
ization of the company.
Such an incorrect assessment of key performance indicators of financial activities
of companies has led to an underestimation of risks involved, and impossibility, or
serious difficulties in adequate managerial decision-making, which was one of the
implicit reasons of global financial crisis in 2008.
Within new modern theory of capital cost and capital structure (BFO theory), a lot
of qualitatively new results have been obtained, among them:
1. The qualitatively new effect in corporate finance, discovered by authors: abnor-
mal dependence of equity cost on leverage, which alters the main principles of the
company’s dividend policy significantly.
2. Bankruptcy of the famous trade-off theory has been proven.
3. A very important discovery has been done recently: the valuation of WACC in
the Modigliani–Miller theory (perpetuity limit) is not minimal and valuation of
the company capitalization is not maximal, as all financiers supposed up to now:
at some age of the company (“golden age”) its WACC value turns out to be lower
than in perpetuity limit and company capitalization V turns out to be greater than
perpetuity limit of V.
ix
x Preface
4. Mechanism of formation of the company optimal capital structure, different from

the one suggested by trade-off theory, has been suggested.
5. The inflation in both Modigliani–Miller as well as in Brusov–Filatova–Orekhova
theories has been taken into account in explicit form, which has a nontrivial
impact on the dependence of equity cost on leverage.
6. Study of the role of taxes and leverage has been done, which allows the Regulator
to set up the tax on profits rate and allows businessmen to choose the optimal
level of debt financing.
7. Investigation of the influence of tax on profit rate on the effectiveness of invest-
ment projects at different debt levels has showed that increase of tax on profit rate
from one side leads to decrease of project NPV, but from other side it leads to
decrease of sensitivity of NPV with respect to leverage level. At high leverage
level L, the influence of tax on profit rate change on effectiveness of investment
projects becomes significantly less.
8. Studying the influence of growth of tax on profit rate on the efficiency of the
investment as well has led to two qualitatively new effects in investments:
– the growth of tax on profit rate changes the nature of the NPV dependence on
leverage L: at some value t*, there is a transition from diminishing function
NPV(L ) at t < t*, to growing function NPV(L ) at t > t*.
– at high leverage levels, the growth of tax on profit rate leads to the growth of
the efficiency of the investments.
Discovered effects in investments can be applied in a real economic practice for
optimizing of the management of investments.
Established BFO theory allows us conduct a valid assessment of the core param-
eters of financial activities of companies, such as weighted average cost of capital,
equity capital cost of the company, and company’s capitalization. It allows the
management of a company to make adequate decisions, which improves the effec-
tiveness of the company management. More generally, the introduction of the new
system of evaluation of the core parameters of financial activities of companies into
the systems of financial reporting (IFRS, GAAP, etc.) would lead to a lower risk of
global financial crisis.
The second part of this book is devoted to the assessment of effectiveness of
investment projects created by the authors within the modern investment models.
The determination of the optimal leverage level for investments is studied in this
book from two points of view: from the point of view of owners of equity capital, as
well as from the point of view of owners of both equity and debt capital.
Corporate management in the modern world is the management of financial
flows. The proposed Brusov–Filatova–Orekhova theory allows to correctly identify
discount rates—basic parameters for discounting of financial flows to arbitrary time
moment, compare financial flows with a view to adopt literate managerial decisions.
The discount rate is a key link to the existing financial system, on which the modern
finance can be adequately built, and this proposed book can be of substantial
assistance.
Preface xi
This book is intended for students, postgraduate students, teachers of economic

and financial institutions, students of MBA program, scientists, financial analysts,
financial directors of company, managers of insurance companies and rating agen-
cies, officials of regional and federal ministries and departments, and ministers
responsible for economic and financial management.
Moscow, Russia Peter Brusov

4 February 2014
Contents
Part I Corporate Finance

1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2 Capital Structure: Modigliani–Miller Theory . . . . . . . . . . . . . . . . . 9
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.2 The Traditional Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2.3 Modigliani–Miller Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.3.1 Modigliani–Miller Theory Without Taxes . . . . . . . . . . 11
2.3.2 Modigliani–Miller Theory with Taxes . . . . . . . . . . . . . 13
2.3.3 Main Assumptions of Modigliani–Miller Theory . . . . . 16
2.3.4 Modifications of Modigliani–Miller Theory . . . . . . . . . 17
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
3 Modern Theory of Capital Cost and Capital Structure:
Brusov–Filatova–Orekhova Theory (BFO Theory) . . . . . . . . . . . . . 29
3.1 Companies of Arbitrary Age and Companies with Arbitrary
Lifetime: Brusov–Filatova–Orekhova Equation . . . . . . . . . . . . . . 30
3.2 Comparison of Modigliani–Miller Results (Perpetuity Company)
with Myers Results (1-Year Company) and Brusov–Filatova–
Orekhova Ones (Company of Arbitrary Age) . . . . . . . . . . . . . . . 32
3.3 Brusov–Filatova–Orekhova Theorem . . . . . . . . . . . . . . . . . . . . . 36
3.4 From Modigliani–Miller to General Theory of Capital Cost
and Capital Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
3.5 BFO Theory in the Case, When the Company Ceased to Exist
at the Time Moment n (BFO-2 Theory) . . . . . . . . . . . . . . . . . . . 43
3.5.1 Application of Formula BFO-2 . . . . . . . . . . . . . . . . . . 44
3.5.2 Comparison of Results Obtained from Formulas BFO
and BFO-2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
xiii
xiv Contents
3.6 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
4 Bankruptcy of the Famous Trade-Off Theory . . . . . . . . . . . . . . . . . 51
4.1 Optimal Capital Structure of the Company . . . . . . . . . . . . . . . . . 51
4.2 Absence of the Optimal Capital Structure in Modified
Modigliani–Miller Theory (MMM Theory) . . . . . . . . . . . . . . . . . 54
4.3 Analysis of the Trade-Off Theory Within the Brusov–Filatova–
Orekhova Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
4.4 The Causes of Absence of the Optimum Capital Structure
in the Trade-Off Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
4.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
5 New Mechanism of Formation of the Company’s Optimal Capital
Structure, Different from Suggested by Trade-Off Theory . . . . . . . 99
5.1 Absence of Suggested Mechanism of Formation
of the Company’s Optimal Capital Structure Within Modified
Modigliani–Miller Theory (MMM Theory) . . . . . . . . . . . . . . . . . 99
5.2 Formation of the Company’s Optimal Capital Structure Within
Brusov–Filatova–Orekhova (BFO) Theory . . . . . . . . . . . . . . . . . 100
5.3 Simple Model of Proposed Mechanism . . . . . . . . . . . . . . . . . . . 113
5.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
6 The Global Causes of the Global Financial Crisis . . . . . . . . . . . . . . 119
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
7 The Role of Taxing and Leverage in Evaluation of Capital Cost and
Capitalization of the Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
7.1 The Role of Taxes in Modigliani–Miller Theory . . . . . . . . . . . . . 126
7.2 The Role of Taxes in Brusov–Filatova–Orekhova Theory . . . . . . 129
7.2.1 Weighted Average Cost of Capital (WACC)
of the Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
7.2.2 Equity Cost ke of the Company . . . . . . . . . . . . . . . . . . 132
7.2.3 Dependence of WACC and ke on the Age of
Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
7.3 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
8 A Qualitatively New Effect in Corporate Finance: Abnormal
Dependence of Equity Cost of Company on Leverage . . . . . . . . . . . 141
8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
8.2 Equity Cost in the Modigliani–Miller Theory . . . . . . . . . . . . . . . 141
8.3 Equity Cost Capital Within Brusov–Filatova–Orekhova
Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
8.3.1 Dependence of Equity Cost ke on Tax on Profit Rate
T at Different Fixed Leverage Level L . . . . . . . . . . . . . 146
Contents xv
8.3.2 Dependence of Equity Cost ke on Leverage Level

L (the Share of Debt Capital wd) at Different Fixed Tax
on Profit Rate T . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
8.4 Dependence of the Critical Value of Tax on Profit Rate T *
on Parameters n, k0, and kd of the Company . . . . . . . . . . . . . . . . 150
8.5 Practical Value of Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
8.6 Equity Cost of a 1-Year Company . . . . . . . . . . . . . . . . . . . . . . . 154
8.7 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
9 Inflation in Brusov–Filatova–Orekhova Theory and in Its
Perpetuity Limit Modigliani–Miller Theory . . . . . . . . . . . . . . . . . . 161
9.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161
9.2 Accounting of Inflation in the Modigliani–Miller Theory
Without Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
9.3 Accounting of Inflation in Modigliani–Miller Theory
with Corporate Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
9.4 Accounting of Inflation in Brusov–Filatova–Orekhova Theory
with Corporate Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
9.4.1 Generalized Brusov–Filatova–Orekhova Theorem . . . . 168
9.5 Generalized Brusov–Filatova–Orekhova Formula Under
Existence of Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
9.6 Irregular Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
9.7 Inflation Rate for a Few Periods . . . . . . . . . . . . . . . . . . . . . . . . . 177
9.8 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
Part II Investments
10 A Portfolio of Two Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
10.1 A Portfolio of Two Securities . . . . . . . . . . . . . . . . . . . . . . . . . 183
10.1.1 A Case of Complete Correlation . . . . . . . . . . . . . . . . 183
10.1.2 Case of Complete Anticorrelation . . . . . . . . . . . . . . . 185
10.1.3 Independent Securities . . . . . . . . . . . . . . . . . . . . . . . 186
10.1.4 Three Independent Securities . . . . . . . . . . . . . . . . . . . 188
10.2 Risk-Free Security . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191
10.3 Portfolio of a Given Yield (or Given Risk) . . . . . . . . . . . . . . . . 193
10.3.1 Case of Complete Correlation (ρ12 ¼ 1)
and Complete Anticorrelation (ρ12 ¼ 1) . . . . . . . . . 194
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
11 Investment Models with Debt Repayment at the End of the Project
and Their Application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
11.1 Investment Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
11.2 The Effectiveness of the Investment Project
from the Perspective of the Equity Holders Only . . . . . . . . . . . . 198
11.2.1 With the Division of Credit and Investment Flows . . . 198
xvi Contents
11.3 Without Flows Separation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

11.4 Modigliani–Miller Limit (Perpetuity Projects) . . . . . . . . . . . . . . 201
11.4.1 With Flows Separation . . . . . . . . . . . . . . . . . . . . . . . 201
11.4.2 Without Flows Separation . . . . . . . . . . . . . . . . . . . . . 202
from the Perspective of the Owners of Equity and Debt . . . . . . . 203
11.6 Modigliani–Miller Limit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207
12 Influence of Debt Financing on the Efficiency of Investment
Projects: The Analysis of Efficiency of Investment Projects
Within the Perpetuity (Modigliani–Miller) Approximation . . . . . . . 209
from the Perspective of the Equity and Debt Owners . . . . . . . . . 225
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241
13 The Analysis of the Exploration of Efficiency of Investment
Projects of Arbitrary Duration (Within Brusov–Filatova–
Orekhova Theory) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
13.1.2 Without Flow Separation . . . . . . . . . . . . . . . . . . . . . 250
13.2.2 Without Flow Separation . . . . . . . . . . . . . . . . . . . . . 266
13.3 The Elaboration of Recommendations on the Capital Structure
of Investment of Enterprises, Companies, Taking into Account
All the Key Financial Parameters of Investment Project . . . . . . . 273
13.3.1 General Conclusions and Recommendations on the
Definition of Capital Structure of Investment of
Enterprises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
Contents xvii
14 Investment Models with Uniform Debt Repayment and Their

Application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
14.1 Investment Models with Uniform Debt Repayment . . . . . . . . . . 277
14.4 Example of the Application of the Derived Formulas . . . . . . . . . 282
14.5 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284
Part III Taxation

15 Is It Possible to Increase Taxing and Conserve a Good Investment
Climate in the Country? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
15.1 Influence of Tax on Profit Rates on the Efficiency
of the Investment Projects . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
15.3 Borrowings Abroad . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
15.4 Dependence of NPV on Tax on Profit Rate at Different
Leverage Levels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
15.5 At a Constant Value of Equity Capital (S ¼ Const) . . . . . . . . . . 294
15.6 Without Flow Separation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
15.6.1 At a Constant Value of the Total Invested Capital
(I ¼ Const) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
15.6.2 At a Constant Value of Equity Capital (S ¼ Const) . . . . 298
15.7 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
16 Is It Possible to Increase the Investment Efficiency by Increasing
Tax on Profit Rate? An Abnormal Influence of the Growth of Tax
on Profit Rate on the Efficiency of the Investment . . . . . . . . . . . . . . 303
16.1 Dependence of NPV on Leverage Level L at Fixed Levels
of Tax on Profit Rate t . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303
16.1.1 The Effectiveness of the Investment Project
from the Perspective of the Equity Holders Only . . . . 303
from the Perspective of the Equity and Debt
Holders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314
xviii Contents
16.2 Dependence of NPV on Tax on Profit Rate at Fixed Leverage

Levels L . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
from the Perspective of the Equity Holders Only . . . . 321
from the Perspective of the Equity and Debt
Holders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
17 Optimizing the Investment Structure of the Telecommunication
Sector Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
17.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
17.2 Investment Analysis and Recommendations for
Telecommunication Company “Nastcom Plus” . . . . . . . . . . . . . 338
17.2.1 The Dependence of NPV on Investment Capital
Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339
17.2.2 The Dependence of NPV on the Equity Capital
Value and Coefficient β . . . . . . . . . . . . . . . . . . . . . . 348
17.3 Effects of Taxation on the Optimal Capital Structure
of Companies in the Telecommunication Sector . . . . . . . . . . . . 354
17.4 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
18 The Golden Age of the Company (Three Colors
of Company’s Time) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
18.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 368
18.2 Dependence of WACC on the Age of the Company n
at Different Leverage Levels . . . . . . . . . . . . . . . . . . . . . . . . . . 371
at Different Values of Capital Costs (Equity, k0, and Debt, kd)
and Fixed Leverage Levels . . . . . . . . . . . . . . . . . . . . . . . . . . . 373
at Different Values of Debt Capital Cost, kd, and Fixed Equity
Cost, k0, and Fixed Leverage Levels . . . . . . . . . . . . . . . . . . . . . 375
at Different Values of Equity Cost, k0, and Fixed Debt
Capital Cost, kd, and Fixed Leverage Levels . . . . . . . . . . . . . . . 379
18.6 Dependence of WACC on the Age of the Company n at High
Values of Capital Cost (Equity, k0, and Debt, kd) and High
Lifetime of the Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
18.7 Further Investigation of Effect . . . . . . . . . . . . . . . . . . . . . . . . . 389
18.8 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 391
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393
Contents xix
19 A “Golden Age” of the Companies: Conditions of Its Existence . . . 395

19.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396
19.2 Companies Without the “Golden Age” (Large Difference
Between k0 and kd Costs) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397
19.2.1 Dependence of the Weighted Average Cost
of Capital, WACC, on the Company Age n
at Different Leverage Levels . . . . . . . . . . . . . . . . . . . 397
19.3 Companies with the “Golden Age” (Small Difference
Between k0 and kd Costs) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 399
19.4 Companies with Abnormal “Golden Age” (Intermediate
Difference Between k0 and kd Costs) . . . . . . . . . . . . . . . . . . . . 403
19.5 Comparing with Results from Previous Chapter . . . . . . . . . . . . 410
19.5.1 Under Change of the Debt Capital Cost, kd . . . . . . . . . 410
19.5.2 Under Change of the Equity Capital Cost, k0 . . . . . . . 411
19.6 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414
20 The Role of the Central Bank and Commercial Banks
in Creating and Maintaining a Favorable Investment Climate
in the Country . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 415
20.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 415
20.2 Investment Models with Debt Repayment at the End
of the Project . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 416
from the Perspective of the Equity Holders Only
(Without Flow Separation) . . . . . . . . . . . . . . . . . . . . 417
20.3 Modigliani–Miller Limit (Long-Term (Perpetuity) Projects) . . . . 419
20.3.1 The Dependence of the Efficiency of Investments
NPV on the Level of Debt Financing L for the Values
of Equity Costs k0 ¼ 0.2 . . . . . . . . . . . . . . . . . . . . . . 419
NPV on the Level of Debt Financing L for the Value
of Equity Costs k0 ¼ 0.28 . . . . . . . . . . . . . . . . . . . . . 422
20.4 Projects of Finite (Arbitrary) Duration . . . . . . . . . . . . . . . . . . . 424
of Equity Costs k0 ¼ 0.2 . . . . . . . . . . . . . . . . . . . . . . 424
of Equity Costs k0 ¼ 0.28 . . . . . . . . . . . . . . . . . . . . . 428
20.5 The Dependence of the Net Present Value, NPV,
on the Leverage Level l for Projects of Different Durations . . . . 430
20.6 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 435
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437
xx Contents
Part IV Ratings and Rating Methodologies

21 Rating: New Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 441
21.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 441
21.2 The Closeness of the Rating Agencies . . . . . . . . . . . . . . . . . . 442
21.3 The Use of Discounting in the Rating . . . . . . . . . . . . . . . . . . . 442
21.4 Incorporation of Parameters, Used in Ratings,
into Perpetuity Limit of Modern Theory of Capital Structure
by Brusov–Filatova–Orekhova . . . . . . . . . . . . . . . . . . . . . . . . 443
21.5 Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 443
21.5.1 One-Period Model . . . . . . . . . . . . . . . . . . . . . . . . . 444
21.5.2 Multi-period Model . . . . . . . . . . . . . . . . . . . . . . . . 444
21.6 Theory of Incorporation of Parameters, Used in Ratings,
into Perpetuity Limit of Modern Theory of Capital Structure
by Brusov–Filatova–Orekhova . . . . . . . . . . . . . . . . . . . . . . . . 445
21.6.1 Coverage Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . 445
21.6.2 More Detailed Consideration . . . . . . . . . . . . . . . . . . 448
21.6.3 Leverage Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . 450
21.7 Equity Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 453
21.8 How to Evaluate the Discount Rate? . . . . . . . . . . . . . . . . . . . . 464
21.8.1 Using One Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . 465
21.8.2 Using a Few Ratios . . . . . . . . . . . . . . . . . . . . . . . . . 465
21.9 Influence of Leverage Level . . . . . . . . . . . . . . . . . . . . . . . . . . 465
21.9.1 The Dependence of Equity Cost ke on Leverage
Level at Two Coverage Ratio Values ij ¼ 1
and ij ¼ 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 465
21.10 The Dependence of Equity Cost ke on Leverage Level
at Two Leverage Ratio Values lj ¼ 1 and lj ¼ 2 . . . . . . . . . . . 468
21.11 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 472
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473
22 Rating Methodology: New Look and New Horizons . . . . . . . . . . . . 475
22.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 475
22.2 The Analysis of Methodological and Systemic Deficiencies
in the Existing Credit Rating of Nonfinancial Issuers . . . . . . . . . 476
22.2.1 The Closeness of the Rating Agencies . . . . . . . . . . . . 476
22.2.2 Discounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 476
22.2.3 Dividend Policy of the Company . . . . . . . . . . . . . . . . 477
22.2.4 Leverage Level . . . . . . . . . . . . . . . . . . . . . . . . . . . . 478
22.2.5 Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 478
22.2.6 Account of the Industrial Specifics of the Issuer . . . . . 479
22.2.7 Neglect of Taking into Account the Particularities
of the Issuer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 479
22.2.8 Financial Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . 479
Contents xxi
22.3 Modification of the BFO Theory for Companies

and Corporations of Arbitrary Age for Purposes of Ranking . . . . 481
22.4 Coverage Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 482
22.4.1 Coverage Ratios of Debt . . . . . . . . . . . . . . . . . . . . . . 483
22.4.2 The Coverage Ratio on Interest on the Credit . . . . . . . 483
22.4.3 Coverage Ratios of Debt and Interest on the Credit
(New Ratios) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485
22.4.4 All Three Coverage Ratios Together . . . . . . . . . . . . . 487
22.5 Coverage Ratios (Different Capital Cost Values) . . . . . . . . . . . . 490
22.5.1 Coverage Ratios of Debt . . . . . . . . . . . . . . . . . . . . . . 490
22.5.2 The Coverage Ratio on Interest on the Credit . . . . . . . 492
(New Ratios) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 493
22.5.4 Analysis and Conclusions . . . . . . . . . . . . . . . . . . . . . 495
22.6 Leverage Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 496
22.6.1 Leverage Ratios for Debt . . . . . . . . . . . . . . . . . . . . . 496
22.6.2 Leverage Ratios for Interest on Credit . . . . . . . . . . . . 498
22.7 Leverage Ratios (Different Capital Costs) . . . . . . . . . . . . . . . . . 499
22.7.1 Leverage Ratios for Debt . . . . . . . . . . . . . . . . . . . . . 499
22.7.2 Leverage Ratios for Interests on Credit . . . . . . . . . . . 500
22.7.3 Leverage Ratios for Debt and Interests on Credit . . . . 500
22.7.4 Analysis and Conclusions . . . . . . . . . . . . . . . . . . . . . 500
22.8 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509
23 Ratings of Long-Term Projects: A New Approach . . . . . . . . . . . . . 511
from the Perspective of the Equity Holders Only
(Without Flows Separation) . . . . . . . . . . . . . . . . . . . . 512
23.1.2 Modigliani–Miller Limit [Long-Term (Perpetuity)
Projects] . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513
23.2 Incorporation of Financial Coefficients, Used in Project Rating,
into Modern Investment Models . . . . . . . . . . . . . . . . . . . . . . . . 514
23.2.1 Coverage Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514
23.2.2 Leverage Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516
23.3 Dependence of NPV on Coverage Ratios . . . . . . . . . . . . . . . . . 517
23.3.1 Coverage Ratio on Debt . . . . . . . . . . . . . . . . . . . . . . 517
23.4 Dependence of NPV on Leverage Ratios . . . . . . . . . . . . . . . . . 522
23.4.1 Leverage Ratio of Debt . . . . . . . . . . . . . . . . . . . . . . . 522
23.5 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535
xxii Contents
24 New Meaningful Effects in Modern Capital Structure Theory . . . . 537

24.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537
24.2 Comparison of Modigliani–Miller (MM)
and Brusov–Filatova–Orekhova (BFO) Results . . . . . . . . . . . . 539
24.2.1 The Traditional Approach . . . . . . . . . . . . . . . . . . . . 539
24.2.2 Modigliani–Miller Theory . . . . . . . . . . . . . . . . . . . . 540
24.3 Comparison of Modigliani–Miller Results (Perpetuity
Company) with Myers Results (1-Year Company)
and Brusov–Filatova–Orekhova Ones (Company
of Arbitrary Age) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 542
24.4 Bankruptcy of the Famous Trade-Off Theory . . . . . . . . . . . . . 544
24.5 The Qualitatively New Effect in Corporate Finance . . . . . . . . . 546
24.5.1 Perpetuity Modigliani–Miller Limit . . . . . . . . . . . . . 548
24.5.2 BFO Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 549
24.6 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550
24.7 Mechanism of Formation of the Company Optimal Capital
Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 551
24.8 “A Golden Age” of the Company . . . . . . . . . . . . . . . . . . . . . . 554
24.9 Inflation in Modigliani–Miller and BFO Theories . . . . . . . . . . 557
24.10 Effects, Connected with Tax Shields, Taxes, and Leverage . . . 560
24.11 Effects, Connected with the Influence of Tax on Profit Rate
on Effectiveness of Investment Projects . . . . . . . . . . . . . . . . . 561
24.12 Influence of Growth of Tax on Profit Rate . . . . . . . . . . . . . . . 561
24.13 New Approach to Ratings . . . . . . . . . . . . . . . . . . . . . . . . . . . 564
24.13.1 New Approach to Ratings: The Creditworthiness
of the Non-Finance Issuers . . . . . . . . . . . . . . . . . . . 564
24.13.2 New Approach to Long-Term Project Ratings . . . . . 566
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 567
25 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 569
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 570
About the Authors
Petr Nickitovich Brusov is professor at the Finan-

cial University under the Government of the Rus-
sian Federation (Moscow). Originally a physicist,
he was the cofounder of (together with Victor
Popov) the theory of collective properties of super-
fluids and superconductors. In the areas of finance
and economy, Peter Brusov has created a modern
theory of capital cost and capital structure, the
Brusov—Filatova—Orekhova theory, together
with Tatiana Filatova and Natali Orekhova. Peter
Brusov has been visiting Professor of Northwestern
University (USA), Cornell University (USA), and
Osaka City University (Japan), among other places.
He is the author of over 500 research publications,
including six monographs, numerous textbooks,
and articles.
Tatiana Filatova is professor at the Financial Uni-

versity under the Government of the Russian Fed-
eration (Moscow). In the last 20 years, she has been
a dean of the faculties of financial management,
management, and state and municipal government,
among others, at the Financial University. Tatiana
Filatova is the author of over 250 research publica-
tions, including five monographs, numerous text-
books, and articles.
xxiii
xxiv About the Authors
Natali Orekhova is professor of the Center of

Corporate Finance, Investment, Taxation and Rat-
ing at the Research Consortium of Universities of
the South of Russia. Natali Orekhova has been
leading scientist of the Financial University under
the Government of the Russian Federation. She is
the author of over 100 research publications,
including three monographs, numerous textbooks,
and articles.
Mukhadin Abdurakhmanovich Eskindarov is

professor, honored scholar of the Russian Federa-
tion, member of the Russian Academy of Education,
and rector of the Financial University under the
Government of the Russian Federation (Moscow).
Mukhadin A. Eskindarov has played crucial admin-
istrative, teaching, and researcher roles at the Finan-
cial University. He is the author of over 200 research
publications, including monographs, manuals, and
articles on issues related to labor and production
efficiency, financial and industrial groups, economic
development of the third-world countries, and mod-
ernization of the educational system. As a member of
various state and public administration bodies,
Mukhadin A. Eskindarov has been honored with
highly recognized state and public awards, including
the IV Class Order for Merit to the Fatherland, Order
of Friendship, Petr Stolypin II Class Medal, badge of
the Honored Worker of the Higher Education Sys-
tem of the Russian Federation, and Patriot of Russia
Medal, among others.
Part I
Corporate Finance
Chapter 1
Introduction
One of the main problems in corporate finance is the problem of cost of capital and
the impact of capital structure on its cost and capitalization of the companies. To
date, even the question of the existence of an optimal capital structure of the
companies (at which the company capitalization is maximal, and weighted average
cost of capital is minimal) is open. Numerous theories and models, including the first
and the only one until recently quantitative theory by Nobel Laureates Modigliani
and Miller (MM) (Modigliani and Miller 1958, 1963, 1966), not only do not solve
the problem but also because of the large number of restrictions (such as, e.g., theory
of MM) have a weak relationship with the real economy. Herewith the qualitative
theories and models, based on the empirical approach, do not allow to carry out the
necessary assessment.
In the monograph, the foundation of modern corporate finance, investment,
taxation, and ratings is laid. It is based on the author’s work on modifying theory
of capital cost and capital structure by Nobel Prize winners Modigliani and Miller,
which led to the actual replacement of this theory by the modern theory by Brusov–
Filatova–Orekhova (BFO theory) (Brusov and Filatova 2011; Brusov et al. 2011a,
b, c, 2012a, b, 2013a, b, 2014a, b, 2015, 2018a, b, c, d; Filatova et al. 2008, Brusova
2011). The authors have moved from the assumption of Modigliani–Miller
concerning the perpetuity of companies (infinite time of life of companies) and
further elaborated quantitative theory of valuation of core parameters of financial
activities of companies of arbitrary age or arbitrary time of life.
Results of modern BFO theory (Brusov and Filatova 2011; Brusov et al. 2011a, b, c,
2012a, b, 2013a, b, 2014a, b, 2015, 2018a, b, c, d; Filatova et al. 2008; Brusova
2011) turn out to be quite different from that of Modigliani–Miller theory (Modi-
gliani and Miller 1958, 1963, 1966). They show that the latter, via its perpetuity,
underestimates (often significantly) the assessment of weighted average cost of
capital and the equity cost of the company and substantially overestimates (also
often significantly) the assessment of the capitalization of both financially indepen-
dent company and the company using the debt financing.
© Springer Nature Switzerland AG 2018 3

P. Brusov et al., Modern Corporate Finance, Investments, Taxation and Ratings,
https://doi.org/10.1007/978-3-319-99686-8_1
4 1 Introduction

serious difficulties in adequate managerial decision-making, which was one of the
implicit reasons of global financial crisis of the year 2008.
Within new theory of capital cost and capital structure (BFO theory), a study of
the role of taxes and leverage has been done, which allows the regulator to set the tax
on profit rate and businesses to choose the optimal level of debt financing. The
qualitatively new effect in corporate finance, discovered by authors, is described:
abnormal dependence of equity cost on leverage, which significantly alters the
principles of development of the company’s dividend policy (modern principles of
which are formulated in monograph). Authors take into account in explicit form the
inflation in both Modigliani–Miller as well as Brusov–Filatova–Orekhova theories,
with which they detected its nontrivial impact on the dependence of equity cost on
leverage.
The established BFO theory (Brusov and Filatova 2011; Brusov et al. 2011a, b, c,
2012a, b, 2013a, b, 2014a, b, 2015, 2018a, b, c, d; Filatova et al. 2008) allows
conduct a valid assessment of the core parameters of financial activities of compa-
nies, such as weighted average cost of capital and equity capital cost of the company,
its capitalization. It allows the management of a company make adequate decisions,
which improves the effectiveness of the company management. More generally, the
introduction of the new system of evaluation of the parameters of financial activities
of companies into the systems of financial reporting (IFRS, GAAP, etc.) would lead
to lower risk of global financial crisis, since, as is shown in the monograph, a primary
cause of the crisis of 2008 was a mortgage crisis in the USA, which is associated
with overvalued capitalization of mortgage companies by rating agencies, using
incorrect MM theory. This reason is now understood by the US Government, which
requires $1 billion from rating agency S&P for overvalued capitalization of mort-
gage companies.
Within Brusov–Filatova–Orekhova theory, the analysis of wide-known trade-off
theory has been made (Brusov et al. 2013a). It is shown that suggestion of risky debt
financing (and growing credit rate near the bankruptcy) in opposite to waiting result
does not lead to growth of weighted average cost of capital, WACC, which still
decreases with leverage. This means the absence of minimum in the dependence of
WACC on leverage as well as the absence of maximum in the dependence of
company capitalization on leverage. This means that the optimal capital structure
is absent in famous trade-off theory, and this fact proves the insolvency of famous
trade-off theory.
Under condition, proved by authors, of insolvency of well-known classical trade-
off theory, the question of finding a new mechanism of the formation of the
company’s optimal capital structure, different from one suggested by trade-off
theory, becomes very important. A new such mechanism has been developed by
the authors in this monograph. It is based on the decrease of debt cost with leverage,
which is determined by growth of debt volume. This mechanism is absent in
perpetuity Modigliani–Miller theory (Modigliani and Miller 1958, 1963, 1966),
even in modified version, developed by us, and exists within more general BFO
theory.
1 Introduction 5
The second part of this monograph is devoted to assess effectiveness of the

investment projects (IP). The authors created the modern investment models of
evaluation of the efficiency of IP index, using, as a discount rate, the correct values
of weighted average cost of capital as well as the equity cost of the company,
obtained in the BFO theory and in its perpetuity limit (MM theory).
Since virtually every investment project uses debt financing, one of the most
important problems is the determination of the optimal leverage level for invest-
ments. The monograph studies this problem from two points of view: from the point
of view of owners of equity capital and from the point of view of owners of both
equity capital and debt capital. The study has being conducted without division of
cash flows as well as with division of cash flows on the financial and operating plus
investment flows (Brusov et al. 2011c, 2012a).
Within the framework of the established models, the evaluation of the effective-
ness of investment from the point of view of their optimal capital structure has been
made on the example of one of the largest telecommunication companies in Russia.
It has been shown that there is an optimum structure of investment capital. But
company has lost from $98 million up to $645 million because the company has
worked at leverage levels, which were far from optimal values. The procedure
proposed by authors for evaluation of the efficiency of investment projects will
avoid such losses in the future.
In this monograph, the significant attention has been given to the study of taxes
and taxation in manufacture as well as in investments. Some recommendations for
regulator concerning taxation (value of tax on profit rates, etc.) have been done.
Investigation of the influence of tax on profit rate on effectiveness of investment
projects at different debt levels showed that increase of tax on profit rate from one
side leads to decrease of project NPV, but from other side, it leads to decrease of
sensitivity of NPV with respect to leverage level. At high leverage level L, the
influence of changes of tax on profit rate on effectiveness of investment projects
becomes significantly less.
Studying the influence of growth of tax on profit rate on the efficiency of the
investment as well has led to two qualitatively new effects in investments:
1. The growth of tax on profit rate changes the nature of the NPV dependence on
leverage at some value t*: there is a transition from diminishing function NPV(L )
when t < t* to growing function NPV(L ).
2. At high leverage levels, the growth of tax on profit rate leads to the growth of the
efficiency of the investments.
optimizing the management of investments.
A very important discovery has been done recently by the authors within BFO
theory. It is shown for the first time that valuation of WACC in the Modigliani–
Miller theory (perpetuity limit) (Modigliani and Miller 1958, 1963, 1966) is not
minimal, and valuation of the company capitalization is not maximal, as all financiers
6 1 Introduction
supposed up to now: at some age of the company (“golden age”), its WACC value
turns out to be lower than in Modigliani–Miller theory, and company capitalization
V turns out to be greater than V in Modigliani–Miller theory (see Chap. 18).
A distinctive feature of the book is the extensive and adequate use of mathematics
that allows the reader to count various financial and economic parameters, including
investment and taxation ones, up to the quantitative result.
flows. The proposed Brusov–Filatova–Orekhova theory (Brusov and Filatova
2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b, 2015, 2018a, b, c, d;
Filatova et al. 2008) allows the reader to correctly identify discount rates—basic
parameters for discounting financial flows to arbitrary time moment—and to com-
pare financial flows with a view to adopt literate managerial decisions. The discount
rate is a key link of the existing financial system, by pulling on which modern
finance can be adequately built, and the proposed monograph can be of substantial
assistance in this.
Existing rating methodologies have a lot of shortcomings. One of the major flaws
of all of them is a failure or a very narrow use of discounting. But even in those rare
cases where it is used, it is not quite correct, since the discount rate when discounting
financial flows is chosen incorrectly. In book a new approach to rating methodology
is suggested. Chapters 21 and 22 are devoted to rating of nonfinancial issuers, while
Chap. 23 is devoted to long-term 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 and (2) the incorporation of rating parameters (finan-
cial “ratios”) into the modern theory of capital structure (Brusov–Filatova–Orekhova
(BFO) theory). This on the one hand allows use of the powerful tools of this theory in
the rating, and on the other hand it ensures the correct discount rates when
discounting of financial flows. We discuss also 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
(Brusov et al. 2018c, d) allows issue more correct ratings of issuers and makes the
rating methodologies more understandable and transparent.
This monograph is intended for students, postgraduate students, teachers of
economic and financial institutions, students of MBA program, scientists, financial
analysts, financial directors of company, managers of insurance companies and
rating agencies, officials of regional and federal ministries and departments, and
ministers responsible for economic and financial management.
References
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capital structure of the company. Finance and Credit 435:2–8
Brusov P, Filatova T, Orehova N, Brusova A (2011a) Weighted average cost of capital in the theory
of Modigliani–Miller, modified for a finite life-time company. Appl Financ Econ 21
(11):815–824
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cost and capital structure of the company. Res J Econ Bus ICT 2:16–21
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investment project within the Modigliani–Miller theory. Res J Econ Bus ICT 2:11–15
Brusov P, Filatova T, Eskindarov M, Orehova N (2012a) Influence of debt financing on the
effectiveness of the finite duration investment project. Appl Financ Econ 22(13):1043–1052
Brusov P, Filatova T, Eskindarov M, Orehova N (2012b) Hidden global causes of the global
financial crisis. J Rev Global Econ 1:106–111
Brusov P, Filatova P, Orekhova N (2013a) Absence of an optimal capital structure in the famous
tradeoff theory! J Rev Global Econ 2:94–116
Brusov P, Filatova T, Orehova N (2013b) A qualitatively new effect in corporative finance:
abnormal dependence of cost of equity of company on leverage. J Rev Global Econ 2:183–193
Brusov P, Filatova P, Orekhova N (2014a) Mechanism of formation of the company optimal capital
structure, different from suggested by trade off theory. Cogent Econ Finance 2:1–13. https://doi.
org/10.1080/23322039.2014.946150
Brusov P, Filatova T, Orehova N (2014b) Inflation in Brusov–Filatova–Orekhova theory and in its
perpetuity limit – Modigliani–Miller theory. J Rev Global Econ 3:175–185
Brusov P, Filatova T, Orehova N, Eskindarov M (2015) Modern corporate finance, investment and
taxation, 1st edn. Springer International Publishing, Berlin, pp 1–368
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capital structure theory. J Rev Global Econ 7:104–122
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its existence. J Rev Global Econ 7:88–103
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horizons. J Rev Global Econ 7:63–87
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7:37–62
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Chapter 2
Capital Structure: Modigliani–Miller
Theory
2.1 Introduction
Under the capital structure, one understands the relationship between equity and debt
capital of the company. Does capital structure affect the company’s main settings,
such as the cost of capital, profit, value of the company, and the others, and, if
affects, how? Choice of an optimal capital structure, i.e., a capital structure, which
minimizes the weighted average cost of capital, WACC, and maximizes the value of
the company, V, is one of the most important tasks solved by financial manager and
by the management of a company. The first serious study (and first quantitative
study) of influence of capital structure of the company on its indicators of activities
was the work by Modigliani and Miller (1958). Until this study, the approach existed
(let us call it traditional), which was based on empirical data analysis.
One of the most important assumptions of the Modigliani–Miller theory is that all
financial flows are perpetuity. This limitation was lift out by Brusov–Filatova–
Orekhova in 2008 (Filatova et al. (2008), who have created BFO theory—modern
theory of capital cost and capital structure for companies of arbitrary age (BFO-1
theory) and for companies of arbitrary lifetime (BFO-2 theory) (Brusov et al. 2015).
See recent development of BFO theory and its new applications in papers (Brusov
et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b, 2015, 2018a, b, c, d). In Fig. 2.1. the
historical development of capital structure theory from the traditional (empirical)
approach, through perpetuity Modigliani–Miller approach to general capital struc-
ture theory—Brusov–Filatova–Orekhova (BFO) theory, is shown.
In 2001 Steve Myers has considered the case of a 1-year company and shown that
in this case the weighted average cost of capital, WACC, is higher than in
Modigliani–Miller case and the capitalization of the company, V, is less than in
Modigliani–Miller case.
So, before 2008 only two results for capital structure of the company were
available: Modigliani–Miller for perpetuity company and Myers for a 1-year com-
pany (see Fig. 2.2). BFO theory has filled out whole interval between t ¼ 1 and

https://doi.org/10.1007/978-3-319-99686-8_2
10 2 Capital Structure: Modigliani–Miller Theory
Fig. 2.1 Historical development of capital structure theory [here TA traditional (empirical)
approach, MM Modigliani–Miller approach, BFO Brusov–Filatova–Orekhova theory]
Fig. 2.2 MM theory describes perpetuity limit; Myers paper describes a 1-year company, while
BFO theory fills the whole numeric axis (from n ¼ 1 up to perpetuity limit n ¼ 1)
t ¼ 1. It gives the possibility to calculate the capitalization V; the weighted average

cost of capital, WACC; equity cost ke; and other financial parameters for companies
of arbitrary age and for companies of arbitrary lifetime. BFO theory has led to a lot of
new meaningful effects in modern capital structure theory, discussed in this
monograph.
2.2 The Traditional Approach
The traditional (empirical) approach told that weighted average cost of capital,
WACC, and the associated company capitalization, V ¼ CF/WACC, depend on
the capital structure, the level of leverage, L. Debt cost always turns out to be lower
than equity cost because first one has lower risk, via the fact, that in the event of
bankruptcy creditor claims are met prior to shareholders claims.
As a result, an increase in the proportion of lower-cost debt capital in the overall
capital structure up to the limit which does not cause violation of financial sustain-
ability and growth of risk of bankruptcy leads to lower weighted average cost of
capital, WACC.
The profitability required by investors (the equity cost) is growing; however, its
growth has not led to compensation of benefits from use of lower-cost debt capital.
Therefore, the traditional approach welcomes the increased leverage L ¼ D/S and the
associated increase of company capitalization. The traditional (empirical) approach
has existed up to appearance of the first quantitative theory by Modigliani and
Miller (1958).
2.3 Modigliani–Miller Theory 11
2.3 Modigliani–Miller Theory
2.3.1 Modigliani–Miller Theory Without Taxes
Modigliani and Miller (ММ) in their first paper (Мodigliani and Мiller 1958) have
come to the conclusions which were fundamentally different from the conclusions of
traditional approach. Under assumptions (see Sect. 2.3 for details) that there are no
taxes, no transaction costs, no bankruptcy costs, perfect financial markets exist with
symmetry information, equivalence in borrowing costs for both companies and
investors, etc., they have showed that choosing of the ratio between the debt and
equity capital does not affect company value as well as capital costs (Fig. 2.3).
Under above assumptions, Modigliani and Miller have analyzed the impact of
financial leverage, supposing the absence of any taxes (on corporate profit as well as
individual one). They have formulated and proven two following statements:
Without taxes, the total cost of any company is determined by the value of its
EBIT-Earnings Before Interest and Taxes, discounted with fixed rate k0,
corresponding to group of business risk of this company:
EBIT
VL ¼ VU ¼ : ð2:1Þ
k0
Fig. 2.3 Dependence of U

company capitalization, UL;
equity cost, ke; debt cost, kd; U∗
and weighted average cost
of capital, WACC, in
traditional (empirical) UL
approach
U0 U0
Ke
WACC
Kd
K0
Kd
0 L∗ L
Index L means financially dependent company (using debt financing), while

index U means a financially independent company.
Authors supposed that both companies belong to the same group of business risk,
and k0 corresponds to required profitability of financially independent company,
having the same business risk.
Because as it follows from the formula (Eq. 2.1), value of the company does not
depend on the value of debt, and thus according to Modigliani–Miller theorem
(Modigliani and Miller 1958), in the absence of taxes, value of the company is
independent of the method of its funding. This means as well that weighted average
cost of capital, WАСС, of this company does not depend on its capital structure and
is equal to the capital cost, which this company will have under the funding by equity
capital only.
V 0 ¼ V L; CF=k0 ¼ CF=WACC, and thus WACC ¼ k 0 :
Note that first Modigliani–Miller theorem is based on suggestion about indepen-

dence of weighted average cost of capital and debt cost on leverage level.
From the first Modigliani–Miller theorem (Мodigliani and Мiller 1958), it is easy
to derive an expression for the equity capital cost
WACC ¼ k 0 ¼ k e we þ k d wd : ð2:2Þ
Finding from here ke, one gets
k0 w d k 0 ðS þ D Þ D D
ke ¼ kd ¼ k d ¼ k0 þ ðk 0 kd Þ ¼ k 0 þ ðk0 k d ÞL ð2:3Þ
we we S S S
Here,
D Value of debt capital of the company

S Value of equity capital of the company
k d , wd ¼ DþS
D Cost and fraction of debt capital of the company
k e , we ¼ DþS
S Cost and fraction of equity capital of the company
L ¼ D/S Financial leverage
Thus, we come to second statement (theorem) of Modigliani–Miller theory about

the equity cost of financially dependent (leverage) company (Мodigliani and Мiller
1958).
Equity cost of leverage company ke could be found as equity cost of finan-
cially independent company k0 of the same group of risk, plus premium for risk,
the value which is equal to production of difference (k0 kd) on leverage level L:
ke ¼ k0 þ ðk 0 kd ÞL: ð2:4Þ
The formula (Eq. 2.4) shows that equity cost of the company increases linearly
with leverage level (Fig. 2.3).
The combination of these two Modigliani–Miller statements implies that the
increasing of level of debt in the capital structure of the company does not lead to
increased value of firms, because the benefits gained from the use of more low-cost
debt capital markets will be exactly offset by an increase in risk (we are speaking
about the financial risk, the risk of bankruptcy) and, therefore, by an increase in cost
of equity capital of firms: investors will increase the required level of profitability
under increased risk, by which a higher level of debt in the capital structure is
accompanied.
In this way, the Modigliani–Miller theorem argues that in the absence of the
taxes, the capital structure of the company does not affect the value of the company
and its weighted average cost of capital, WACC, and equity cost increases linearly
with the increase of financial leverage.
Explanations, given by Modigliani and Miller under receiving of their conclu-
sions, are the following (Мodigliani and Мiller 1958). Value of the company
depends on profitability and risk only and does not depend on the capital structure.
Based on the principle of preservation of the value, they postulated that the value of
the company, which is equal to the sum of the equity and debt funds, is not changed
when the ratio between its parts is changed. An important role in justification of
Modigliani–Miller statements an existence of an arbitral awards opportunities for the
committed markets plays. Two identical companies, differing only by the leverage
level, must have the same value. If this is not the case, the arbitration aligns business
cost: investors of less cost company can invest capital in a company of more value.
Selling of shares of the first company and buying of stock of the second company
will continue until the values of both companies are not equalized.
Most of Modigliani and Miller assumptions (Мodigliani and Мiller 1958), of
course, are unrealistic. Some assumptions can be removed without changing the
conclusions of the model. However, assuming no costs of bankruptcy and the
absence of taxes (or the presence of corporate taxes only) are crucial, the change
of these assumptions alters conclusions. The last two assumptions rule out the
possibility of signaling theory and agency cost theory and, thus, also constitute a
critical prerequisite (Fig. 2.4).
2.3.2 Modigliani–Miller Theory with Taxes
In the real situation, taxes on profit of companies always exist. Since the interests
paid on debt are excluded from the tax base, t leads to the so-called effect of “tax
shield”: value of the company that used the borrowed capital (leverage company) is
higher than the value of the company that financed entirely by the equity
Fig. 2.4 Dependence of CC

equity cost ke and WACC on ke = k0+L (k0-kd)
leverage level L within
Modigliani–Miller theory
without taxes
WACC
k0
L= D
S
(non-leverage company). The value of the “tax shield” for 1 year is equal to kdDT,
where D is the value of debt; T, the income tax rate; and kd, the interest on the debt
(or debt capital cost) (Мodigliani and Мiller 1963). The value of the “tax shield” for
perpetuity company for all time of its existence is equal to (we used the formula for
the sum of terms of an infinitely decreasing geometric progression)
X
1
ðPVÞTS ¼ k d DT ð1 þ kd Þt ¼ DT ð2:5Þ
t¼1
and the cost of leverage company is equal to
V ¼ V 0 þ DT, ð2:6Þ
where V0 is the value of financially independent company.

Thus, we obtain the following result obtained by Мodigliani and Мiller (1963):
The value of financially dependent company is equal to the value of the
company of the same risk group used no leverage, increased by the value of tax
shield arising from financial leverage, and equal to the product of rate of corpo-
rate income tax T and the value of debt D.
Let us now get the expression for the equity capital cost of the company under the
existence of corporate taxes.
Accounting that V0 ¼ CF/k0 and that the ratio of debt capital wd ¼ D/V, one gets
V ¼ CF=k 0 þ wd VT: ð2:7Þ
Because the value of leverage company is V ¼ CF/WACC, for weighted average

cost of capital, WACC, we get
WACC ¼ k0 ð1 wd T Þ: ð2:8Þ
From here the dependence of WACC on leverage L ¼ D/S becomes the

following:
WACC ¼ k0 ð1 LT=ð1 þ LÞÞ: ð2:9Þ
On the other hand, on definition of the weighted average cost of capital with “tax
shield” accounting, we have
WACC ¼ k0 we þ k d wd ð1 T Þ: ð2:10Þ
Equating Eqs. (2.9) and (2.11), one gets
k 0 ð1 wd T Þ ¼ k 0 we þ kd wd ð1 T Þ ð2:11Þ
and from here, for equity cost, we get the following expression:
ð1 wd T Þ wd 1 wd D
ke ¼ k0 k d ð1 T Þ ¼ k 0 k 0 T k d ð1 T Þ
we we we we S
DþS D D
¼ k0 k 0 T kd ð1 T Þ ¼ k0 þ Lð1 T Þðk0 k d Þ: ð2:12Þ
S S S
So, we get the following statement obtained by Мodigliani and Мiller (1963):
Equity cost of leverage company ke paying tax on profit could be found as
equity cost of financially independent company k0 of the same group of risk,
plus premium for risk, the value which is equal to production of difference
(k0 kd) on leverage level L and on tax shield (1 T).
It should be noted that the formula (Eq. 2.12) is different from the formula
(Eq. 2.4) without tax only by the multiplier (1 T) in term, indicating a premium
for risk. As the multiplier is less than unit, the corporate tax on profits leads to the
fact that capital is growing with the increasing of financial leverage, slower than it
would have been without them.
Analysis of formulas (Eqs. 2.4, 2.9, and 2.12) leads to following conclusions.
When leverage grows:
1. Value of company increases.
2. Weighted average cost of capital (WACC) decreases from k0 (at L ¼ 0) up to
k0(1 T ) (at L ¼ 1) (when the company is funded solely by borrowed funds).
3. Equity cost increases linearly from k0 (at L ¼ 0) up to 1 (at L ¼ 1).
Fig. 2.5 Dependence of CC Ke = K0+L(K0-Kd)

equity capital cost, debt
cost, and WACC on Ke = K0+L(K0-Kd)(1-t)
leverage in Modigliani–
Miller theory without taxes
(t ¼ 0) and with taxes (t 6¼ 0) K0
WACC(t=0)
Kd
WACC(t 0)
Kd(1-t)
D
0 L=
S
Within their theory, Мodigliani and Мiller (1963) had come to the following
conclusions. With the growth of financial leverage (Fig. 2.5):
1. The company value increases.
2. The weighted average cost of capital decreases from k0 (for L ¼ 0) up to k0(1 T )
(for L ¼ 1, when the company is financed entirely with borrowed funds).
3. The cost of equity capital increases linearly from k0 (for L ¼ 0) up to 1 (for
L ¼ 1).
2.3.3 Main Assumptions of Modigliani–Miller Theory
The most important assumptions of the Modigliani–Miller theory are as follows:

1. Investors are behaving rationally and instantaneously see profit opportunity
which is inadequate to investment risk. Therefore, the possibility of a stable
situation of the arbitration, i.e. of obtaining the risk-free profit on the difference
in prices for the same asset cannot be kept any long time-reasonable investors
quickly take advantage of it for their own purposes and equalize conditions in
the market. This means that in a developed financial market capital, the same
risk should be rewarded by the same rate of return.
2. Investment and financial market opportunities should be equally accessible to all
categories of investors—whether institutional or individual investors, large or
small, rapidly growing or stable, or experienced or relatively inexperienced.
3. Transaction costs associated with funding are very small. In practice, the
magnitude of transaction costs is inversely proportional to the amount of finance
involved, so this assumption is more consistent with reality than the large sums
involved: i.e., in attracting small amounts, the transaction costs can be high,
while, as in attracting large loans, as well as during placement of shares at a

significant amount, the transaction costs can be ignored.
4. Investors get money and provide funds to borrowers at risk-free rate. In all
probability, this assumption is due to the fact that the lender seeks to protect
himself by using one or other guarantees, pledge of assets, the right to pay
claims on third parties, and the treaty provisions restricting the freedom of the
borrower to act to the detriment of the creditor. Lender’s risk is really small, but
its position can be considered risk-free with respect to the position of the
borrower and, accordingly, should be rewarded by a risk-free rate of return.
5. Companies have only two types of assets: risk-free debt capital and risky equity
capital.
6. There is no possibility of bankruptcy, i.e., irrespective of what the level of
financial leverage of the company—borrowers are reached—bankruptcy is not
threatening them. Thus, bankruptcy costs are absent.
7. There are no corporate taxes and taxes on personal income of investors. If the
personal income tax can indeed be neglected, because the assets of the company
separated from the assets of shareholders, the corporate income taxes should be
considered in the development of more realistic theories (which was done by
Modigliani and Miller in their second paper devoted to the capital structure
(Modigliani and Miller 1963).
8. Companies are in the same class of risky companies.
9. All financial flows are perpetuity.
10. Companies have the same information.
11. Management of the company maximizes the capitalization of the company.
2.3.4 Modifications of Modigliani–Miller Theory
Taking into Account Market Risk: Hamada Model Robert Hаmаdа (1969)
united Capital Asset Pricing Model (CAPM) with Modigliani–Miller model with
taxation. As a result, he derived the following formula for calculation of the equity
cost of financially dependent company, including both financial and business risks of
company:
D
k e ¼ kF þ ðkM kF ÞbU þ ðkM kF ÞbU ð1 T Þ, ð2:13Þ
S
where bU is the β-coefficient of the company of the same group of business risk, that
the company under consideration, but with zero financial leverage. The formula
(Eq. 2.13) represents the desired profitability of equity capital ke as a sum of three
components: risk-free profitability kF, compensating to shareholders a temporary
value of their money, premium for business risk (kM kF)bU, and premium for
financial risk ðk M kF ÞbU DS ð1 T Þ.
If the company does not have borrowing (D ¼ 0), the financial risk factor will be
equal to zero (the third term is drawn to zero), and its owners will only receive the
premium for business risk.
To apply the Hamada equation, specialists in practice, in most cases, use book
value of equity capital as its approach of market value. Nevertheless, the Hamada
formula implies the use of market value of the assets.
It should be noted also that the formula (Eq. 2.13) can be used to derive other
equation, using which you can analyze the impact of financial leverage on β-factor of
company shares.
Equating CAPM formula to equity cost, we get
D
kF þ ðkM kF ÞbU ¼ kF þ ðkM kF ÞbU þ ðkM kF ÞbU ð1 T Þ ð2:14Þ
S
or

D
b ¼ bU 1 þ ð1 T Þ : ð2:15Þ
S
In this way, the assumptions on which Modigliani–Miller theory and CAPM are
based, β-factor of equity capital of financially dependent company is equal to β-
factor of financially independent company, corrected on tax on profit rate and
applied leverage level. Consequently, market risk of the company, measured by a
factor b, depends on both the business risk of the company, a measure of which is bU,
and on the financial risk b, which is calculated by the formula (Eq. 2.15).
In conclusion, here are the formulas for calculating the capital costs within the
CAPM model [in parenthesis, there are formulas within the Modigliani–Miller
theory (Modigliani and Miller 1958, 1963, 1966)].
The equity cost for company without debt capital

ke ¼ kF þ kM kF βU , ðke ¼ k 0 Þ: ð2:16Þ
The equity cost for company with debt capital

k e ¼ kF þ kM kF βe , ðke ¼ k 0 þ ð1 T Þðk0 k d ÞLÞ: ð2:17Þ
The debt cost

kd ¼ kF þ kM kF βd , ðkd ¼ kF ; βd ¼ 0Þ: ð2:18Þ
The weighted average cost of capital (WACC)
WACC ¼ ke we þ kd wd ð1 T Þ, ðWACC ¼ k 0 ð1 Twd ÞÞ: ð2:19Þ

The Cost of Capital Under Risky Debt Another hypothesis of Modigliani and
Miller was the suggestion about free of risk debt (in their theory, there are two types
of assets: risky equity and free of risk debt). However, if we assume the risk of
bankruptcy of company (and, accordingly, the ability to nonpayment of loans), the
situation may change. Stiglitz (1969) and Rubinstein (1973) have shown that the
conclusions concerning the total value of company do not change as compared to the
findings derived by Modigliani and Miller under assumptions about free of risk debt
(Modigliani and Miller 1958, 1963, 1966). However, the debt cost is changed. If
previously, under assumption about the free of risk debt, it (debt cost) was regarded
as a constant kd ¼ kF; now it is not a constant. This claim is based on the work by
Hsia (1981), where based on the models of pricing options, Modigliani–Miller and
CAPM, it was shown that if one uses the formula for the net discount income, a term,
reflecting tax protection on debt, should be discounted at the rate
1
k0d ¼ kF þ ðk0 k F ÞN ðd1 Þ , ð2:20Þ
wd
where
ln wd þ kF t 1 pffi
d1 ¼ pffi kF þ σ t, ð2:21Þ
σ t 2
here t is a moment of payment a credit and N(d1), cumulative normal distribution

of probability of random value d1.
The Account of Corporate and Individual Taxes (Miller Model) In the second
article, Modigliani and Miller (1963) considered taxation of corporate profits, but did
not take into account the presence in the economy of individual taxes of investors.
Merton Miller (1997) has introduced the model, demonstrating impact of lever-
age on the company value with account of the corporate and individual taxes (Miller
1976).
To describe his model, we will enter the following legends: TC, tax on corporate
profits rate; TS, the tax rate on income of an individual investor from his ownership
by stock of corporation; TD, tax rate on interest income from the provision of
investor—individuals of credits to other investors and companies. Income from
shares partly comes in the form of a dividend and, in part, as capital profits, so
that TS is a weighted average value of effective rates of tax on dividends and capital
profits on shares, while the income from the provision of loans usually comes in the
form of the interests. The last are usually taxed at a higher rate. In the light of the
individual taxes, and with the same assumptions that have been made for
Modigliani–Miller models previously, the financially independent company value
can be determined as follows:
EBITð1 T C Þð1 T S Þ
VU ¼ : ð2:22Þ
k0
A term (1 TS) allows to take into account the individual taxes in the formula. In
this way, numerator indicates which part of the operating company’s profit remains
in the possession of the investors, after the company will pay taxes on their profits,
and its shareholders then will pay individual taxes on income from stock ownership.
Since individual taxes reduce profits, remaining in the disposal of investors, the last,
at other things being equal circumstances, also reduce and an overall assessment of
the financially independent company value.
We will assess the financially dependent company under condition of a double
taxation of income investors. To start, let us divide the annual cash flows of
financially dependent company CFL into flows sent to its shareholders CFe and the
flows belonging to debt owners CFd, with account of both corporation tax on profits
and on the income of individuals:
CFL ¼ CFe þ CFd ¼ ðEBIT I Þð1 T C Þð1 T S Þ þ I ð1 T D Þ, ð2:23Þ
where I is the annual interest payments on debt.

The formula (Eq. 2.23) can also be rewritten as follows:
CFL ¼ CFe þ CFd ¼ EBITð1 T C Þð1 T S Þ I ð1 T C Þð1 T S Þ

þ I ð1 T D Þ: ð2:24Þ
The first term of the equation (Eq. 2.24) corresponds to cash flow after taxes for
financially independent company, shown in equation (Eq. 2.22), which shows its
present value. The second and the third terms of the equation, reflecting the financial
dependence, corresponds to cash flows related to the debt financing, which, as
previously, is considered as free of risk. Their present values are obtained by
discounting by risk-free nominal rate on debt kd.
By combining the present values of all three terms, we get the company value
under using the debt financing and in the presence of all types of taxation:
EBITð1 T C Þð1 T S Þ I ð1 T C Þð1 T S Þ I ð1 T d Þ

VU ¼ þ : ð2:25Þ
k0 kd kd
First term in Eq. (2.25) is identical to VU in formula (Eq. 2.22). Accounting this
and combining two last terms, we get the following formula:

I ð1 T d Þ ð1 T C Þð1 T S Þ
VL ¼ VU þ 1 : ð2:26Þ
kd ð1 T d Þ
The amount of paid interests with taking into account the taxation, divided by the
desired profitability of debt capital,
I ð1 T d Þ
ð2:27Þ
kd
is equal to market value of the debt D. Substituting D in the previous formula, we get
the final expression, which is known as a formula of a Miller model:

ð1 T C Þð1 T S Þ
VL ¼ VU þ 1 D: ð2:28Þ
ð1 T d Þ
The Miller model allows you to obtain an estimate of the value of financially
dependent company, taking into account the corporate tax, as well as tax on
individuals. The Miller formula (Eq. 2.28) has several important consequences:
1. Second term of sum,

1 D, ð2:29Þ
ð1 T d Þ
represents the gains from the use of debt capital. This term replaces the tax on profit
of corporation rate in the Modigliani–Miller model with corporate taxes:
V L ¼ V U þ TD: ð2:30Þ
2. If we ignore taxes, a term (Eq. 2.29) will be equal to zero. Thus, in this case, the
formula (Eq. 2.28) is transformed into the original version of the Modigliani–
Miller model without taxes.
3. If we neglect taxes on individuals, the considering term becomes 1 (1 TC) ¼ TC,
so, in this case, (Eq. 2.28) becomes a Modigliani–Miller model with corporate
taxes (Eq. 2.30).
4. If the shareholder receives profit only in the form of dividend, and if effective tax
rates on income from shares and bonds are equal (TS ¼ TD), the terms 1 TS and
1 TD are shrinking, and the factor for D in Eq. (2.29) again is equal to TC.
5. If the shareholder receives dividends, and income from capital, the situation is
changed.
In this case, effective tax rates on income from shares and bonds are not equal.
Let’s take a look at common case, when individual taxes on income for the
company shares are less than individual taxes of creditors. This encourages
investors to purchase the shares of the company compared to purchasing the
bonds of the company. In this case, TS < TD. Then factor in D in Eq. (2.28) β has a
look
β ¼1 ¼ 1 ð1 T C Þα ¼ 1 ð1 T C Þð1 þ γ Þ
ð1 T d Þ
¼ T C þ γ ð T C 1Þ < T C : ð2:31Þ
It is less than TC, because γ > 0, TC < 1, therefore, in this case, the effect of using
of debt financing, although there is, but it is less, than in the absence of individual
taxes. In other words, the effect of tax shields for the company in this case
decreases, and it becomes less than the above individual taxes of creditors
(individual taxes for the obligations of the company) in comparison with the
individual income tax on shares.
6. Let’s take a look at case TS > TD, when individual income taxes on shares are
bigger than individual taxes creditors. The factor β takes view:
β ¼1 ¼ 1 ð1 T C Þα ¼ 1 ð1 T C Þð1 γ Þ
ð1 T d Þ
¼ T C þ γ ð1 T C Þ > T C : ð2:32Þ
It is bigger than TC, because γ > 0, TC < 1; therefore, in this case, the effect of use
of debt financing is increased compared with the case of the absence of individual
taxes.
7. If (1 TC)(1 TS) ¼ 1 TD, then this term is zero, and the effect of using debt
financing will also be zero. This means that the benefits of the use of tax shields as
a result of the application of debt financing will be fully offset by additional losses
of investors, associated with a higher tax rate on interest on income of individuals.
In this case, the capital structure will not affect the company value and its capital
cost—in other words, you can apply Modigliani–Miller theory without tax
(Мodigliani and Мiller 1958).
In his report, Miller (1976) claimed that companies on average will use issuance
of shares and debt securities in such a way as to result in taxation of investors’
income to be optimal. In such an equilibrium state will occur equality:
ð1 T C Þð1 T S Þ ¼ 1 T D , ð2:33Þ
and thus, as we have pointed out above, capital structure will not affect the market
company value and its capital cost. Thus, by Miller, the conclusions on the irrele-
vance of the capital structure, made on the base of the original Modigliani–Miller
model with zero taxes, remain in force.
Subsequently, researchers adapted and checked the Miller results. Their works, as
a rule, have been devoted to the Miller’s conclusion concerning the absence of the
gains from the use of the debt capital by the company. In the USA, an effective tax
rate on the income of shareholders is lower than the one on the income of creditors,
but, nevertheless, the product (1 TC)(1 TS) is less than 1 TD.
Consequently, the companies may receive the benefit from the use of debt financ-
ing. However, Miller’s work, in fact, has shown that the distinction of rates of
individual taxes on income of shareholders and creditors to some extent compensates
the advantages from the attraction of debt financing, and, in this way, the tax benefits
from the attraction of debt financing are less than anticipated in a more earlier
Modigliani–Miller model, where only corporate taxes have been taken into account.
In conclusion, we present in Table 2.1 classification and summary of main
theories of capital structures of company.
Table 2.1 Classification and summary of main theories of capital structures of company
Theory Main thesis
Traditional theory Empirical theory, existing before appearance of the first quantitative theory of capital structures
(Modigliani–Miller theory) in 1958 (Modigliani and Miller 1958, 1963, 1966). Weighted average
cost of capital depends on capital structures of company. There is an optimal dependence on capital
structures of company
Modigliani–Miller Without taxes Capital cost and capitalization of the company are irrelevant on the capital structures of company
theory (ММ) With taxes Weighted average cost of capital is decreased with leverage level, equity cost is increased linearly
with leverage level, and capitalization of the company is increased with leverage level continuously
Brusov–Filatova– For arbitrary age BFO theory (Brusov and Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b;
Orekhova theory Without inflation Filatova et al. 2008; Brusova 2011) has replaced the famous theory of capital cost and capital
(BFO-1) structure by Nobel laureates, Modigliani and Miller (1958, 1963, 1966). The authors have moved
from the assumption of Modigliani–Miller concerning the perpetuity (infinite time of life) of
companies and further elaborated quantitative theory of valuation of core parameters of financial
activities of companies with arbitrary age. Results of modern BFO theory turn out to be quite
different from that of Modigliani–Miller theory. It shows that later, via its perpetuity, underesti-
mates the assessment of weighted average cost of capital and the equity cost of the company and
substantially overestimates the assessment of the capitalization of the company. Such an incorrect
assessment of key performance indicators of financial activities of companies has led to an
underestimation of risks involved, and impossibility, or serious difficulties in adequate managerial
decision-making, which was one of the implicit reasons of global financial crisis of 2008 year. In
the BFO theory, in investments at certain values of return on investment, there is an optimum
investment structure. As well authors have developed a new mechanism of formation of the
company optimal capital structure, different from suggested by trade-off theory
For arbitrary age Inflation not only increases the equity cost and the weighted average cost of capital, but as well it
With inflation changes their dependence on leverage. In particular, it increases growing rate of equity cost with
leverage. Capitalization of the company is decreased under accounting of inflation
For arbitrary age In BFO theory, with increased financial distress costs and risk of bankruptcy, the optimal capital
With increased financial dis- structure is absent, which means that trade-off theory does NOT work
tress costs and risk of
bankruptcy
23
(continued)
Table 2.1 (continued)
24
Theory Main thesis

Brusov–Filatova– For arbitrary lifetime In perpetuity limit (Modigliani–Miller theory) time of life of company and company age turn out to
Orekhova theory be the same: both of them are infinite. When we move from the assumption of Modigliani–Miller
(BFO-2) concerning the perpetuity of companies, these concepts (time of life of company and company age)
become different, and one should distinguish them under generalization of Modigliani–Miller
theory with respect to finite n.
Thus we have developed two kinds of finite n-theories: BFO-1 and BFO-2. BFO-1 theory is
related to companies with arbitrary age, and BFO-2 theory is related to companies with arbitrary
lifetime companies. In other words, BFO-1 is applicable for most interesting case of companies that
reached the age of n-years and continue to exist on the market and allows to analyze the financial
condition of the operating companies. BFO-2 theory allows to examine the financial status of the
companies which ceased to exist, i.e., of those for which n means not age but a lifetime, i.e., the
time of existence. A lot of schemes of termination of activities of the company can exist:
bankruptcy, merger, acquisition, etc. One of those schemes, when the value of the debt capital
D becomes zero at the time of termination of activity of company n, is considered in Chap. 3 and
2
comparison of results of BFO-1 and BFO-2 has been done

Brusov–Filatova– For rating needs A new approach to rating methodology has been developed in Chapters 21, 22, and 23. Chapters 21
Orekhova theory and 22 are devoted to rating of nonfinancial issuers, while Chap. 23 is devoted to long-term project
(BFO-3) 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 and (2) the incorporation of rating parameters
(financial “ratios”) into the modern theory of capital structure [Brusov–Filatova–Orekhova
(BFO-3) theory] (in Chap. 21 into its perpetuity limit). This on the one hand allows use of the
powerful tools of this theory in the rating, and on the other hand, it ensures the correct discount
rates when discounting of financial flows. The interplay between rating ratios and leverage level
which can be quite important in rating is discussed as well. All these create a new base for rating
methodologies. New approach to ratings and rating methodologies allows to issue more correct
ratings of issuers and makes the rating methodologies more understandable and transparent
Trade-off theory Static The static trade-off theory is developed with accounting of tax on profit and bankruptcy cost. It
attempts to explain the optimal capital structure in terms of the balancing act between the benefits of
debt (tax shield from interest deduction) and the disadvantage of debt (from the increased financial
distress and expected bankruptcy costs). The tax shield benefit is the corporate income tax rate
Capital Structure: Modigliani–Miller Theory
multiplied by the market value of debt, and the expected bankruptcy costs are the probability of
bankruptcy multiplied by the estimated bankruptcy costs
Does not take into account the costs of the adaptation of financial capital structure to the optimal
one, economic behavior of managers, owners, and other participants of economical process, as well
as a number of other factors
As it has been shown in BFO theory, the optimal capital structure is absent in trade-off theory
Dynamic The dynamic trade-off models assume that costs of constant capital adjustment are high and thus
firms will change capital structure only if benefits exceed costs. Therefore, there is an optimal
range, outside of each leverage changes but remains unchanged inside. Companies try to adjust
their leverage when it reaches the boundary of the optimal range. Subject to types of adjustment
costs firms reach target ratio faster or slower. Proportional changes imply slight correction, whereas
fixed changes imply considerable costs. In the dynamic model, correct decision on financial
structure capital of the company in this period depends on the profit, which the company hopes to
receive in the next period
In BFO theory, with increased financial distress costs and risk of bankruptcy, the optimal capital
structure is absent, which means that trade-off theory does NOT work: in static version as well as in
dynamic one
Accounting of transaction cost Accounting of the recapitalization transaction costs for the company, in which these costs are high,
leads to the conclusion that a more cost-effective is not to modify financial capital structure, even if
it is not optimal, during a certain period of time. The actual and target capital structure may vary
because of the tool costs
Accounting of asymmetry of information At the real financial markets, information is asymmetric (managers of the companies have owned
more reliable information than investors and creditors), and rationality of economic subjects is
limited
Signaling theory Information asymmetry may be reduced on the basis of certain signals for creditors and investors,
related to the behavior of managers on the capital market. It should take into account the previous
development of the company and the current and projected cost-effectiveness of activities
Pecking order theory The pecking order theory is the preferred, and empirically observed, sequence of financing type to
raise capital. That is, firms first tap retained earnings (internal equity) finance, second source is
debt, and the last source is issuing new common stock shares (external equity). The empirical
evidence of nonfinancial firm debt ratios coupled with the decision-making process of top man-
25
agement and the board of directors point to greater adherence to the pecking order theory
(continued)
26
Theory Main thesis

Theories of conflict of Theory of agency costs Management of the company may take decisions that are contrary to the interests of the share-
interests holders or creditors, respectively; the costs are necessary to monitor its actions. An effective tool for
resolving agent problem is the correct selection of compensation package (the share of participation
of agent in property, bonus, stock options), allowing to link revenue of managers with the dynamics
of equity capital and to provide motivation for managers to its (equity capital) conservation and
growth
Theory of corporate control If asymmetries of information exist, creditors, providing the capital, are interested in the possibility
and costs monitoring of the implementation of the self-monitoring of the effectiveness of its use and return. Costs for
monitoring, as a rule, put on the company owners by their inclusion into credit rate. The level of
monitoring costs depends on the scale of the business; therefore, with the increase of the business
scale, the weighted average cost of capital of the company grows and company market value is
reduced
Theory of stakeholders Stakeholder theory is a theory that identifies and models the groups that are stakeholders of a
corporation or project. The diversity and the intersection of stakeholders’ interests and different
2
assessment by them of acceptable risk generate conditions for conflict of their interest, that is,
making some corrections into the process of optimizing financial capital structure
Behavioral theories Manager investment autonomy Managers implement those decisions, which, from their point of view, will be positively perceived
by investors and, respectively, positively affect the market value of companies: when the market
value of shares of a company and the degree of consensus of expectations of managers and
investors are high, the company has an additional issue of shares, and in the opposite situation, it
uses debt instruments. In this way, the financial capital structure is more influenced by investors,
the expectations of which are taken into account by managers
The equity market timing Leverage level is determined by market dynamics. Equity market timing theory means that the
theory company should issue shares at high price and repurchase them at low price. The idea is to exploit
temporary fluctuations in the equity cost relative to the cost of other forms of capital
Information cascades In order to save costs and to avoid errors, financial capital structure can be formed not on the basis
of the calculations of optimal capital structure or depending on available in different periods of
company life funding sources but borrow from other companies that have successful, reputable
managers (companies’ leaders), as well as using (in the wake of the majority) the most popular
Capital Structure: Modigliani–Miller Theory
methods of management of capital structure

References 27
References
(11):815–824
Brusov P, Filatova T, Orehova N, Brusov PP, Brusova N (2011b) From Modigliani–Miller to
general theory of capital cost and capital structure of the company. Res J Econ Bus ICT 2:16–21
investment project within the Modigliani–Miller theory. Res J Econ Bus ICT (UK) 2:11–15
org/10.1080/23322039.2014.946150
Brusov P, Filatova T, Orehova N, Kulk V, Weil I (2018a) New meaningful effects in modern capital
structure theory. J Rev Global Econ 7:104–122
Brusov P, Filatova T, Orehova N, Kulk V (2018b) A “golden age” of the companies: conditions of
Brusov P, Filatova T, Orehova N, Kulk V (2018c) Rating methodology: new look and new
Brusov P, Filatova T, Orehova N, Kulk V (2018d) Rating: new approach. J Rev Global Econ
7:37–62
Hamada R (1969) Portfolio analysis, market equilibrium, and corporate finance. J Financ 24
(1):13–31
Hsia С (1981) Coherence of the modern theories of finance. Financ Rev 16(1):27–42
Miller M (1976) Debt and taxes. J Financ 32(2):261–275
Miller M (1997) Merton miller on derivatives. Wiley, New York, NY
1954–1957. Am Econ Rev 56:333–391
Myers S (2001) Capital structure. J Econ Perspect 15(2):81–102
Rubinstein M (1973) A mean-variance synthesis of corporate financial theory. J Financ 28:167–181
Stiglitz J (1969) A re-examination of the Modigliani–Miller theorem. Am Econ Rev 59(5):784–793
Econ Rev 53:147–175
Chapter 3
Modern Theory of Capital Cost and Capital
Structure: Brusov–Filatova–Orekhova
Theory (BFO Theory)
One of the serious limitations of the Modigliani–Miller theory is the suggestion

about perpetuity of the companies. In 2008, Brusov–Filatova–Orekhova (Filatova
et al. 2008) have lifted up this limitation and have shown that the accounting of the
finite lifetime of the company leads to significant changes of all Modigliani–Miller
results (Modigliani and Miller 1958, 1963, 1966): capitalization of the company is
changed, as well as the equity cost, ke, and the weighted average cost of capital,
WACC, in the presence of corporate taxes. Besides, a number of qualitatively new
effects in corporate finance, obtained in Brusov–Filatova–Orekhova theory (Brusov
and Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b, 2015,
2018a, b, c, d), are absent in Modigliani–Miller theory.
Only in the absence of corporate taxes, we give a rigorous proof of the Brusov–
Filatova–Orekhova theorem that equity cost, ke, as well as its weighted average cost,
WACC, does not depend on the lifetime (or age) of the company, so the Modigliani–
Miller theory could be generalized for arbitrary lifetime (arbitrary age) companies.
Until recently (before 2008, when the first paper by Brusov–Filatova–Orekhova
(Filatova et al. 2008) has appeared), the basic theory (and the first quantitative one)
of the cost of capital and capital structure of companies was the theory by Nobel
Prize winners Modigliani and Miller (1958, 1963, 1966). One of the serious limita-
tions of the Modigliani–Miller theory is the suggestion about perpetuity of the
companies. We lift up this limitation and show that the accounting of the finite
lifetime (finite age) of the company leads to change of the equity cost, ke, as well as
of the weighted average cost of capital, WACC, in the presence of corporate taxes.
The effect of leverage on the cost of equity capital of the company, ke, with an
arbitrary lifetime, and its weighted average cost of WACC is investigated. We give a
rigorous proof of the Brusov–Filatova–Orekhova theorem that in the absence of
corporate taxes, cost of company equity, ke, as well as its weighted average cost,
WACC, does not depend on the lifetime of the company.

https://doi.org/10.1007/978-3-319-99686-8_3
30 3 Modern Theory of Capital Cost and Capital Structure: Brusov–Filatova–. . .
3.1 Companies of Arbitrary Age and Companies

with Arbitrary Lifetime: Brusov–Filatova–Orekhova
Equation
Let us consider companies of arbitrary age and companies with arbitrary lifetime.
In perpetuity limit (Modigliani–Miller theory) time of life of company and
company age turn out to be the same: both of them are infinite. When we move
from the assumption of Modigliani–Miller concerning the perpetuity of companies,
these concepts (time of life of company and company age) become different, and one
should distinguish them under generalization of Modigliani–Miller theory with
respect to finite n.
Thus we have developed two kinds of finite n-theories: BFO-1 and BFO-2.
BFO-1 theory is related to companies with arbitrary age, and BFO-2 theory is related
to companies with arbitrary lifetime companies. By other words, BFO-1 is applica-
ble for the most interesting case of companies that reached the age of n-years and
continue to exist on the market and allows to analyze the financial state of the
operating companies. BFO-2 theory allows examine the financial status of the
companies which ceased to exist, i.e., of those companies for which n means not
age, but a lifetime, i.e., the time of existence. A lot of schemes of termination of
activities of the company can exist: bankruptcy, merger, acquisition, etc. One of
those schemes, when the value of the debt capital D becomes zero at the time of
termination of activity of company n, is considered in this chapter below (Sect. 3.5)
and comparison of results of BFO-1 and BFO-2 has been done as well.
To start with the case of finite n, let us first of all find the value of tax shield, TS, of
the company for n-years:
X
n
TS ¼ kd DT ð1 þ k d Þt ¼ DT ½1 ð1 þ kd Þn : ð3:1Þ
t¼1
(We used the formula for the sum of n terms of a geometric progression).
Here, D is the value of debt capital; kd the cost of debt capital; and T the tax on
profit rate.
Next, we use the Modigliani–Miller theorem (Modigliani and Miller 1958, 1963,
1966):
The value of financially dependent company is equal to the value of the
company of the same risk group used no leverage, increased by the value of tax
shield arising from financial leverage, and equal to the product of rate of corpo-
rate income tax T and the value of debt D.
V ¼ V 0 þ DT: ð3:2Þ
This theorem was formulated by Modigliani and Miller for perpetuity companies,
but we modify it for a company of arbitrary age.
3.1 Companies of Arbitrary Age and Companies with Arbitrary Lifetime:. . . 31
X
1
V ¼ V 0 þ TS ¼ V 0 þ kd DT ð1 þ kd Þt
t¼1
ð3:3Þ
¼ V 0 þ wd VT ½1 ð1 þ kd Þn ,
V ð1 wd VT ½1 ð1 þ kd Þn Þ ¼ V 0 : ð3:4Þ
There is a common use of the following two formulas for the cost of the
financially independent and financially dependent companies (Modigliani and Miller
1958, 1963, 1966):
V 0 ¼ CF=k 0 and V ¼ CF=WACC: ð3:5Þ
However, these almost always used formulas were derived for perpetuity com-
pany, and in case of a company of finite age (or with a finite lifetime), they must be
modified in the same manner as the value of tax shields (Brusov and Filatova 2011;
Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b; Filatova et al. 2008):
V 0 ¼ CF½1 ð1 þ k 0 Þn =k0 ; V ¼ CF½1 ð1 þ WACCÞn =WACC: ð3:6Þ
From formula (Eq. 3.4), we get Brusov–Filatova–Orekhova equation for WACC

(Brusov and Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b;
Filatova et al. 2008):
1 ð1 þ WACCÞn 1 ð1 þ k0 Þn
¼ : ð3:7Þ
WACC k0 ½1 ωd T ð1 ð1 þ k d Þn Þ
Here, S is the value of the equity capital of the company; wd ¼ DþS D

, the share of
debt capital; ke , we ¼ DþS, the cost and the share of the equity capital of the company;
S
and L ¼ D/S, financial leverage.

At n ¼ 1, we get Myers (2001) formula for a 1-year company:
ð1 þ k0 Þkd
WACC ¼ k0 wd T ð3:8Þ
1 þ kd
For n ¼ 2, one has
1 ð1 þ WACCÞ2 1 ð1 þ k0 Þ2
¼ h i : ð3:9Þ
WACC k0 1 ωd T 1 ð1 þ k d Þ2
This equation can be solved for WACC analytically:

pffiffiffiffiffiffiffiffiffiffiffiffiffiffi
1 2α 4α þ 1
WACC ¼ , ð3:10Þ
2α
where
2 þ k0
α¼ h i: ð3:11Þ
2 2k d þk2d
ð1 þ k0 Þ 1 ωd T ð1þk Þ2
d
For n ¼ 3 and n ¼ 4, equation for the WACC becomes more complicated, but it
still can be solved analytically, while for n > 4, it can be solved only numerically.
We would like to make an important methodological notice: taking into account
the finite lifetime of the company, all formulas, without exception, should be
received with used formulas (Eq. 3.6) instead of their perpetuity limits (Eq. 3.5).
Below, we will describe the algorithm for the numerical solution of the equation
(Eq. 3.7).
Algorithm for Finding WACC in Case of Companies of Arbitrary Age
Let us return back to n-year project (n-year company). We have the following
equation for WACC in n-year case:
1 ð1 þ WACCÞn
AðnÞ ¼ 0, ð3:12Þ
WACC
where
1 ð1 þ k0 Þn
AðnÞ ¼ : ð3:13Þ
k0 ½1 ωd T ð1 ð1 þ kd Þn Þ
The algorithm of solving Eq. (3.12) should be as follows:

1. Putting the values of parameters k0, ωd, T, and given n, we calculate A(n).
2. We determine two WACC values, for which the left part of Eq. (3.12) has
opposite signs. It is obvious that in these two values, we can use WACC1 and
WACC1, because WACC1 > WACCn > WACC1 for finite n 2.
3. Using, for example, the bisection method, we can solve Eq. (3.12) numerically.
In MS Excel, it is possible to solve Eq. (3.7) much easily by using the option
“matching of parameter”: we will use it through the monograph.

of Arbitrary Age)
Myers (2001) has compared his result for a 1-year company (project) (Eq. 3.8) with
Modigliani and Miller’s result for perpetuity limits (Eq. 2.8). He has used the
following values of parameters:
3.2 Comparison of Modigliani–Miller Results (Perpetuity Company) with. . . 33
k0 ¼ 8% 24%; kd ¼ 7%; T ¼ 50%; wd ¼ 0% 60%
and estimated the difference in the WACC values following from the formulas
(Eqs. 3.8 and 2.8). We did make the similar calculations for a 2-, 3-,5-, and
10-year project for the same set of parameters, and we have gotten the following
results, shown in the tables [Table 3.1 (second line (bulk)), Table 3.2 (second line
(bulk)), and Table 3.3)] and corresponding figures (Figs. 3.1, 3.2, and 3.3).
Note that data for equity cost k0 ¼ 8% turn out to be a little bit uncertain: this
could be related to the fact that this value of equity cost is quite close to value of
Table 3.1 WACC dependence on debt share wd for different values of equity cost k0 for companies
with different lifetime n
k0 n wd ¼ 10% 20% 30% 40% 50% 60%
k0 ¼ 8% n¼1 7.6% 7.3 6.9 6.6 6.2 5.9
n¼2 7.52 7.08 6.6 6.17 5.67 5.21
n¼1 7.6 7.2 6.8 6.4 6.0 5.6
k0 ¼ 10% n¼1 9.7 9.3 8.9 8.6 8.2 7.8
n¼2 9.51 9.05 8.59 8.13 7.64 7.16
n¼1 9.5 9.0 8.5 8.0 7.5 7.0
k0 ¼ 12% n¼1 11.6 11.3 10.9 10.5 10.2 9.8
n¼2 11.51 11.02 10.54 10.07 9.6 9.09
n¼3 11.46 10.93 10.39 9.85 9.31 8.77
n¼5 11.42 10.83 10.25 9.66 9.06 8.46
n ¼ 10 11.396 10.786 10.1695 9.5455 8.914 8.2745
n¼1 11.4 10.8 10.2 9.6 9.0 8.4
k0 ¼ 16% n¼1 15.62 15.2 14.9 14.5 14.1 13.7
n¼2 15.52 14.99 14.5 13.98 13.47 12.96
n¼3 15.44 14.88 14.31 13.75 13.18 12.61
n¼5 15.38 14.76 14.14 13.51 12.88 12.24
n ¼ 10 15.34 14.67 13.99 13.31 12.62 11.92
n¼1 15.2 14.4 13.6 12.8 12.0 11.2
k0 ¼ 20% n¼1 19.6 19.2 18.8 18.4 18.1 17.7
n¼2 19.45 18.97 18.45 17.93 17.37 16.86
n¼3 19.41 18.82 18.23 17.64 17.05 16.45
n¼5 19.35 18.69 18.03 17.36 16.70 16.03
n ¼ 10 19.27 18.54 17.80 17.05 16.30 15.54
n¼1 19.0 18.0 17.0 16.0 15.0 14.0
k0 ¼ 24% n¼1 23.6 23.2 22.8 22.4 22.0 21.6
n¼2 23.46 22.94 22.37 21.80 21.30 20.75
n¼3 23.39 22.77 22.15 21.54 20.91 20.29
n¼5 23.31 22.61 21.91 21.21 20.51 19.80
n ¼ 10 23.21 22.40 21.60 20.78 19.96 19.13
n¼1 22.8 21.6 20.4 19.2 18.0 16.8
Table 3.2 Dependence of the differences Δ1 ¼ WACC1 WACC1 (first line),

Δ2 ¼ WACC1 WACC2 [second line (bulk)], and their ratio r ¼ Δ1/Δ2 (third line) on debt share
wd for different values of equity cost k0
wd ¼ 10% 20% 30% 40% 50% 60%
k0 ¼ 10% 0.20 0.30 0.4 0.60 0.7 0.8
0.19 0.25 0.31 0.47 0.56 0.64
1.05 1.2 1.29 1.28 1.25 1.25
k0 ¼ 12% 0.2 0.5 0.7 0.9 1.2 1.4
0.09 0.28 0.36 0.43 0.6 0.71
2.22 1.76 1.94 2.09 2 1.97
k0 ¼ 16% 0.4 0.8 1.3 1.7 2.1 2.5
0.08 0.21 0.4 0.52 0.63 0.74
5.0 3.81 3.25 3.27 3.33 3.38
k0 ¼ 20% 0.6 1.2 1.8 2.4 3.1 3.7
0.15 0.23 0.35 0.47 0.73 0.84
4.0 5.22 5.14 5.11 4.25 4.4
k0 ¼ 24% 0.8 1.6 2.4 3.2 4.0 4.8
0.14 0.26 0.43 0.6 0.7 0.85
5.7 6.15 5.58 5.33 5.71 5.65
Table 3.3 Average (by debt share wd) values of ratios r ¼ hΔ1 =Δ2 i for k0 ¼ 10%; 12%; 16%; 20%;
and 24%
k0 10% 12% 16% 20% 24%
r ¼< Δ1 =Δ2 > 1.22 2.00 3.67 4.69 5.69
interest rate of the debt kd ¼ 7%. For all other values of equity cost, the results are
reproducible and very informative and are discussed below.
For a graphic illustration of the results, we use data for n ¼ 1, 2, 1, which
adequately reflect the results we have obtained.
Discussion of Results
1. From Table 3.1 and Fig. 3.1, it is obvious that WACC is maximum for a 1-year
company (project) and decreases with the lifetime (age) of the company (project)
and reaches the minimum in the Modigliani–Miller perpetuity case. Dependence
of all WACC values on debt share wd turns out to be linear at any equity cost k0
for all considered durations of the project (lifetime values of the companies). It is
natural for a 1-year project because it is described by Myers linear formula (3.8)
as well as, in the Modigliani–Miller perpetuity case, described by the formula
(2.8), which is linear too, but it is surprise for a 2-year project, where formula for
WACC (3.7) is obviously nonlinear.
The negative slope in WACC increases with the equity cost k0.
2. As it follows from the Table 3.2 and Fig. 3.3, the dependence of the average ratios
r ¼ hΔ1 =Δ2 i on debt share wd is quite weak and can be considered as almost
Fig. 3.1 The dependence of the WACC on debt share wd for companies with different lifetime n for
different cost of equity, k0 (from Table 3.1)
constant. The value of this constant increases practically linear with the equity
cost k0 from 1.22 at k0 ¼ 10% up to 5.69 at k0 ¼ 24% (see Fig. 3.4).
3. The relative difference between 1-year and a 2-year projects increases when the
equity cost k0 decreases. At the same time, the relative difference between a
2-year project and perpetuity MM project increases with the equity cost k0.
We can also show below at Table 3.4 and Fig. 3.5 the dependence of the WACC
on leverage level L for n ¼ 1, n ¼ 3, and n ¼ 1.
From Table 3.4 and Fig. 3.5, it is obvious that WACC has a maximum for a
1-year company and decreases with the age (lifetime) of the company, reaching the
minimum in the Modigliani–Miller perpetuity case. (Note, however, that this not
always be so via the effect of “golden age” of the company (see Chaps 18 and 19)).
Fig. 3.2 Dependence of the ratior ¼ Δ1/Δ2 of differencesΔ1 ¼ WACC1 WACC1and

Δ2 ¼ WACC1 WACC2 on debt share wd for different values of equity cost k0 (from Table 3.2)
7.00
6.00
5.00
4.00
–
r
3.00
2.00
1.00
0.00
10.00 12.00 16.00 20.00 24.00
Ko
Fig. 3.3 Dependence of the average values of ratio r ¼ hΔ1 =Δ2 i on the equity cost, k0
3.3 Brusov–Filatova–Orekhova Theorem
Case of Absence of Corporate Taxes

Modigliani–Miller theory in case of absence of corporate taxes gives the following
results for dependence of WACC and equity cost ke on leverage:
1.
V 0 ¼ V L; CF=k 0 ¼ CF=WACC, and thus WACC ¼ k0 : ð3:14Þ
2. WACC ¼ we ke + wd kd; and thus

3.3 Brusov–Filatova–Orekhova Theorem 37
WACC
k0 t = 0(any n)
(1+k0)kd
k0 1- t n=1
(1+kd)k0
k0(1-t) n=∞
Fig. 3.4 The dependence of the WACC on leverage in the absence of corporate taxes [the
horizontal line (t ¼ 0)], as well as in the presence of corporate taxes [for 1-year (n ¼ 1) and
perpetuity companies (n ¼ 1)]. Curves for the WACC of companies with an intermediate lifetime
(age) (1 < n < 1) lie within the shaded region
Table 3.4 The dependence of the WACC on leverage level L for n ¼ 1, n ¼ 3, and n ¼ 1
WACC WACC
L k0 kd t wd n ¼ 1 (%) n ¼ 3 (%) WACC (MM) (%)
0 0.2 0.1 0.2 0.00 20.00 20.00 20.00
1 0.2 0.1 0.2 0.50 18.91 18.41 18.00
2 0.2 0.1 0.2 0.67 18.55 17.87 17.33
3 0.2 0.1 0.2 0.75 18.36 17.61 17.00
4 0.2 0.1 0.2 0.80 18.25 17.44 16.80
5 0.2 0.1 0.2 0.83 18.18 17.34 16.67
6 0.2 0.1 0.2 0.86 18.13 17.26 16.57
7 0.2 0.1 0.2 0.88 18.09 17.20 16.50
8 0.2 0.1 0.2 0.89 18.06 17.16 16.44
9 0.2 0.1 0.2 0.90 18.04 17.12 16.40
10 0.2 0.1 0.2 0.91 18.02 17.09 16.36
L
WACC wd kd k0 1 þ Lkd
ke ¼ ¼
we 1 ð3:15Þ
1þL
¼ k0 þ Lðk0 k d Þ:
For the finite lifetime (finite age) companies, Modigliani–Miller theorem about
equality of value of financially independent and financially dependent companies
(V0 ¼ VL) has the following view (Brusov and Filatova 2011; Brusov et al. 2011a, b,
c, 2012a, b, 2013a, b, 2014a, b):
V 0 ¼ V L;
20,00%
19,50%
19,00%
18,50%
18,00%
n=1 ko=0,2 kd=0,1
WACC
17,50%
n=3 ko=0,2 kd=0,1
17,00%
MM ko=0,2 kd=0,1
16,50%
16,00%
15,50%
15,00%
0 1 2 3 4 5 6 7 8 9 10
Fig. 3.5 Dependence of WACC on leverage level for n ¼ 1, n ¼ 3, and n ¼ 1
½1 ð1 þ k 0 Þn ½1 ð1 þ WACCÞn
CF ¼ CF : ð3:16Þ
k0 WACC
Using this relation, we prove an important Brusov–Filatova–Orekhova theorem:

Under the absence of corporate taxes, the equity cost of the company, ke, as
well as its weighted average cost of capital (WACC) does not depend on the
lifetime (age) of the company and is equal, respectively, to
ke ¼ k 0 þ Lðk0 kd Þ; WACC ¼ k0 : ð3:17Þ
Let us consider first the 1- and 2-year companies

(a) For a 1-year company, one has from (3.15)
1 ð1 þ k 0 Þ1 1 ð1 þ WACCÞ1
¼ , ð3:18Þ
k0 WACC
and thus
1 1
¼ : ð3:19Þ
1 þ k 0 1 þ WACC
Hence
WACC ¼ k0 : ð3:20Þ
3.3 Brusov–Filatova–Orekhova Theorem 39
The formula for equity cost ke ¼ k0 + L(k0 kd) is now obtained by substituting
WACC ¼ k0 into (3.14).
(b) For a 2-year company, one has from (3.15)
h i h i
1 ð1 þ k0 Þ2 1 ð1 þ WACCÞ2
¼ ,
k0 WACC
and thus
2 þ k0 2 þ WACC
2
¼ : ð3:21Þ
ð1 þ k 0 Þ ð1 þ WACCÞ2
Denoting α ¼ ð1þk
2þk 0
Þ2
, we get the following quadratic equation for WACC:
0
α WACC2 þ ð2α 1Þ WACC þ ðα 2Þ ¼ 0: ð3:22Þ
It has two solutions:

pffiffiffiffiffiffiffiffiffiffiffiffiffiffi
1 2α 4α þ 1
WACC1, 2 ¼ : ð3:23Þ
2α
Substituting α ¼ ð1þk
2þk 0
Þ2
, we get
0

k20 3 ðk 0 þ 3Þð1 þ k 0 Þ
WACC1, 2 ¼ : ð3:24Þ
2ð 2 þ k 0 Þ
2k0 þ 3
WACC1 ¼ k0 ; WACC2 ¼ < 0: ð3:25Þ
k0 þ 2
The second root is negative, but the weighted average cost of capital can only be
positive, so only one value remains:
WACC1 ¼ k0 :
(c) For a company with arbitrary lifetime, n, Brusov–Filatova–Orekhova formula

(3.15) gives
1 ð1 þ k0 Þn 1 ð1 þ WACCÞn
¼ : ð3:26Þ
k0 WACC
For a fixed k0, (Eq. 3.25) is an equation of (n + 1)—a degree relative to WACC. It
has n + 1 roots (in general complex). One of the roots, as a direct substitution shows,
is always WACC ¼ k0.. Investigation of the remaining roots is difficult and not a part
of our problem.
Formula for equity cost ke ¼ k0 + L(k0 kd) is now obtained by substituting
WACC ¼ k0 into (Eq. 3.14).
Thus, we have proved the Brusov–Filatova–Orekhova theorem.
Case of the Presence of Corporate Taxes
Modigliani–Miller theory in case of presence of corporate taxes gives the following
results for dependence of WACC and equity cost ke on leverage:
1. WACC
V L ¼ V 0 þ Dt; D ¼ wd V L ; ð3:27Þ
CF=WACC ¼ CF=k0 þ Dt ¼ CF=k0 þ wd tCF=WACC, ð3:28Þ
1 wd t 1
¼ ; ð3:29Þ
WACC k 0

L
WACC ¼ k0 ð1 wd t Þ ¼ k0 1 t : ð3:30Þ
1þL
Thus, WACC decreases with leverage from k0 [in the absence of debt financing
(L ¼ 0)] up to k0(1 t) (at L ¼ 1).
2. The equity cost ke
WACC ¼ k0 ð1 wd t Þ ¼ we k e þ wd kd ð1 t Þ;
and thus
WACC wd kd ð1 t Þ
ke ¼
we
L
k 0 ð1 w d t Þ k d ð1 t Þ ð3:31Þ
¼ 1þL ¼ k0 þ Lðk 0 kd Þð1 t Þ:
1
1þL
3.4 From Modigliani–Miller to General Theory of Capital

Cost and Capital Structure
Let us consider, how the weighted average cost of capital (WACC) and the cost of
the equity capital, ke, will be changed when taking into account the finite age of the
company.
3.4 From Modigliani–Miller to General Theory of Capital Cost and Capital Structure 41
(a) 1-year company

From (3.7), one has
¼ : ð3:32Þ
WACC k0 ½1 wd t ð1 ð1 þ k d Þn Þ
For a 1-year company, we get
1 ð1 þ WACCÞ1 1 ð1 þ k0 Þ1
¼ h i ð3:33Þ
WACC k0 1 wd t 1 ð1 þ kd Þ1
From (Eq. 3.33), we obtain the well-known Myers formula (Eq. 3.8), which is the
particular case of Brusov–Filatova–Orekhova formula (Eq. 3.7).
1 þ k0
WACC ¼ k0 k d wd t:
1 þ kd
Thus

ð1 þ k 0 Þ k d L
WACC ¼ k0 1 t : ð3:34Þ
ð1 þ k d Þ k 0 1 þ L
Thus, WACC decreases with leverage from k0 [in the absence of debt financing
(L ¼ 0)] up to k 0 1 ðð1þk 0 Þk d
1þkd Þk 0 t ðat L ¼ 1Þ:
Equating the right part of Eq. (3.34) to general expression for WACC
WACC ¼ we ke þ wd kd ð1 t Þ, ð3:35Þ
one gets
1 þ k0
k0 kd wd t ¼ we ke þ wd k d ð1 t Þ: ð3:36Þ
1 þ kd
Thus
1 1 þ k0
ke ¼ k0 kd wd t kd wd ð1 t Þ
we 1 þ kd
kd
¼ ð1 þ LÞk0 L ½ð1 þ k0 Þt þ ð1 þ kd Þð1 t Þ
1 þ kd

kd
¼ k 0 þ Lð k 0 k d Þ 1 t :
1 þ kd
Fig. 3.6 Dependence of the ke t = 0(any n)

equity cost, ke, on leverage
in the absence of corporate
taxes [the upper line (t ¼ 0)],
as well as in the presence of n=1
corporate taxes [for 1-year
(n ¼ 1) and perpetuity
companies (n ¼ 1)]. n=∞
Dependences of the cost of
the equity capital of the
k0
companies, ke, of an
intermediate age
(1 < n < 1) lie within the
shaded region
0 L

kd
k e ¼ k0 þ Lðk 0 kd Þ 1 t : ð3:37Þ
1 þ kd
So we see that in case of a 1-year company, the perpetuity limit

ke ¼ k0 + L(k0 kd)(1 t) is replaced by (Eq. 3.37).
Difference is due to different values of the tax shield for a 1-year company and
perpetuity one (Fig. 3.6).
Let us investigate the question of the tax shield value for companies with different
lifetime (age) in more detail.
Tax Shield
General expression for the tax shield for n-year company has the form (Brusov–
Filatova–Orekhova)
X
n
kd Dt kd Dt ½1 ð1 þ k d Þn
TS ¼ ¼ ¼ Dt ½1 ð1 þ kd Þn : ð3:38Þ
i¼1 ð1 þ kd Þi ð1 þ kd Þ 1 ð1 þ k d Þ1
1. In perpetuity limit (n ! 1), tax shield is equal to TS1 ¼ Dt, which leads to the
so-called effect of the tax shield associated with the appearance of a factor (1 t)
in the equity cost ke ¼ k0 + L(k0 kd)(1 t).
2. For the 1-year company, tax shield value is equal to

TS1 ¼ Dt 1 ð1 þ kd Þ1 ¼ Dtk d =ð1 þ kd Þ: ð3:39Þ

This leads to appearance of a factor 1 1þk
kd
t in the equity cost (Eq. 3.36):
d
ke ¼ k0 þ Lðk 0 kd Þ 1 1þk
kd
d
t :
3.5 BFO Theory in the Case, When the Company Ceased to Exist at the Time. . . 43
3. Tax shield for a 2-year company is equal to

TS2 ¼ Dt 1 ð1 þ kd Þ2 ¼ Dtkd ð2 þ kd Þ=ð1 þ kd Þ2 ð3:40Þ
and if the analogy with a 1-year company will keep, then factor (1 t) in the
Modigliani–Miller theory would be replaced by the factor
!
k d ð2 þ k d Þ
1 t : ð3:41Þ
ð1 þ k d Þ2
However, due to a nonlinear relation between WACC and k0 and kd in Brusov–

Filatova–Orekhova formula (Eqs. 3.9, 3.10, and 3.11) for a 2-year company (and
companies of bigger age), such a simple analogy is no longer observed, and the
calculations become more complex.
3.5 BFO Theory in the Case, When the Company Ceased

to Exist at the Time Moment n (BFO-2 Theory)
From the output of the BFO formula, it follows that developed ideology is applied to
companies which have reached the age of n-years and continue to exist on the
market, while the theory of MM is only applicable to infinitely old (perpetuity)
companies. By other words, BFO is applicable for most interesting case of compa-
nies that reached the age of n-years and continue to exist on the market and allows to
analyze the financial condition of the operating companies.
However, the BFO theory allows also to examine the financial status of the
companies which ceased to exist, i.e., of those for which n means not age but a
lifetime, i.e., the time of existence. A lot of schemes of termination of activities of the
company can exist: bankruptcy, merger, acquisition, etc. Below we consider one of
those schemes, when the value of the debt capital D becomes zero at the time of
termination of activity of company n: in this case the BFO theory requires minimal
upgrades, showed below.
From the formula for the capitalization of the company (3.1), it is easy to get an
estimation for the “residual capitalization” of the company, discounted to the time
moment k:
X
n
CF CF h ðnk Þ
i
Vk ¼ t ¼ 1 ð 1 þ WACC Þ : ð3:42Þ
t¼kþ1 ð1 þ WACCÞ
WACC
Using the formula

V k ¼ wd D, ð3:43Þ
we obtain an expression for the tax shield for n-years subject to the termination of the
activities of the company at the moment n:
X
n
V k1 tk d wd CF X
n
1 ð1 þ WACCÞðnkþ1Þ
TSn ¼ tk d wd ¼ ¼
k¼1 ð1 þ k d Þk WACC k¼1 ð1 þ k d Þk
ð3:44Þ
tk d wd 1 ð1 þ kd Þn ð1 þ kd Þn ð1 þ WACCÞn
¼ :
WACC kd WACC kd
Substituting this expression into Eq. (3.3)
V L ¼ V 0 þ ðTSÞn
one gets the equation (let us call it BFO-2)
¼
WACC k0
tk d wd 1 ð1 þ k d Þn ð1 þ kd Þn ð1 þ WACCÞn
þ ,
WACC kd WACC k d
ð3:45Þ
from which one can find the WACC for companies with arbitrary lifetime n,
provided that the company ceases to function at the time moment n.
Below in the monograph, we investigate the companies that have reached the
age of n-years and continue to exist on the market, i.e., we will use formula BFO
(3.7), but in this paragraph we present some results obtained from the formula
BFO-2 (3.45).
3.5.1 Application of Formula BFO-2
Formula BFO-2 (3.45) in MS Excel takes the following form:

1 ð1 þ C4ÞðH4Þ =C4 1 ð1 þ D4ÞðH4Þ =D4

þ ððG4∗ E4∗ F4:Þ=C4Þ∗ 1 ð1 þ E4ÞðH4Þ =E4 :

ð1 þ E4ÞðH4Þ ð1 þ C4ÞðH4Þ =ðC4 E4Þ ¼ 0: ð3:46Þ
3.5 BFO Theory in the Case, When the Company Ceased to Exist at the Time. . . 45
Fig. 3.7 The dependence of WACC(L)

the WACC on leverage level 0.2050
L for n ¼ 3 and n ¼ 5; 0.2000
k0 ¼ 0.2; kd ¼ 0.15 0.1950
0.1900
WACC
0.1850
0.1800
0.1750
0.1700
0.1650
0 2 4 6 8 10 12
n
n=3 n=5
Fig. 3.8 The dependence of WACC(n)

the WACC on lifetime n at 0.1900
different leverage level L
0.1850
0.1800
WACC
0.1750
0.1700
0.1650
0.1600
0 10 20 30 40 50
n
L=1 L=2 L=3 L=5 L=7
Fig. 3.9 The dependence of WACC(t)

the WACC on tax on profit 0.2500
rate t for n ¼ 3 and n ¼ 5;
k0 ¼ 0.2; kd ¼ 0.15 0.2000
0.1500
WACC
0.1000
0.0500
0.0000
0 0.2 0.4 0.6 0.8 1 1.2
n
n=3 n=5
Using it we get the following results for dependence of WACC on leverage level
L, lifetime n, and on tax on profit rate t (Figs. 3.7, 3.8, and 3.9)
3.5.2 Comparison of Results Obtained from Formulas BFO

and BFO-2
Let us compare results obtained from formulas BFO and BFO-2 (Figs. 3.10, 3.11,
3.12, and 3.13).
Comparison of results obtained from formulas BFO and BFO-2 shows that
WACC values (at the same values of other parameters) turn out to be higher for
the companies which ceased to exist at the time moment n, than for companies which
have reached the age of n-years and continue to exist on the market. By other words,
the companies which ceased to exist at the time moment n can attract a capital at
higher rate than for companies which have reached the age of n-years and continue to
exist on the market.
We will develop the detailed investigation of the companies which ceased to exist
at the time moment n (described by formula BFO-2) somewhere also, and in this
Fig. 3.10 Comparison of WACC(L)

the dependence of the 0.2100
WACC on leverage level 0.2000
L for n ¼ 3 and n ¼ 5 from
formulas BFO and BFO-2 0.1900
WACC
0.1800
0.1700
0.1600
0.1500
0 5 10 15
L
n=3 n=5 n=3(2)
n=5(2)
Fig. 3.11 Comparison of WACC(n)

WACC on lifetime n from 0.0740
formulas BFO (lower curve)
and BFO-2 (upper curve); 0.0720
k0 ¼ 0.08; kd ¼ 0.04 0.0700
WACC
0.0680
0.0660
0.0640
0.0620
0.0600
0 10 20 30 40 50
n
k0=0,08; kd=0,04 k0=0,08; kd=0,04

3.6 Conclusions 47
Fig. 3.12 Comparison of WACC(n)

WACC on lifetime n from
formulas BFO (lower curve) 0.1750
and BFO-2 (upper curve);
k0 ¼ 0.2; kd ¼ 0.15; L ¼ 3 0.1700
WACC
0.1650
0.1600
0.1550
0.1500
0 10 20 30 40 50
n
k0=0,2; kd=0,15 k0=0,2; kd=0,15
Fig. 3.13 Comparison of WACC(t)

WACC on tax on profit rate
t from formulas BFO (lower 0.2000
curve) and BFO-2 (upper
WACC
0.1500
curve); k0 ¼ 0.2; kd ¼ 0.15;
n¼5 0.1000
0.0500
0.0000
0 0.2 0.4 0.6 0.8 1 1.2
n
n=5 n=5(2)
monograph we will limit ourselves by consideration of the companies which have

reached the age of n-years and continue to exist on the market (described by formula
BFO).
3.6 Conclusions
In this chapter, an important step toward a general theory of capital cost and capital
structure of the company has been done. For this, perpetuity theory of Nobel Prize
winners Modigliani and Miller, which was until recently (until 2008) the main and
the basic theory of capital cost and capital structure of companies, has been extended
to the case of companies of arbitrary age and of companies with an arbitrary lifetime,
as well as for projects of arbitrary duration.
We show that taking into account the finite age of the company or the finite
lifetime of the company in the presence of corporate taxes leads to a change in the
equity cost of the company, ke, as well as in its weighted average cost (WACC) and
company capitalization, V.
Thus, we have removed one of the most serious limitations of the theory of
Modigliani–Miller, connected with the assumption of perpetuity of the companies.
The effect of leverage on the cost of equity capital, ke, of the company of an arbitrary
age or with arbitrary lifetime and its weighted average cost (WACC) is investigated.
We give a rigorous proof of an important Brusov–Filatova–Orekhova theorem that
in the absence of corporate tax, equity cost of companies, ke, as well as its weighted
average cost (WACC) does not depend on the lifetime (age) of the company.
We summarize the difference in results obtained within modern Brusov–
Filatova–Orekhova theory and within classical Modigliani–Miller one in Table 3.5.
Table 3.5 Comparison of results, obtained within Modigliani–Miller theory and within general
Brusov–Filatova–Orekhova theory
Financial Modigliani–Miller
parameter (MM) results Brusov–Filatova–Orekhova (BFO) results
n
Capitalization of V0 ¼ CF/k0 V 0 ¼ CF
k 0 ½1 ð1 þ k 0 Þ
financially inde-
pendent company
Capitalization of V ¼ CF/WACC V ¼ WACC
CF
½1 ð1 þ WACCÞn
leverage (finan-
cially dependent)
company
Tax shield (TS)1 ¼ DT BFO-1: TSn ¼ DT[1 (1 + kd)n]
BFO-2:
T k d wd 1 ð1 þ k d Þn
TSn ¼
WACC kd
n n
ð1 þ k d Þ ð1 þ WACCÞ

WACC k d
Modigliani– V ¼ V0 + DT V ¼ V0 + DT[1 (1 + kd)n]
Miller theorem
with taxes
Weighted average WACC ¼ BFO-1:
cost of capital ¼ k 0 ð1 wd t Þ 1 ð1 þ WACCÞn
(WACC) ¼
WACC
1 ð1 þ k 0 Þn
¼
k 0 ½1 ωd T ð1 ð1 þ k d Þn Þ
BFO-2:
1 ð1 þ WACCÞn 1 ð1 þ k 0 Þn Tkd wd
¼ þ
WACC k0 WACC
n n n
1 ð1 þ k d Þ ð1 þ k d Þ ð1 þ WACCÞ

kd WACC k d
Equity cost, ke ke ¼ k0 þ k e ¼ ð1 þ LÞ WACC
þLðk 0 k d Þð1 t Þ k d Lð1 T Þ
References 49
The first four formulas from the right-hand column are sometimes used in
practice, but there are several significant nuances. First, these formulas do not take
into account the residual value of the company and only take into account the
operating flows, and this must be borne in mind. Second, these formulas contain
the weighted average cost of capital of the company (WACC). If it is estimated
within the traditional approach or the theory of Modigliani–Miller, it gives a lower
WACC value than the real value and, therefore, overestimates the capitalization of
both financially dependent and financially independent companies. Therefore, in
order to assess a company’s capitalization by the first two formulas, one needs to use
Brusov–Filatova–Orekhova formulas for weighted average cost of capital (WACC)
and equity cost, ke.
To calculate the equity cost in BFO approximation (last line in Table 3.5), one
first needs to use Brusov–Filatova–Orekhova formula for weighted average cost of
capital (WACC) (Brusov and Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b,
2013a, b, 2014a, b; Filatova et al. 2008).
References
of Modigliani–Miller, modified for a finite life–time company. Appl Financ Econ 21
(11):815–824
org/10.1080/23322039.2014.946150
perpetuity limit—Modigliani–Miller theory. J Rev Global Econ 3:175–185
taxation, 1st edn. Springer, Berlin, pp 1–368
7:37–62
Modigliani–Miller, modified for a finite life–time company. Bull FU 48:68–77
1954–1957. Am Econ Rev 56:333–391
Econ Rev 53:147–175
Chapter 4
Bankruptcy of the Famous Trade-Off
Theory
Within the modern theory of capital cost and capital structure by Brusov–Filatova–
Orekhova (Brusov and Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b,
2014a, b; Filatova et al. 2008), an analysis of the widely known trade-off theory has
been made. It is shown that suggestion about risky debt financing (and about growth
of credit rate near the bankruptcy) in opposite to waiting result does not lead to
growth of weighted average cost of capital (WACC) which still decreases with
leverage. This means the absence of minimum in the dependence of WACC on
leverage as well as the absence of maximum in the dependence of company
capitalization on leverage. Thus, it means that the optimal capital structure is absent
in the famous trade-off theory. The explanation to this fact has been done.
Under the condition of proved by us of insolvency of well-known classical trade-
off theory, the question of search of new mechanisms for the formation of a
company’s optimal capital structure, which will be different from one suggested
by trade-off theory, becomes very important. One of the real such mechanisms has
been developed by us in the next chapter.
4.1 Optimal Capital Structure of the Company
Choosing optimal capital structure of the company, i.e., proportion of debt and
equity, which minimizes weighted average cost of capital (WACC) and maximizes
the company capitalization, V, is one of the most important tasks of the financial
manager and the management of a company. The search for an optimal capital
structure, like the search for a “Golden Fleece,” attracts the attention of the econo-
mists and financiers during many tens of years. And it is clear why: someone,
nothing making, but only by changing the proportion between the values of equity
capital and debt one of the company, can significantly enhance the company
capitalization, in other words, he can fulfill the primary task and reach critical goal

https://doi.org/10.1007/978-3-319-99686-8_4
52 4 Bankruptcy of the Famous Trade-Off Theory
of the business management. Spend a little less of your own, loan slightly more
(or vice versa), and company capitalization reaches the maximum.
Note that the problem of capital structure is studied very intensively. There are
theories that consider the perfect markets (Brusov and Filatova 2011; Brusov et al.
2011a, b, c, 2012a, b, 2013a, b, 2014a, b; Filatova et al. 2008; Modigliani and Miller
1958, 1963, 1966) and other ones that consider the imperfect markets (Brennan and
Schwartz 1978, 1984; Leland 1994; Kane et al. 1984; Dittmar and Thakor 2007;
Bikhchandani et al. 1998; Post et al. 2002; Filbeck et al. 1996; Jenter 2005; Baker
and Wurgler 2002; Graham and Harvey 2001; Hovakimian et al. 2001; Myers and
Majluf 1984; Myers 1984; Fama and French 2004; Jensen et al. 1973).
Among the latter ones, we can mention agent cost theory (Jensen et al. 1973),
stakeholders theory (Post et al. 2002), manager investment autonomy (Dittmar and
Thakor 2007), information cascades (Bikhchandani et al. 1998), behavioral theories
(Filbeck et al. 1996; Jenter 2005; Baker and Wurgler 2002; Graham and Harvey
2001), signaling theory (Myers and Majluf 1984), and pecking order theory (Myers
1984; Hovakimian et al. 2001; Fama and French 2004). Historically, the conceptions
of the influence of capital structure on the well-being of shareholders have developed
not monotonically. We consider the traditional (empirical) approach (Brusov and
Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b, 2015, 2018a,
b, c, d; Filatova et al. 2008), the Modigliani and Miller theory (Мodigliani and Мiller
1958, 1963, 1966), trade-off theory (Brennan and Schwartz 1978; Leland 1994;
Brennan and Schwartz 1984; Kane et al. 1984), and modern Brusov–Filatova–
Orekhova theory of capital cost and capital structure (Brusov and Filatova 2011;
Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b; Filatova et al. 2008).
The Traditional Approach The traditional (empirical) approach told businessmen
that the weighted average cost of capital (WACC) and the associated company
capitalization, V ¼ CF/WACC, depend on the capital structure, the level of leverage.
Debt cost always turns out to be lower, than equity cost, because first one has lower
risk, because in the event of bankruptcy, creditor claims are met prior to shareholders
claims.
As a result, an increase in the proportion of lower-cost debt capital in the overall
capital structure up to the limit, which does not cause violation of financial sustain-
ability and growth in risk of bankruptcy, leads to lower weighted average cost of
capital (WACC).
The profitability required by investors (the equity cost) is growing; however, its
growth has not led to compensation of benefits from the use of lower-cost debt
capital. Therefore, the traditional approach welcomes the increased leverage L ¼ D/S
and the associated increase of company capitalization. The traditional (empirical)
approach has existed up to appearance of the first quantitative theory by Modigliani
and Miller (1958).
Modigliani–Miller Theory Modigliani and Miller (ММ) in their first paper (with-
out taxes) (Modigliani and Miller 1958) have come to the conclusion (based on
assumptions that there are no taxes, no transaction costs, no bankruptcy costs, that
perfect market exists with symmetric information, that there is equivalence in
4.1 Optimal Capital Structure of the Company 53
borrowing costs for both companies and investors, etc.) that the choosing of pro-
portion of debt and equity does not affect WACC and company value as well
(Fig. 2.2).
Most of Modigliani and Miller assumptions (Modigliani and Miller 1958), of
course, are unrealistic. Some assumptions can be removed without changing the
conclusions of the model. However, assuming no costs of bankruptcy and the
absence of taxes (or the presence of only corporate taxes) are crucial, the change
of these assumptions alters conclusions. The last two assumptions rule out the
possibility of signaling and agency costs theories and, thus, also constitute a critical
prerequisite.
Modigliani–Miller theory with taxes (see Chap. 2) leads to conclusion that in
accordance with formula obtained by them,
WACC ¼ k 0 ð1 wd T Þ, ð4:1Þ
weighted average cost of capital (WАСС) decreases continuously (Fig. 2.3) (WACC
decreases from k0 (at L ¼ 0) up to k0(1 T ) (at L ¼ 1), when the company is
financed entirely with borrowed funds). So, there is no optimal capital structure
within this theory. Below we modify Modigliani–Miller theory with taxes by taking
off the suggestion about riskless of debt capital, modeling the growth of risk of
bankruptcy by increase of credit rate, and show that optimal capital structure of the
company is still absent.
Trade-Off Theory Reduction in financial sustainability of companies and increase
of bankruptcy risk, which relate to the use of different forms of borrowing in the
formation of financial capital structure of the company, are increased with the
increasing of debt.
Modigliani–Miller theory did not take into account the bankruptcy risk and
related costs. From its version with the tax on profit, it follows that debt financing
brings only some benefits associated with tax benefits (tax shield). Since company
capitalization grows with leverage level and there is no compensating increase in the
debt cost, increasing of the capitalization requires only the use of debt financing.
This obvious contradiction with the real economy has created many theories,
which had tried to find a balance between the advantages and disadvantages of using
debt financing by the companies. The advantage is a reduction of weighted average
cost of capital (WACC) and the corresponding increase of capitalization of the
companies, V, and the drawback is that the increase of debt financing reduces the
financial sustainability of the companies and increases the financial distress and risk
of bankruptcy.
One of these theories is trade-off theory (Brennan and Schwartz 1978; Leland
1994). There are two versions of this theory: static and dynamic. Former one is based
on the fact that at the low leverage level, the benefits of debt financing are
manifested: when WACC drops with leverage, a company’s capitalization grows.
Starting with a certain leverage level, financial distress costs and risk of bank-
ruptcy are growing, the WACC begins to grow, and the value of the company begins
to fall. The leverage level, at which the value of tax benefits is approximately equal
to the cost of bankruptcy, determines the optimal (objective) capital structure.
While the static trade-off theory is a single-period model (Brennan and Schwartz
1978; Leland 1994), in the dynamic trade-off theory (Brennan and Schwartz 1984),
the financing decision depends on what the company anticipates in the next periods
and which will be a capital structure.
4.2 Absence of the Optimal Capital Structure in Modified

Modigliani–Miller Theory (MMM Theory)
Let us show first that in Modigliani–Miller theory (Мodigliani and Мiller 1958,
1963), modified by us by taking off the suggestion about risklessness of debt capital,
the optimal capital structure is still absent.
Consider the case of arbitrary dependence of debt cost on leverage f(L).
Suppose that debt cost kd is described by the following function:

kd0 ¼ const; at L L0
kd ¼ , ð4:2Þ
kd0 þ f ðLÞ; at L > L0
here f(L) is arbitrary (growing or decreasing) function of leverage level L. We are

interested in leverage levels L > L0, because at L < L0, the standard Modigliani–
Miller theory works and weighted average cost of capital (WACC) is decreased with
leverage
WACC ¼ k0 ð1 wd t Þ, ð4:3Þ
while an equity cost grows linearly with leverage
k e ¼ k0 þ Lðk 0 kd Þð1 t Þ, ð4:4Þ
here ke is an equity cost; k0 is an equity cost of financially independent company; kd

is debt cost; t is tax on profit rate; and WACC is a weighted average cost of capital.
In this case, for WACC, one has
1 L
WACC ¼ ke we þ kd wd ð1 t Þ ¼ k e þ kd ð1 t Þ
1þL 1þL ð4:5Þ
1
¼ ½ke þ k d Lð1 t Þ:
1þL
Substituting Eqs. (4.2) and (4.4) into (4.5), one has finally for weighted average
cost of capital (WACC)
4.3 Analysis of the Trade-Off Theory Within the Brusov–Filatova–Orekhova Theory 55
1
WACC ¼ k 0 þ Lð k 0 k d Þ ð 1 t Þ
1þL
1
þLkd ð1 t Þ ¼ ½k0 þ k 0 Lð1 t Þ ð4:6Þ
1þL
k 0 ½1 þ Lð1 t Þ
¼ ¼ k0 ½we þ wd ð1 t Þ ¼ k 0 ð1 wd t Þ:
1þL
One can see that weighted average cost of capital (WACC) does not depend on f
(L ). Moreover, it is described by the same expression (Eq. 4.3), as in the case of
riskless debt capital. Note that the obtained result is consistent with the conclusions
of Rubinstein (1973) and Stiglitz (1969) that company value within Modigliani–
Miller theory is not changed upon the introduction of riskiness of debt capital. In our
approximation, as well as at Hsia (1981), debt cost is not already constant.
Differentiating the weighted average cost of capital (WACC) with respect to
leverage level L, one has
½ð1 t Þð1 þ LÞ 1 Lð1 t Þ t

ðWACCÞ0L ¼ k 0 2
¼ k0 < 0: ð4:7Þ
ð 1 þ LÞ ð1 þ LÞ2
We have proved the following theorem:

In the modified Modigliani–Miller theory (allowing riskiness debt capital)
under arbitrary change of debt cost with leverage (growing, as well as decreasing),
weighted average cost of capital (WACC) always falls down with leverage. This
means the absence of the company’s optimal capital structure and proves insol-
vency of the well-known classical trade-off theory in its original formulation.
4.3 Analysis of the Trade-Off Theory Within

the Brusov–Filatova–Orekhova Theory
Modigliani and Miller (1958, 1963, 1966) assumed that all financial flows are
perpetuity. Because, in reality, the lifetime of the companies is always, of course,
finite, this condition is one of the weaknesses of the Modigliani and Miller theory.
Account of the finite lifetime of the companies changes all the formulas of Modi-
gliani and Miller drastically. The solution of the problem of weighted average cost of
capital (WACC) for the companies with arbitrary lifetime has been done for the first
time by Brusov–Filatova–Orekhova with coauthors (Brusov and Filatova 2011;
Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b; Filatova et al. 2008; Brusova
2011). Their theory has allowed to find hidden global causes of the global financial
crisis (Brusov et al. 2012b) (see Chap. 6 for details).
The main formula, received by them, is an algebraic equation of n + 1 power (here
n is the lifetime of company) to calculate weighted average cost of capital (WACC)
taking the form
¼ : ð4:8Þ
For n > 3, this equation can be solved numerically only. It is easy to use for this a
function “matching parameters” in the Excel.
Using Eq. (4.8), let us investigate the optimal capital structure in the trade-off
theory.
We are modeling the emergence of a financial volatility and of bankruptcy risk by
the growth of the cost of debt capital, kd, indicating that kd becomes risky, and its
growth represents a fee for the state of financial volatility and bankruptcy risk.
It is impossible to study such effects, as the growth of credit rate with leverage in
the theory of Modigliani and Miller (MM), because:
– MM theory considers two types of assets: risky equity capital and free of risk debt
capital.
– Weighted average cost of capital (WACC) in the theory of Modigliani and Miller
is determined by the following expression (Eq. 4.3), which depends on k0, wd,
and T and does NOT depend on kd. This is due to the fact that discounted value of
tax shield for an infinite period of time,
X
1
ðPVÞTS ¼ kd DT ð1 þ k d Þt ¼ DT ð4:9Þ
t¼1
with the use of kd as discount rate does NOT depend on kd.

In contrast to the theory of the Modigliani and Miller, in a modern theory of
capital cost and capital structure of the company by Brusov–Filatova–Orekhova
Filatova et al. 2008), discounted value of tax shield is valuated for finite period of
time n [lifetime of company or the time from the establishment of company up to the
present moment (n)] and depends on kd:
X
n
ðPVÞTS ¼ k d DT ð1 þ kd Þt ¼ DT ½1 ð1 þ k d Þn : ð4:10Þ
t¼1
Capitalization of a financially independent company is equal to
V 0 ¼ CF½1 ð1 þ k0 Þn =k0 ð4:11Þ
and capitalization of a financially dependent company is equal to
V ¼ CF½1 ð1 þ WACCÞn =WACC: ð4:12Þ

As a result, for weighted average cost of capital (WACC), the formula BFO is
derived
¼ ð4:13Þ
WACC k0 ½1 ωd T ð1 ð1 þ kd Þn Þ
and WACC now depends on kd.

We consider linear and quadratic growth of debt cost kd with leverage, starting
from some value (with different coefficients), different values of k0 and different
lifetime n of the companies. Let us find WACC values.
1. n ¼ 3; t ¼ 20%; L ¼ 0,1,2, . . .,10

0:07; at L 2
k0 ¼ 24%; kd ¼ : ð4:14Þ
0:07 þ 0:01ðL 2Þ2 ; at L > 2
See Table 4.1.

2. n ¼ 5; t ¼ 20%; L ¼ 0,1,2, . . .,10

0:07; at L 2
k0 ¼ 24%; kd ¼ : ð4:15Þ
0:07 þ 0:01ðL 2Þ2 ; at L > 2
See Table 4.2.

3. n ¼ 3; t ¼ 20%; L ¼ 0,1,2, . . .,10

0:07; at L 2
k0 ¼ 24%; kd ¼ : ð4:16Þ
0:07 þ 0:1ðL 2Þ2 ; at L > 2
See Table 4.3.

4. n ¼ 5; t ¼ 20%; L ¼ 0,1,2, . . .,10

0:07; at L 2
k0 ¼ 24%; kd ¼ : ð4:17Þ
0:07 þ 0:1ðL 2Þ2 ; at L > 2
See Table 4.4.

5. n ¼ 3; t ¼ 20%; L ¼ 0,1,2, . . .,10
58
Table 4.1 Dependence of WACC on L

n L 0 1 2 3 4 5 6 7 8 9 10
3 kd 0.07 0.07 0.07 0.08 0.11 0.16 0.23 0.32 0.43 0.56 0.71
k0 A 1.9813 2.0184 2.0311 2.0445 2.0703 2.1075 2.1520 2.1988 2.2438 2.2842 2.3186
0.24 WACC 0.2401 0.2279 0.2238 0.2195 0.2111 0.1997 0.1864 0.1730 0.1605 0.1496 0.1406
4 Bankruptcy of the Famous Trade-Off Theory
n L 0 1 2 3 4 5 6 7 8 9 10
5 kd 0.07 0.07 0.07 0.08 0.11 0.16 0.23 0.32 0.43 0.56 0.71
k0 A 2.7454 2.8265 2.8546 2.8835 2.9364 3.0080 3.0866 3.1605 3.2225 3.2703 3.3052
0.24 WACC 0.2400 0.2261 0.2215 0.2168 0.2083 0.1973 0.1858 0.1753 0.1669 0.1605 0.1560
4.3 Analysis of the Trade-Off Theory Within the Brusov–Filatova–Orekhova Theory
59
60

n L 0 1 2 3 4 5 6 7 8 9 10
3 kd 0.07 0.07 0.07 0.17 0.47 0.97 1.67 2.57 3.67 4.97 6.47
k0 A 1.9813 2.0184 2.0311 2.0996 2.2253 2.3170 2.3655 2.3904 2.4046 2.4137 2.4203
0.24 WACC 0.2401 0.2279 0.2238 0.2021 0.1656 0.1410 0.1289 0.1228 0.1193 0.1171 0.1156
n L 0 1 2 3 4 5 6 7 8 9 10
5 kd 0.07 0.07 0.07 0.17 0.47 0.97 1.67 2.57 3.67 4.97 6.47
k0 A 2.7454 2.8265 2.8546 2.9893 3.1801 3.2724 3.3084 3.3265 3.3387 3.3479 3.3554
0.24 WACC 0.2400 0.2261 0.2215 0.2001 0.1726 0.1603 0.1556 0.1533 0.1517 0.1506 0.1496
61

0:07; at L 2
k0 ¼ 24%; kd ¼ : ð4:18Þ
0:07 þ 0:01ðL 2Þ; at L > 2
See Table 4.5.

6. n ¼ 5; t ¼ 20%; L ¼ 0,1,2, . . .,10

0:07; at L 2
k0 ¼ 24%; kd ¼ : ð4:19Þ
0:07 þ 0:01ðL 2Þ; at L > 2
See Table 4.6.

7. n ¼ 3; t ¼ 20%; L ¼ 0,1,2, . . .,10

0:07; at L 2
k0 ¼ 24%; kd ¼ : ð4:20Þ
0:07 þ 0:1ðL 2Þ; at L > 2
See Table 4.7.

8. n ¼ 5; t ¼ 20%; L ¼ 0,1,2, . . .,10

0:07; at L 2
k0 ¼ 24%; kd ¼ : ð4:21Þ
0:07 þ 0:1ðL 2Þ; at L > 2
See Table 4.8.

9. n ¼ 3; t ¼ 20%; L ¼ 0,1,2, . . .,10

0:07; at L 2
k0 ¼ 12%; kd ¼ : ð4:22Þ
0:07 þ 0:01ðL 2Þ2 ; at L > 2
See Table 4.9.

10. n ¼ 5; t ¼ 20%; L ¼ 0,1,2, . . .,10

0:07; at L 2
k0 ¼ 12%; kd ¼ : ð4:23Þ
0:07 þ 0:01ðL 2Þ2 ; at L > 2
See Table 4.10.

11. n ¼ 3; t ¼ 20%; L ¼ 0,1,2, . . .,10
n L 0 1 2 3 4 5 6 7 8 9 10
3 kd 0.07 0.07 0.07 0.08 0.09 0.1 0.11 0.12 0.13 0.14 0.15
k0 A 1.9813 2.0184 2.0311 2.0445 2.0563 2.0670 2.0770 2.0865 2.0957 2.1044 2.1129
0.24 WACC 0.2401 0.2279 0.2238 0.2195 0.2159 0.2122 0.2090 0.2061 0.2033 0.2006 0.1981
63
64

n L 0 1 2 3 4 5 6 7 8 9 10
5 kd 0.07 0.07 0.07 0.08 0.09 0.1 0.11 0.12 0.13 0.14 0.15
k0 A 2.7454 2.8265 2.8546 2.8835 2.9083 2.9305 2.9511 2.9702 2.9883 3.0054 3.0216
0.24 WACC 0.2400 0.2261 0.2215 0.2168 0.2128 0.2093 0.2060 0.2031 0.2003 0.1977 0.1952
n L 0 1 2 3 4 5 6 7 8 9 10
3 kd 0.07 0.07 0.07 0.17 0.27 0.37 0.47 0.57 0.67 0.77 0.87
k0 A 1.9813 2.0184 2.0311 2.0996 2.1580 2.2060 2.2450 2.2768 2.3028 2.3242 2.3420
0.24 WACC 0.2401 0.2279 0.2238 0.2021 0.1847 0.1710 0.1602 0.1516 0.1447 0.1391 0.1346
65
66

n L 0 1 2 3 4 5 6 7 8 9 10
5 kd 0.07 0.07 0.07 0.17 0.27 0.37 0.47 0.57 0.67 0.77 0.87
k0 A 2.7454 2.8265 2.8546 2.9893 3.0902 3.1634 3.2164 3.2553 3.2843 3.3063 3.3232
0.24 WACC 0.2400 0.2261 0.2215 0.2001 0.1853 0.1749 0.1677 0.1625 0.1587 0.1559 0.1537
n L 0 1 2 3 4 5 6 7 8 9 10
3 kd 0.07 0.07 0.07 0.08 0.11 0.16 0.23 0.32 0.43 0.56 0.71
k0 A 2.4018 2.4468 2.4621 2.4785 2.5098 2.5548 2.6087 2.6655 2.7200 2.7690 2.8107
0.12 WACC 0.1200 0.1093 0.1057 0.1019 0.0948 0.0849 0.0734 0.0615 0.0506 0.0412 0.0333
67
68

n L 0 1 2 3 4 5 6 7 8 9 10
5 kd 0.07 0.07 0.07 0.08 0.11 0.16 0.23 0.32 0.43 0.56 0.71
k0 A 3.6048 3.7113 3.7482 3.7862 3.8556 3.9496 4.0528 4.1498 4.2312 4.2940 4.3399
0.12 WACC 0.1200 0.1084 0.1045 0.1005 0.0934 0.0841 0.0744 0.0655 0.0584 0.0530 0.0492

0:07; at L 2
k0 ¼ 12%; kd ¼ : ð4:24Þ
0:07 þ 0:1ðL 2Þ2 ; at L > 2
See Table 4.11.

12. n ¼ 5; t ¼ 20%; L ¼ 0,1,2, . . .,10

0:07; at L 2
k0 ¼ 12%; kd ¼ : ð4:25Þ
0:07 þ 0:1ðL 2Þ2 ; at L > 2
See Table 4.12.

One can see (Figs. 4.1, 4.2, 4.3, 4.4, 4.5, 4.6, 4.7, 4.8, 4.9, 4.10, 4.11, and 4.12)
that WACC(L ) is monotonically diminishing function. In spite of the fact that the
rise in the cost of debt financing was assumed, and fairly significant, WACC is not
growing with leverage.
In dependence of WACC(L ), a cupped zone (in the mathematical sense, WACC00L2
< 0) appears only, which more or less corresponds to the leverage level, at which the
increase in the cost of debt capital begins (in our case, L ¼ 2).
Note that distortion of the WACC(L ) dependence is mostly determined by the
function kd(L ) (linear or quadratic) and by the factors at (L 2) or (L 2)2. Linear
dependence of kd(L) distorts the WACC(L ) dependence less than square one, as well
as the smaller factor (0.01).
The change of the company’s lifetime (from 3 to 5 years) has a smaller effect,
although a bigger lifetime may lead to more substantial changes in WACC(L )
dependence. The reduction of a difference k0 kd between k0 and kd leads to an
increase of effect.
The main conclusion that can be drawn from the obtained results is the following:
the optimal capital structure in the well-known “trade-off” theory is missing,
contrary to hopes and expectations of its creators and supporters.
The question immediately appears: why this turned out to be possible, and how
this can be? How can the weighted average cost of capital
WACC ¼ we ke þ wd kd ð1 T Þ, ð4:26Þ
not grow if both kd and ke are growing? (ke is growing with leverage in accordance to
(Eq. 4.4), and kd is growing in accordance to our assumption).
The answer will be received in the next paragraph, where we are investigating the
dependence of equity cost ke on leverage L with the same assumptions about the risk
of debt capital and growth, as a consequence, of its cost with the leverage.
70

n L 0 1 2 3 4 5 6 7 8 9 10
3 kd 0.07 0.07 0.07 0.17 0.47 0.97 1.67 2.57 3.67 4.97 6.47
k0 A 2.4018 2.4468 2.4621 2.5452 2.6976 2.8087 2.8676 2.8978 2.9150 2.9260 2.9340
0.12 WACC 0.1200 0.1093 0.1057 0.0870 0.0551 0.0337 0.0230 0.0176 0.0146 0.0127 0.0113
n L 0 1 2 3 4 5 6 7 8 9 10
5 kd 0.07 0.07 0.07 0.17 0.47 0.97 1.67 2.57 3.67 4.97 6.47
k0 A 3.6048 3.7113 3.7482 3.9250 4.1755 4.2968 4.3440 4.3678 4.3838 4.3959 4.4058
0.12 WACC 0.1200 0.1084 0.1045 0.0866 0.0633 0.0528 0.0489 0.0468 0.0455 0.0445 0.0437
71
Fig. 4.1 Dependence of WACC on L


4.4 The Causes of Absence of the Optimum Capital

Structure in the Trade-Off Theory
So, we will investigate the dependence of the equity cost ke on leverage L with the
same assumptions about the risk of the debt and growth of its cost with leverage.
In the Modigliani–Miller theory, equity cost ke always grows with leverage, as
well as in Brusov–Filatova–Orekhova theory. In the latter one, however, an abnor-
mal effect, discovered by us, exists (Brusov et al. 2013a, b): decreasing of equity cost
ke with leverage L. This effect, which is absent in perpetuity Modigliani–Miller limit,
takes place under account of finite lifetime of the company at tax on profits rate,
4.4 The Causes of Absence of the Optimum Capital Structure in the Trade-Off Theory 75

which exceeds some value T*. At some ratios between debt cost and equity capital
cost, the discovered effect takes place at tax on profit rate, existing in western
countries and Russia. But this effect has been obtained under condition of a constant
debt cost kd. Let us see, how the growth of debt cost kd with leverage affects the
equity cost’s ke dependence on leverage. We will consider the same cases as above
for the calculations of dependences of WACC(L).
1. n ¼ 3; t ¼ 20%; L ¼ 0,1,2, . . .,10

0:07; at L 2
k 0 ¼ 24%; kd ¼ : ð4:27Þ
0:07 þ 0:01ðL 2Þ2 ; at L > 2
See Table 4.13.

2. n ¼ 5; t ¼ 20%; L ¼ 0,1,2, . . .,10

0:07; at L 2
k0 ¼ 24%; kd ¼ : ð4:28Þ
0:07 þ 0:01ðL 2Þ2 ; at L > 2
See Table 4.14.

3. n ¼ 3; t ¼ 20%; L ¼ 0,1,2, . . .,10

0:07; at L 2
k0 ¼ 24%; kd ¼ 2 : ð4:29Þ
0:07 þ 0:1ðL 2Þ ; at L > 2
See Table 4.15.

4. n ¼ 5; t ¼ 20%; L ¼ 0,1,2, . . .,10
Table 4.13 Dependence of equity cost ke on L
n L 0 1 2 3 4 5 6 7 8 9 10
3 kd 0.07 0.07 0.07 0.08 0.11 0.16 0.23 0.32 0.43 0.56 0.71
k0 A 1.9813 2.0184 2.0311 2.0445 2.0703 2.1075 2.1520 2.1988 2.2438 2.2842 2.3186
0.24 ke 0.2401 0.3997 0.5594 0.6861 0.7036 0.5581 0.2011 0.4081 1.3075 2.5356 4.133
4.4 The Causes of Absence of the Optimum Capital Structure in the Trade-Off Theory
77
78

n L 0 1 2 3 4 5 6 7 8 9 10
5 kd 0.07 0.07 0.07 0.08 0.11 0.16 0.23 0.32 0.43 0.56 0.71
k0 A 2.7454 2.8265 2.8546 2.8835 2.9364 3.0080 3.0866 3.1605 3.2225 3.2703 3.3052
0.24 ke 0.2400 0.3962 0.5524 0.6750 0.6897 0.5438 0.1966 0.3892 1.2501 2.4267 3.964
n L 0 1 2 3 4 5 6 7 8 9 10
3 kd 0.07 0.07 0.07 0.17 0.47 0.97 1.67 2.57 3.67 4.97 6.47
k0 A 1.9813 2.0184 2.0311 2.0996 2.2253 2.3170 2.3655 2.3904 2.4046 2.4137 2.4203
0.24 ke 0.2401 0.3997 0.5594 0.4003 0.6760 3.0339 7.1136 13.4098 22.4140 34.6126 50.489
79

0:07; at L 2
k 0 ¼ 24%; kd ¼ : ð4:30Þ
0:07 þ 0:1ðL 2Þ2 ; at L > 2
See Table 4.16.

5. n ¼ 3; t ¼ 20%; L ¼ 0,1,2, . . .,10

0:07; at L 2
k0 ¼ 24%; kd ¼ : ð4:31Þ
0:07 þ 0:01ðL 2Þ; at L > 2
See Table 4.17.

6. n ¼ 5; t ¼ 20%; L ¼ 0,1,2, . . .,10

0:07; at L 2
k0 ¼ 24%; kd ¼ : ð4:32Þ
0:07 þ 0:01ðL 2Þ; at L > 2
See Table 4.18.

7. n ¼ 3; t ¼ 20%; L ¼ 0,1,2, . . .,10

0:07; at L 2
k0 ¼ 24%; kd ¼ : ð4:33Þ
0:07 þ 0:1ðL 2Þ; at L > 2
See Table 4.19.

8. n ¼ 5; t ¼ 20%; L ¼ 0,1,2, . . .,10

0:07; at L 2
k0 ¼ 24%; kd ¼ : ð4:34Þ
0:07 þ 0:1ðL 2Þ; at L > 2
See Table 4.20.

9. n ¼ 3; t ¼ 20%; L ¼ 0,1,2, . . .,10

0:07; at L 2
k0 ¼ 12%; kd ¼ : ð4:35Þ
0:07 þ 0:01ðL 2Þ2 ; at L > 2
See Table 4.21.

10. n ¼ 5; t ¼ 20%; L ¼ 0,1,2, . . .,10
n L 0 1 2 3 4 5 6 7 8 9 10
5 kd 0.07 0.07 0.07 0.17 0.47 0.97 1.67 2.57 3.67 4.97 6.47
k0 A 2.7454 2.8265 2.8546 2.9893 3.1801 3.2724 3.3084 3.3265 3.3387 3.3479 3.3554
0.24 ke 0.2400 0.3962 0.5524 0.3926 0.6408 2.9184 6.9268 13.1658 22.1224 34.2784 50.114
81
82

n L 0 1 2 3 4 5 6 7 8 9 10
3 kd 0.07 0.07 0.07 0.08 0.09 0.1 0.11 0.12 0.13 0.14 0.15
k0 A 1.9813 2.0184 2.0311 2.0445 2.0563 2.0670 2.0770 2.0865 2.0957 2.1044 2.1129
0.24 ke 0.2401 0.3997 0.5594 0.6861 0.7913 0.8730 0.9353 0.9767 0.9976 0.9982 0.9787
n L 0 1 2 3 4 5 6 7 8 9 10
5 kd 0.07 0.07 0.07 0.08 0.09 0.1 0.11 0.12 0.13 0.14 0.15
k0 A 2.7454 2.8265 2.8546 2.8835 2.9083 2.9305 2.9511 2.9702 2.9883 3.0054 3.0216
0.24 ke 0.2400 0.3962 0.5524 0.6750 0.7759 0.8555 0.9143 0.9525 0.9706 0.9689 0.9477
83
84

n L 0 1 2 3 4 5 6 7 8 9 10
3 kd 0.07 0.07 0.07 0.17 0.27 0.37 0.47 0.57 0.67 0.77 0.87
k0 A 1.9813 2.0184 2.0311 2.0996 2.1580 2.2060 2.2450 2.2768 2.3028 2.3242 2.3420
0.24 ke 0.2401 0.3997 0.5594 0.4003 0.0594 0.4542 1.1348 1.9792 2.9855 4.1526 5.48
n L 0 1 2 3 4 5 6 7 8 9 10
5 kd 0.07 0.07 0.07 0.17 0.27 0.37 0.47 0.57 0.67 0.77 0.87
k0 A 2.7454 2.8265 2.8546 2.9893 3.0902 3.1634 3.2164 3.2553 3.2843 3.3063 3.3232
0.24 ke 0.2400 0.3962 0.5524 0.3926 0.0624 0.4304 1.0822 1.8920 2.8596 3.9853 5.269
85
86

n L 0 1 2 3 4 5 6 7 8 9 10
3 kd 0.07 0.07 0.07 0.08 0.11 0.16 0.23 0.32 0.43 0.56 0.71
k0 A 2.4018 2.4468 2.4621 2.4785 2.5098 2.5548 2.6087 2.6655 2.7200 2.7690 2.8107
0.12 ke 0.1200 0.1626 0.2051 0.2157 0.1222 0.1307 0.5904 1.2998 2.2963 3.6202 5.313

0:07; at L 2
k0 ¼ 12%; kd ¼ : ð4:36Þ
0:07 þ 0:01ðL 2Þ2 ; at L > 2
See Table 4.22.

11. n ¼ 3; t ¼ 20%; L ¼ 0,1,2, . . .,10

0:07; at L 2
k0 ¼ 12%; kd ¼ : ð4:37Þ
0:07 þ 0:1ðL 2Þ2 ; at L > 2
See Table 4.23.

12. n ¼ 5; t ¼ 20%; L ¼ 0,1,2, . . .,10

0:07; at L 2
k0 ¼ 12%; kd ¼ : ð4:38Þ
0:07 þ 0:1ðL 2Þ2 ; at L > 2
See Table 4.24.

An analysis of the obtained results (Figs. 4.13, 4.14, 4.15, 4.16, 4.17, 4.18, 4.19,
4.20, 4.21, 4.22, 4.23, and 4.24) leads to the following conclusions.
Under the turning on the growth of debt cost kd with leverage, the dependence of
equity cost ke on leverage is undergoing significant changes. The linear growth of
equity cost ke at low leverage level is changed by its fall, starting with some value L0.
The L0 value sometimes exactly correlates with the starting point of kd growth with
leverage (L0 ¼ 2) but sometimes takes values which are significantly higher (up to
L0 ¼ 8.5).
The speed of decreasing of equity cost ke with leverage increases with increasing
of growth factor of debt cost kd as well as under the transition to quadratic growth.
This is especially noticeable in the case 6, where there is a ke growth, up to the
leverage level L ¼ 8.5.
So, we come to the conclusion that the increase in the cost of debt capital kd with
leverage leads to the decrease of equity cost ke with leverage, starting with some
value L0. This is the cause of the absence of weighted average capital cost growth
with leverage at all its values.
Note that the results remain qualitatively the same, if one uses different depen-
dences of kd on leverage. For example, for the case of exponential growth of kd with
leverage
n ¼ 5; t ¼ 20%; L ¼ 0, 1, 2, . . . , 6,

0:12; at L 1
k 0 ¼ 22%; kd ¼ ð4:39Þ
0:12 þ 0:01 3L1 ; at L > 1
one gets the following dependence of kd, kd, and WACC on leverage (Fig. 4.25).
88

n L 0 1 2 3 4 5 6 7 8 9 10
5 kd 0.07 0.07 0.07 0.08 0.11 0.16 0.23 0.32 0.43 0.56 0.71
k0 A 3.6048 3.7113 3.7482 3.7862 3.8556 3.9496 4.0528 4.1498 4.2312 4.2940 4.3399
0.12 ke 0.1200 0.1607 0.2014 0.2100 0.1152 0.1352 0.5829 1.2677 2.2267 3.5020 5.139
n L 0 1 2 3 4 5 6 7 8 9 10
3 kd 0.07 0.07 0.07 0.17 0.47 0.97 1.67 2.57 3.67 4.97 6.47
k0 A 2.4018 2.4468 2.4621 2.5452 2.6976 2.8087 2.8676 2.8978 2.9150 2.9260 2.9340
0.12 ke 0.1200 0.1626 0.2051 0.0601 1.2286 3.6778 7.8553 14.2512 23.3566 35.6572 51.636
89
90

n L 0 1 2 3 4 5 6 7 8 9 10
5 kd 0.07 0.07 0.07 0.17 0.47 0.97 1.67 2.57 3.67 4.97 6.47
k0 A 3.6048 3.7113 3.7482 3.9250 4.1755 4.2968 4.3440 4.3678 4.3838 4.3959 4.4058
0.12 ke 0.1200 0.1607 0.2014 0.0615 1.1876 3.5634 7.6740 14.0175 23.0784 35.3389 51.279
Fig. 4.13 Dependence of equity cost ke on L




4.5 Conclusion 95
Fig. 4.25 Dependence of equity cost ke, debt cost kd, and WACC on leverage L
So, the conclusions made are independent of rate of growth of kd with leverage.
4.5 Conclusion
The analysis of the well-known trade-off theory, conducted with the help of modern
theory of capital structure and capital cost by Brusov–Filatova–Orekhova, has
shown that the suggestion of risky debt financing (and growth of a credit rate near
the bankruptcy) in opposite to waiting result does not lead to the growth of WACC,
which still decreases with leverage. This means the absence of minimum in the
dependence of WACC on leverage as well as the absence of maximum in the
dependence of capitalization V on leverage. Thus, this means that the optimal capital
structure is absent in the famous trade-off theory. The explanation to this fact has
been done within the same Brusov–Filatova–Orekhova theory by studying the
dependence of the equity cost ke on leverage. It turned out that the growth of debt
cost kd with leverage led to the decrease of equity cost ke with leverage, starting from
some leverage level, which is higher than starting point of debt cost growth. This
paradox conclusion gives the explanation of the absence of the optimal capital
structure in the famous trade-off theory. This means that competition of benefits
from the use of debt financing and of financial distress cost (or a bankruptcy cost) are
NOT balanced, and the hope that trade-off theory gives us the optimal capital
structure, unfortunately, is not realized.
The absence of the optimal capital structure in the trade-off theory questioned the
existence of an optimal capital structure of the company at all [but as authors have
shown, the optimal capital structure in the investments still exists (Brusov et al.
2011b)]. In the search for the “Golden Fleece,” one needs to switch to study of other
mechanisms for formation of the optimal capital structure of the company, different
from ones considered in the trade-off theory. And one of such mechanisms has been
discovered by us (see Chap. 5 for details).
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Chapter 5
New Mechanism of Formation
of the Company’s Optimal Capital
Structure, Different from Suggested
by Trade-Off Theory
5.1 Absence of Suggested Mechanism of Formation

of the Company’s Optimal Capital Structure Within
Modified Modigliani–Miller Theory (MMM Theory)
Analyzing the validity of the well-known trade-off theory (Brennan and Schwartz
1978, 1984; Leland 1994), we have investigated the problem of existing optimal
capital structure of company within Modigliani–Miller theory (Мodigliani and
Мiller 1958, 1963, 1966), modified by us by taking off the suggestion about
risklessness of debt capital (MMM theory), as well as within modern theory of
capital cost and capital structure by Brusov–Filatova–Orekhova (BFO theory) appli-
cable to companies with arbitrary lifetime and investment projects of arbitrary
duration (Brusov and Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b,
2014a, b, 2015, 2018a, b, c, d; Filatova et al. 2008; Brusova 2011). Within both
theories (МММ and BFO), the absence of the optimal capital structure has been
proved under the modeling of financial distress and danger of bankruptcy by increase
of debt cost. This proves the insolvency of the classical trade-off theory (Brusov
et al. 2013a), which is based on the following suggestions (Brennan and Schwartz
1978, 1984; Leland 1994).
At low leverage levels, the advantages of using debt financing (which is cheaper
than equity one) are connected to the fact that the weighted average cost of capital,
WACC, decreases with leverage and consequently the company capitalization
grows. Starting from some leverage level, financial distress appears and grows;
bankruptcy risk grows as well. The increase of WACC and consequently the
decrease of the company’s capitalization start. The leverage level, at which profits
of debt capital using are approximately equal to the bankruptcy cost, determines the
company’s optimal capital structure.
As our investigations show (Brusov et al. 2013a), within both theories, growth of
WACC and consequently decrease of the company’s capitalization are absent. We
have given the explanation of such a phenomenon: for leverage levels above some

https://doi.org/10.1007/978-3-319-99686-8_5
100 5 New Mechanism of Formation of the Company’s Optimal Capital. . .
value L *, the equity cost decreases with leverage, providing continuous (at all
leverage levels) fall down of WACC.
The conclusion, made by us, is as follows: the mechanism of formation of the
company’s optimal capital structure, suggested in the trade-off theory about 40 years
ago, turns out to be insolvent (Brusov et al. 2013a). From the other side, continuous
and unlimited fall of weighted average cost of capital (WACC) and, consequently,
unlimited growth of the company’s capitalization with leverage seem to contradict
the existing experience.
Willing to study the problem of the existing optimal capital structure of company,
we investigate the influence of debt cost on equity cost and on weighted average cost
of capital, WACC. We have discovered the presence of correlations between debt
cost and equity cost, which could give another mechanism of formation of optimal
capital structure of the company (different from the one suggested by the trade-off
theory) at leverage levels, which are far enough from the “critical” levels, at which
financial distress appears and the bankruptcy risk increases. The detailed description
of such a mechanism is the main purpose of this chapter.
Suggested mechanism of formation of the optimal capital structure of company is
based on the decrease of debt cost, which (in some range of leverage levels) is
determined by the growth of the debt volume.
As it has been shown in the previous chapter, in modified Modigliani–Miller
theory (MMM theory) (allowing riskiness debt capital), under arbitrary change of
debt cost with leverage (growing as well as decreasing), the weighted average cost of
capital (WACC) always falls with leverage. If one considers the growth of debt cost
with leverage, this means the absence of the optimal capital structure of company
and proves insolvency of the well-known classical trade-off theory in its original
formulation. If one considers the decrease of debt cost with leverage, this means the
absence of suggested mechanism of formation of the company’s optimal capital
structure within modified (by us) Modigliani–Miller theory. But, as it will be seen
below, situation turns out to be different in the modern theory of capital cost and
capital structure by Brusov–Filatova–Orekhova (BFO theory).
5.2 Formation of the Company’s Optimal Capital Structure

Within Brusov–Filatova–Orekhova (BFO) Theory
The situation is different in the modern theory of capital cost and capital structure by
Brusov–Filatova–Orekhova (BFO theory) (Brusov and Filatova 2011; Brusov et al.
2011a, b, c, 2012a, b, 2013a, b, 2014a, b; Filatova et al. 2008). As it will be shown
below, the decrease of debt cost with leverage leads to the formation of minimum in
the dependence of WACC on leverage at moderate leverage levels (far from the
“critical” levels, at which financial distress appears and the bankruptcy risk
increases). Existence of such minimum leads to the appearance of maximum in
capitalization of the company. So, we suggest a new mechanism of formation of the
5.2 Formation of the Company’s Optimal Capital Structure Within. . . 101
company’s optimal capital structure, different from the one suggested by the (already
insolvent) trade-off theory.
Before studying the problem within BFO theory (Brusov and Filatova 2011;
Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b; Filatova et al. 2008), let us
consider 1-year companies, which have been studied by Myers (2001). This case is
the particular case of more general BFO theory.
For the weighted average cost of capital (WACC) of a 1-year company, one has
1 þ k0
WACC ¼ k 0 kd wd t, ð5:1Þ
1 þ kd
where wd is the debt fraction.

The debt cost kd still has the following form:

k d0 ¼ const; at L L0
kd ¼ , ð5:2Þ
kd0 þ f ðLÞ; at L > L0
Thus, the weighted average cost of capital (WACC) at leverage levels L > L0 is
equal to
1 þ k0 L
WACC ¼ k 0 ðkd0 þ f ðLÞÞ t ð5:3Þ
1 þ kd0 þ f ðLÞ 1þL
and, obviously, depends on the form of f(L). Thus, the difference of the simplest case
of 1-year companies from perpetuity ones, which, as we have shown above in
previous chapter, is independent of the form of f(L), becomes obvious.
We will not analyze here 1-year companies in detail, but instead, we will go now
to analysis of companies with arbitrary lifetime (arbitrary age), described by BFO
theory (Brusov and Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b,
2014a, b; Filatova et al. 2008).
Let us consider a few types of dependences of debt cost on leverage f(L ).
Decrease of Debt Cost at Exponential Rate
We have the following parameters:
L0 ¼ 1; k 0 ¼ 0:22; kd ¼ 0:12; t ¼ 0:2
and the debt cost has the form

kd0 ¼ const; at L L0 ¼ 1
kd ¼ : ð5:4Þ
k d0 þ α α 3LL0 ; at L > L0 ¼ 1
Calculation of the weighted average cost of capital (WACC) will be done, using
the BFO formula:
¼ : ð5:5Þ
WACC n
k 0 1 t ð1þL
L
Þ ð1 ð1 þ k d Þ Þ
By the function “matching parameter” in Excel, we will find the weighted average
cost of capital (WACC) values.
Then, using obtained values of WACC, we will find the cost of equity values ke
by the formula
WACC ¼ ke we þ kd wd ð1 t Þ
ð5:6Þ
k e ¼ WACCð1 þ LÞ kd Lð1 t Þ:
Formula (Eq. 5.6) is the definition of the weighted average cost of capital,
WACC, for the case of existing of taxing.
The application of BFO formula (Eq. 5.5) is very wide: authors have applied it in
corporate finance, in investments, in taxing, in business valuation, in banking, and in
some other areas (Brusov and Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b,
2013a, b, 2014a, b; Filatova et al. 2008). Using this formula (Eq. 5.5), one can study
the dependence of the weighted average cost of capital, WACC, as well as the equity
cost ke on leverage level, L, on tax on profit rate, t, and on lifetime of the company, n.
The Case α ¼ 0.01 Let us consider first the case α ¼ 0.01.
We will study below the dependence of debt cost, kd; equity cost, ke; and
weighted average cost of capital, WACC, on leverage level L in case of exponential
decrease of kd (Table 5.1 and Figs. 5.1, 5.2, 5.3, 5.4, 5.5, 5.6, and 5.7).
The Case α ¼ 0.1 Let us consider now the case α ¼ 0.1 (Table 5.2 and Figs. 5.8,
5.9, 5.10, 5.11, 5.12, and 5.13).
Let us valuate the optimum position L* and its depth, ΔWACC, using obtained
results (see Table 5.3).
Table 5.1 kd, ke, and weighted average cost of capital, WACC, for companies with lifetimes (ages)
n ¼ 1, 3, 5, and 10
L 0 0.5 1 1.1 1.3 1.6 2 3 4
kd 0.12 0.12 0.12 0.1188 0.1161 0.1107 0.1 0.04 –0.14
WACC (n ¼ 1) 0.220 0.211 0.207 0.206 0.205 0.206 0.206 0.214 0.252
ke (n ¼ 1) 0.220 0.257 0.294 0.302 0.320 0.358 0.417 0.736 1.819
WACC (n ¼ 3) 0.219 0.208 0.201 0.201 0.199 0.199 0.198 0.209 0.279
ke (n ¼ 3) 0.219 0.252 0.281 0.291 0.307 0.340 0.395 0.716 1.955
WACC (n ¼ 5) 0.220 0.206 0.200 0.199 0.197 0.197 0.196 0.207 0.301
ke (n ¼ 5) 0.220 0.250 0.279 0.287 0.303 0.335 0.388 0.710 2.067
WACC 0.220 0.206 0.199 0.198 0.196 0.196 0.194 0.205 0.383
(n ¼ 10)
ke(n ¼ 10) 0.220 0.249 0.277 0.285 0.301 0.332 0.383 0.699 2.474
Fig. 5.1 Dependence of Kd(L)

debt cost kd on leverage 1
level L in case of its 0.8
exponential decrease at 0.6
α ¼ 0.01 0.4
0.2
0
–0.2
–0.4 0 1 2 3 4 5
–0.6
–0.8
L
Fig. 5.2 Dependence of

weighted average cost of
capital, WACC, on leverage
level L in case of
exponential decrease of debt
cost at α ¼ 0.01

equity cost ke on leverage
level L in case of its
exponential decrease at
α ¼ 0.01
Fig. 5.4 Dependence of n=1

debt cost kd, equity cost ke, 0.4
0.3 Ke
of capital, WACC, on
leverage level L in case of Wacc
exponential decrease of debt 0.2
cost, kd, at α ¼ 0.01 for a
1-year company 0.1
Kd
0
0 0.5 1 1.5 2 2.5 3 3.5
L

and weighted average cost Ke
0.3
0.2
cost kd, at α ¼ 0.01 for a 0.1 Kd
3-year company
0
0 0.5 1 1.5 2 2.5 3 3.5
L

of capital, WACC, on 0.3
0.2
cost, kd, at α ¼ 0.01 for a 0.1
5-year company Kd
0
0 0.5 1 1.5 2 2.5 3 3.5
L

0.3
0.2
10-year company Kd
0
0 0.5 1 1.5 2 2.5 3 3.5
L
Table 5.2 Debt cost kd and weighted average cost of capital, WACC, for companies with lifetimes
n ¼ 1, 3, 5, and 10
L 0 0.5 0.7 1 1.1 1.3 1.5 2 4
kd 0.12 0.12 0.12 0.12 0.108 0.081 0.047 –0.08 –2.48
WACC (n ¼ 1) 0.220 0.211 0.209 0.207 0.207 0.210 0.213 0.233 –0.107
ke (n ¼ 1) 0.220 0.257 0.272 0.294 0.316 0.377 0.463 0.860 9.384
WACC (n ¼ 3) 0.219 0.207 0.204 0.201 0.202 0.205 0.210 0.244 0.079
ke (n ¼ 3) 0.219 0.251 0.264 0.281 0.304 0.365 0.455 0.892 10.314
WACC (n ¼ 5) 0.220 0.207 0.204 0.200 0.200 0.203 0.208 0.252 0.132
ke (n ¼ 5) 0.220 0.250 0.262 0.279 0.301 0.362 0.451 0.916 10.578
WACC (n ¼ 10) 0.220 0.206 0.203 0.199 0.199 0.201 0.206 0.272 0.170
ke (n ¼ 10) 0.220 0.249 0.261 0.277 0.299 0.357 0.446 0.976 10.768
Fig. 5.8 Dependence of WACC (L)

weighted average cost of 0.225
capital, WACC, on leverage 0.220
level L in case of 0.215 n=1
cost, kd, at α ¼ 0.1 0.205 n=10 n=3
0.200
n=5
0.195
0 0.2 0.4 0.6 0.8 1 1.2 1.4
L

equity cost ke on leverage
level L in case of
cost, kd, at α ¼ 0.1

debt cost kd, equity cost ke,
0.3 Ke
0.2
cost, kd, at α ¼ 0.1 for a Kd
1-year company 0
–0.1 0.1 0.3 0.5 0.7 0.9 1.1 1.3 1.5
L

and weighted average cost 0.4
0.3 Ke
of capital, WACC, on Wacc
0.2
leverage level L in case of 0.1
exponential decrease of debt 0 Kd
cost, kd, at α ¼ 0.1 for a –0.1 0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2
3-year company –0.2
–0.3
L

of capital, WACC, on 0.4
Ke
leverage level L in case of 0.3 Wacc
5-year company Kd
0
–0.1 0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2
–0.2
L

0.3 Ke
Wacc
leverage level L in case of 0.2
cost, kd, at α ¼ 0.1 for a Kd
0
10-year company –0.1 0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2
–0.2
–0.3
L
Table 5.3 Optimum position L* and its depth ΔWACC for lifetimes n ¼ 1, 3, 5, and 10
Optimum position L* Optimum depth ΔWACC
n 1 3 5 10 1 3 5 10
α ¼ 0.01 1.3 2 2 2 1.7% 2.2% 2.4% 2.6%
α ¼ 0.1 1–1.1 1 1–1.1 1–1.1 1.5% 2.1% 2.2% 2.3%
The Quadratic Decrease of Debt Cost kd with Leverage Let us consider the
quadratic decrease of debt cost kd with leverage.
We will study below the dependence of debt cost kd, equity cost ke, and weighted
average cost of capital, WACC, on leverage level L in case of quadratic decrease of
kd..
We use the same parameters, as above
L0 ¼ 1; k 0 ¼ 0:22; kd ¼ 0:12; t ¼ 0:2
with the following dependence of debt cost kd on leverage:

kd0 ¼ const; at L L0 ¼ 1
kd ¼ : ð5:7Þ
k d0 α ðL L0 Þ2 ; at L > L0 ¼ 1
1-Year Companies Let us start from 1-year companies. For them, we get the
following results (Table 5.4 and Figs. 5.14 and 5.15).
Table 5.4 kd and WACC for 1-year companies

α L 0 0.2 0.4 0.6 0.8 1 2 3 4
wd 0.000 0.167 0.286 0.375 0.444 0.500 0.667 0.750 0.800
we 1.000 0.833 0.714 0.625 0.556 0.500 0.333 0.250 0.200
0.01 kd 0.12 0.12 0.12 0.12 0.12 0.12 0.11 0.08 0.03
0.1 kd 0.12 0.12 0.12 0.12 0.12 0.12 0.02
0.01 WACC 0.220 0.213 0.208 0.204 0.201 0.199 0.193 0.195 0.207
0.1 WACC 0.220 0.213 0.208 0.204 0.201 0.199 0.213
0.01 ke 0.22 0.24 0.25 0.27 0.29 0.3 0.4 0.59 0.94
0.1 ke 0.22 0.24 0.25 0.27 0.29 0.3 0.61
Fig. 5.14 Dependence of WACC(L), Ke(L), Kd(L) at α = 0.01

debt cost kd, equity cost ke, 100%
90%
leverage level L in case of 80%
quadratic decrease of debt 70%
cost kd, at α ¼ 0.01 for a
1-year company 60%
50%
40%
30%
20%
10%
0%
0 1 2 3 4 5
L

60%
leverage level L in case of
quadratic decrease of debt
cost, kd, at α ¼ 0.1 for a 50%
1-year company
40%
30%
20%
10%
0%
0 1 2 3 4 5
L
3-Year Companies For 3-year companies, we get the following results (Table 5.5
and Figs. 5.16 and 5.17).

α L 0 0.2 0.4 0.6 0.8 1 2 3 4
wd 0.000 0.167 0.286 0.375 0.444 0.500 0.667 0.750 0.800
we 1.000 0.833 0.714 0.625 0.556 0.500 0.333 0.250 0.200
0.01 kd 0.12 0.12 0.12 0.12 0.12 0.12 0.11 0.08 0.03
0.1 kd 0.12 0.12 0.12 0.12 0.12 0.12 0.02
0.01 WACC 0.220 0.214 0.210 0.207 0.205 0.203 0.199 0.202 0.212
0.1 WACC 0.220 0.214 0.210 0.207 0.205 0.203 0.215
0.01 ke 0.22 0.24 0.26 0.27 0.29 0.31 0.42 0.62 0.97
0.1 ke 0.22 0.24 0.26 0.27 0.29 0.31 0.61

100%
leverage level L in case of
3-year company
60%
40%
20%
0%
0 1 2 3 4 5
L

3-year company
40%
30%
20%
10%
0%
0 1 2 3 4 5
L
5-Year Companies For 5-year companies, we get the following results (Table 5.6
and Figs. 5.18 and 5.19).

α L 0 0.2 0.4 0.6 0.8 1 2 3 4
wd 0.000 0.167 0.286 0.375 0.444 0.500 0.667 0.750 0.800
we 1.000 0.833 0.714 0.625 0.556 0.500 0.333 0.250 0.200
0.01 kd 0.12 0.12 0.12 0.12 0.12 0.12 0.11 0.08 0.03
0.1 kd 0.12 0.12 0.12 0.12 0.12 0.12 0.02
0.01 WACC 0.220 0.213 0.208 0.205 0.202 0.200 0.194 0.197 0.210
0.1 WACC 0.220 0.213 0.208 0.205 0.202 0.200 0.214
0.01 ke 0.22 0.24 0.25 0.27 0.29 0.3 0.41 0.6 0.95
0.1 ke 0.22 0.24 0.25 0.27 0.29 0.3 0.61

and weighted average cost 90%
quadratic decrease of debt 70%
5-year company 60%
50%
40%
30%
20%
10%
0%
0 1 2 3 4 5
L

5-year company
40%
30%
20%
10%
0%
0 1 2 3 4 5
L
10-Year Companies For 10-year companies, we get the following results

(Table 5.7 and Figs. 5.20 and 5.21).

α L 0 0.2 0.4 0.6 0.8 1 2 3 4
wd 0.000 0.167 0.286 0.375 0.444 0.500 0.667 0.750 0.800
we 1.000 0.833 0.714 0.625 0.556 0.500 0.333 0.250 0.200
0.01 kd 0.12 0.12 0.12 0.12 0.12 0.12 0.11 0.08 0.03
0.1 kd 0.12 0.12 0.12 0.12 0.12 0.12 0.02
0.01 WACC 0.220 0.213 0.208 0.205 0.202 0.200 0.194 0.197 0.210
0.1 WACC 0.220 0.213 0.208 0.205 0.202 0.200 0.214
0.01 ke 0.22 0.24 0.25 0.27 0.29 0.3 0.41 0.6 0.95
0.1 ke 0.22 0.24 0.25 0.27 0.29 0.3 0.61

90%
10-year company
60%
50%
40%
30%
20%
10%
0%
0 1 2 3 4 5
L

50%
10-year company
40%
30%
20%
10%
0%
0 1 2 3 4 5
L
Table 5.8 Optimum position L* and its depth ΔWACC for lifetimes n ¼ 1, 3, 5, and 10
Optimum position L* Optimum depth ΔWACC
n 1 3 5 10 1 3 5 10
α ¼ 0.01 2 2 2 2 2.7% 2.1% 2.6% 2.6%
α ¼ 0.1 1–1.1 1 1–1.1 1–1.1 2.1% 1.7% 2.2% 2.2%
Let us valuate the optimum position L* and its depth ΔWACC using obtained
results (Table 5.8).
Discussion of Results Thus, we have considered the impact of reducing the cost of
debt kd with increases of debt volume. We deal with two cases: quadratic and an
exponential dependence of cost of debt kd on leverage. We have considered as well
other dependences, giving similar results.
It is shown that in considered cases, the equity capital cost of firm correlates with
the debt cost, which leads to the emergence of an optimal capital structure of
companies. Cause of the emergence of an optimal structure is that the speed of
increase of equity cost ke of the firm begins to grow, starting from some leverage
level L *, which not only compensates the fall in cost of debt kd with leverage but has
also led to an increase in weighted average cost of capital (WACC) with leverage,
starting from some leverage level. This leverage level determines the optimal capital
structure of company.
5.3 Simple Model of Proposed Mechanism 113
It was found that in all examined cases (quadratic as well as exponential one fall
of debt cost), in case of weak drops in debt cost with leverage (α ¼ 0.01), the optimal
capital structure of the company is formed at bigger leverage values, than the
beginning of the fall (in our case L∗ / 2L0), and in the case of a stronger fall of kd
(α ¼ 0.1), the optimal capital structure of the company is formed directly above the
start point of the fall of k d (L∗ L0).
It turns out that the depth of optimum (and, accordingly, the achieved in optimum
company capitalization) is bigger at weak drops of debt cost with leverage
(α ¼ 0.01), that is, due to the more long-term fall of the weighted average cost of
capital (WACC) with leverage L in this case.
5.3 Simple Model of Proposed Mechanism
The features of the proposed mechanism can be demonstrated at its simplest example
of step-like dependence of debt cost on leverage in the BFO model.
Let us suppose

kd1 ¼ 0:12 ¼ const; at L L0
kd ¼ ; k0 ¼ 0:18; L0 ¼ 5: ð5:8Þ
kd2 ¼ 0:06 ¼ const; at L > L0
We will find the dependence WACC(L ) for 2-year and 4-year companies at
T ¼ 0.2.
The calculations will be done in MS Excel using BFO formula:
¼ , ð5:9Þ
WACC k 0 1 wd T ð1 ð1 þ k d Þn Þ
where
L
wd ¼ :
1þL
For a 2-year company, one gets the following results (Table 5.9).
They are illustrated at Fig. 5.22.
Table 5.9 Dependence of WACC(L ) for company with lifetime n ¼ 2

L 0 1 2 3 4 5 6 7 8 9 10
WACC, % 18 16.33 15.8 15.52 15.35 15.23 16.45 16.42 16.39 16.37 16.35
Fig. 5.22 Dependence of WACC(L); n=2

weighted average cost of 18.50%
18.00%
level L in case of step-like
decrease of debt cost for a 17.50%
2-year company
WACC
17.00%
16.50%
16.00%
15.50%
15.00%
0 2 4 6 8 10
L
Fig. 5.23 Dependence of WACC(L); n=4

level L in case of step-like 17.50%
decrease of debt cost for a
WACC
4-year company 16.50%
15.50%
14.50%
13.50%
0 2 4 6 8 10
L
Similar calculations for a 4-year company are given at Fig. 5.23.

Let us compose the mutual figure for a 2-year company and for a 4-year company
(Fig. 5.24).
Fig. 5.24 Dependence of WACC(L); n=2 & n=4

level L in case of step-like
17.50%
decrease of debt cost for
2-year (two upper curves)
and 4-year companies (two 16.50%
WACC
lower curves)
15.50%
14.50%
13.50%
0 2 4 6 8 10
L
5.4 Conclusion 115
It can be easily seen that the weighted average cost of capital, WACC, decreasing
with leverage, in descending point of cost of credit, has a gap (jump up) and then
continues to decrease, however, with a slower speed, corresponding to the higher
leverage levels. This means that there is an optimum (minimum) in the dependence
of weighted average cost of capital (WACC) on leverage. The optimum depth in this
model is equal to the gap value in the descending point of cost of credit.
With increase of the lifetime of companies, the total lower of graph takes place:
weighted average cost of capital (WACC) decreases. The optimum depth does not
change: for biennial and quadrennial companies, it remains equal to 1.32% (for this
values set of k0, kd, Δkd, L0).
It should be noted that this model with step-like decrease of debt cost, in spite of
its simplicity, turns out to be realistic: many credit organizations use this scheme. For
continuous descending of credit cost, weighted average cost of capital, WACC, is
also continuous, and minimum is described by a more familiar bowl, as it was shown
above for exponential and quadratic decrease of credit cost.
5.4 Conclusion
1. The Modigliani–Miller theory in its classical version does not consider risky debt
funds in principle; therefore, within this theory, it is not possible to investigate the
current problem.
2. In the modified (by us) theory of Modigliani–Miller, with the modeling of
riskiness of debt funds by dependence of their cost on leverage level, as shown
in this chapter, at arbitrary change of debt cost with leverage (the growing as well
as the falling), the weighted average cost of capital (WACC) always decreases
with leverage, which demonstrates the absence of the optimal capital structure
and proves insolvency of the well-known classical trade-off theory in its original
formulation as well as the inability to implement the mechanism of formation of
an optimal capital structure proposed in this chapter.
3. Within modern theory of capital cost and capital structure by Brusov–Filatova–
Orekhova (BFO theory), it is shown that decrease of debt cost with leverage leads
to the formation of minimum in dependence of the weighted average cost of
capital (WACC) on leverage at moderate leverage levels (far from critical ones, at
which financial distressed appear and the bankruptcy risk increases). Existence of
minimum in dependence of the weighted average cost of capital (WACC) on
leverage leads to maximum in company capitalization (Fig. 5.25).
Thus, a new mechanism of formation of optimal capital structure of the
company, different from the one suggested by trade-off theory (now insolvent)
and which is based on the decrease of debt cost with leverage, has been developed
by us and is described in this chapter.
The cause of optimum formation is as follows: decrease of debt cost with leverage
leads to more significant growth of equity cost, which is not compensated by the fall
Fig. 5.25 Mechanism of k

formation of optimal capital
structure of the company,
different from the one
suggested by the trade-off
theory. Decrease of debt
cost with increase of credit k0
volume in leverage range ke
from L0 up to L1 leads to the
formation of optimum in
dependence of WACC(L) at kd
L ¼ Lopt
kd
WACC
L0 L opt L1 L
of the debt cost, and WACC starts to increase with leverage at some (moderate)
leverage level. From the other side, the increase of debt cost with leverage at higher
leverage level, as we have shown before (Brusov et al. 2013a), leads to the fall of
WACC with leverage. Thus, within BFO theory, under suggestion of decrease of
debt cost at moderate leverage levels and of its increase at high leverage levels,
WACC first decreases with leverage and then, going through minimum, starts to
grow and finally fall again already continuously (under growing or constant debt
cost). Note that continuous fall of WACC with leverage at high leverage levels has
been proved by us in the previous chapter (see also Brusov et al. 2013a), where the
insolvency of the well-known classical trade-off theory has been demonstrated.
Obtained conclusions do not depend qualitatively on velocity of debt cost fall.
Only optimum depth and its position (but not its existence) depend on the particular
form of dependence of debt cost on leverage [mainly on velocity of debt cost fall and
significantly less on the particular form of function f(L )].
References
Brennan M, Schwartz E (1978) Corporate income taxes, valuation, and the problem of optimal
capital structure. J Bus 51:103–114
Brennan M, Schwartz E (1984) Optimal financial policy and firm valuation. J Financ 39:593–607
(11):815–824
References 117
org/10.1080/23322039.2014.946150
7:37–62
Leland H (1994) Corporate debt value, bond covenants, and optimal capital structure. J Financ 49
(4):1213–1252
Myers S (2001) Capital structure. J Econ Perspect 15:81–102
Econ Rev 53:147–175
1954–1957. Am Econ Rev 56:333–391
Chapter 6
The Global Causes of the Global Financial
Crisis
Whether it is possible to manage the finance, being unable to properly assess them
Hopes of ending the financial crisis did not materialize. Recent events (the
problems of the euro zone, the threat of default in the USA, the collapse of the
financial market after a reduction of the credit rating of the USA, debt problems in
the world (Europe, USA), etc.) show that the crisis deepened, affecting new areas
and taking on a systemic character.
It becomes clear that we need in-depth analysis of its general, systemic causes. In
this chapter, we describe recent results in this field, obtained by the authors.
Analysts have called for a lot of particular specific reasons that have led to the
global financial crisis in 2008: the crisis in mortgage lending in the USA, unscru-
pulous financial statements of a number of leading investment funds, problems in the
booming derivatives market in recent years, and others.
But, as our recent researches show, there are also global, fundamental causes of
the current and future financial crises. And one important cause of this is the wrong
long-term systematic assessment of key financial parameters of companies: their
capitalization and the value of attracting funds, including the cost of equity and
weighted average cost of capital. To illustrate the importance of a correct evaluation
of financial parameters, we give only one example, associated with a reduction of the
credit rating of the USA.
When the rating agency Standard & Poor’s informed the Obama administration
about the decision to lower credit ratings, the White House has pointed out to
representatives of S&P an error in its calculations in the trillions of dollars. After
the official downgrade of the US credit rating, the government has publicly stated
about these errors. The representative of the US Treasury Department stated: “Built
on an error in the $2 trillion in the analysis of S&P, which led to a decrease in the
rating speaks for itself.” Last month, S&P warned that only spending budget cuts by
$4 trillion will be able to prevent a fall. However, Congress approved the plan, which
included a reduction by only $2.4 trillion over 10 years. According to the estimates
of S&P, this means that the US foreign debt could reach 74% of GDP by the end of
2011, 79% by 2015, and 85% by 2021. Moody’s and Fitch Ratings, in turn, affirmed

https://doi.org/10.1007/978-3-319-99686-8_6
120 6 The Global Causes of the Global Financial Crisis
the top rating of the USA after Barack Obama signed the bill, preventing default on
August 2.
Thus, we have, on the one hand, the White House, President Obama (stated that
America always will be the country with the AAA rating), and agencies Moody’s
and Fitch and, on the other hand, agency Standard & Poor’s, whose decision brought
down the markets on August 8, 2011, and the difference in the assessment of about
$2 trillion.
Leaving aside the question of a possible trade of insider information, we note that
this is a striking example which demonstrates the great importance of quantitative
assessments in the finance areas and the utmost responsibility in financial
calculations.
As it has been shown by us (Brusov et al. 2012b), a primary cause of the crisis of
2008 was a mortgage crisis in the USA, which is associated with overvalued
capitalization of mortgage companies by rating agencies, using incorrect Modigliani
and Miller (MM) theory. This reason is now (in 2015) understood by the US
Government, which requires $1 billion from rating agency Standard & Poor’s for
overvalued capitalization of mortgage companies.
And let us cite the last news on this topic from The New York Times (2015/01/
21):
The international rating agency Standard & Poor’s has agreed to pay nearly
$80 million fine to the US authorities. The relevant agreements S&P has reached
with the Securities and Exchange Commission. The Agency also agreed to take the
annual “timeout” and to refrain from assign a rating of a number of investments
in commercial mortgage. For the purposes of this agreement the fine in the $1.37
billion threatens to the agency on the case of inflated ratings.
Let us pose the rhetorical question: whether it is possible to manage by the
finance, being unable to properly consider them.
The current system of assessment of key financial parameters of the companies
goes back to Nobel Prize winners Modigliani and Miller (Мodigliani and Мiller
1958, 1963, 1966), who half a century ago replaced existing at that time empirical
intuitive approach (let’s call it traditional). The theory of Modigliani–Miller has been
established under a number of limitations, which obviously had a rough model
character and had a very weak relationship to the real economy. Among the
limitations, it is sufficient to mention the lack of corporate and individual income
taxes, perpetuity (infinite lifetime) of the companies, the existence of perfect mar-
kets, etc. Some restrictions (such as a lack of corporate and individual income taxes,
etc.) were removed later by the authors themselves and their followers, while others
(such as perpetuity of companies) remained in the approach of Modigliani–Miller,
until recently. However, since the theory of Modigliani–Miller (Мodigliani and
Мiller 1958, 1963, 1966) was the first quantitative theory, and since finance is
essentially a quantitative science, the theory has become widely used in practice,
since it gave even inaccurate, even rude, but at least some quantitative estimates of
key financial parameters of companies; thus, it was necessary as an air for forecast-
ing activities of the companies and to make informed management decisions.
Widespread use of the Modigliani–Miller theory, as usual, led to the neglect of
restrictions on which it was based and to the absolutization of the theory.
6 The Global Causes of the Global Financial Crisis 121
As it has been shown by Brusov–Filatova–Orekhova (Brusov and Filatova 2011;

Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b, 2018a, b, c, d; Filatova et al.
2008), the theory of Modigliani–Miller (Мodigliani and Мiller 1958, 1963, 1966), to
put it mildly, does not adequately evaluate the most important financial indicators of
the company. It yields significantly lower estimates of weighted average cost of
capital and of the value of its equity, compared with the actual estimates. This
underestimation leads to overestimated values of capitalization of the company.
The first researcher, who drew attention to the fact that the calculations of
weighted average cost of capital in the theory of Modigliani–Miller are inaccurate,
was Myers (2001), who derived a formula for the weighted average cost of capital,
WACC, for a 1-year project. He suggested that the estimate given by the theory of
Modigliani–Miller is the lowest bound estimate of weighted average cost of capital
[our recent discovery; Brusov et al. (2015a, b) show that, however, this statement by
Myers, generally speaking, turns out to be wrong (see Chap. 18 for details)].
The general solution of the problem of weighted average cost of capital for
companies of arbitrary age or with an arbitrary finite lifetime was first obtained by
Brusov–Filatova–Orekhova (Brusov and Filatova 2011; Brusov et al. 2011a, b, c,
2012a, b, 2013a, b, 2014a, b, 2018a, b, c, d; Filatova et al. 2008).
Note that the results of their theory are applicable not only to companies with a
finite lifetime, which had completed its work, but also to existing companies which
give the opportunity to assess the real value of equity cost and its weighted average
capital cost, supposing that the company existed to date n years (is an n years old).
Let us give a couple of graphic illustrations of their results, for equity cost and for
weighted average capital cost (Figs. 6.1 and 6.2).
Fig. 6.1 Dependence of the ke

equity cost, ke, on leverage t = 0(any n)
L in the absence of corporate
taxes [the upper line (t ¼ 0)],
as well as in the presence of
corporate taxes [for 1-year n=1
(n ¼ 1) and perpetuity
companies (n ¼ 1)].
Dependences of the cost of n=∞
equity capital of companies,
ke, with an intermediate
lifetime (1 < n < 1) lie k0
within the shaded region
0 L
Fig. 6.2 The dependence of the WACC on debt share wd for companies with different lifetimes for
different cost of equity, k0 (in each triplet, upper curve corresponds to n ¼ 1, middle one to n ¼ 2,
and bottom one to n ¼ 1)
Results obtained by Brusov–Filatova–Orekhova (Brusov and Filatova 2011;

Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b; Filatova et al. 2008) show
that the theory of Modigliani–Miller (Мodigliani and Мiller 1958, 1963, 1966), due
to its perpetuity, underestimates (and often significantly) an assessment of weighted
average cost of capital, cost of equity of the company, and inflating (also often
significant) estimate of the capitalization of leverage companies as well as of
financially independent companies.
Such incorrect estimations of the basic financial parameters of companies lead
to an underestimation of the financial risks, the impossibility, or severe difficulties
in making appropriate management decisions, which is one of the implicit reasons
for the financial crisis.
Brusova (2011) has made a comparative analysis of the calculation of the cost of
equity and weighted average cost of capital of one of the leading telecommunication
companies in Russia by three methods: traditional, Modigliani–Miller method, and
Brusov–Filatova–Orekhova. She has shown that the least accurate is the traditional
6 The Global Causes of the Global Financial Crisis 123
Fig. 6.3 Dependence of the 60 k, %

weighted average cost of ke
capital of the company,
50 ke
WACC, and equity cost, ke,
on leverage by traditional
method (lines 3, 6), by 4
40
Modigliani–Miller method 5
(lines 2, 5), and by Brusov– 6
Filatova–Orekhova method
30 ke
(lines 1, 4) 1 WACC
20 2 WACC
3
WACC
10
0 L
0 0.5 1 1.5 2 2.5 3
approach. Better results are obtained by the method of Modigliani–Miller (and this
was the reason that it is used more than half a century). And the most relevant results
are provided by the Brusov–Filatova–Orekhova method (Fig. 6.3). (See Chap. 17 for
more details.)
Note that the present methods of estimation of the main financial parameters of
companies are a blend of the traditional approach and the method of Modigliani–
Miller. If we will continue the use of the existing system of evaluation of financial
indicators, it will inevitably be the hidden global cause of new financial crises
because it does not allow us to make informed management decisions. The danger
of the situation found by us is that the causes for the crisis do not lie on the surface;
they are implicit and hidden, though no less important and significant. Therefore, the
problem of their identification and disclosure is extremely important and relevant.
Informed–so protected.
Authors are working now on the development of methodology for assessing the
key financial parameters of the companies on the basis of the Brusov–Filatova–
Orekhova theory.
The conclusion is that we must globally transform the system of assessment of
key financial parameters of companies, their capitalization, the cost of equity, and
weighted average cost of capital, in order to lower the financial risks. This will
lower the danger of global financial crisis.
The authors are aware of the complexity of the task—to transform the world’s
system of evaluation of the basic financial parameters of the companies to a new,
more realistic basis, it will take years and years, but there is no other way for the
world economic community.
References
(11):815–824
org/10.1080/23322039.2014.946150
Brusov P, Filatova T, Orehova N, Eskindarov M (2015a) Modern corporate finance, investment and
Brusov P, Filatova T, Orehova N, Kulik V (2015b) The golden age of the company. J Rev Global
Econ 4:21–42
7:37–62
capital and equity cost of company. Financ Anal Probl Sol 34(76):36–42
Econ Rev 53:147–175
1954–1957. Am Econ Rev 56:333–391
Chapter 7
The Role of Taxing and Leverage
in Evaluation of Capital Cost
and Capitalization of the Company
In this chapter, the role of tax shield, taxes, and leverage in the modern theory of
corporate finance is investigated. Modigliani–Miller theory and modern theory of
capital cost and capital structure by Brusov–Filatova–Orekhova are considered. It is
shown that the equity cost, as well as the weighted average cost of capital, decreases
with the tax on profit rate, while the capitalization increases. The detailed investi-
gation of the dependence of the weighted average cost of capital (WACC) and the
equity cost ke on the tax on profit rate at fixed leverage (debt capital fraction wd) and
on the leverage level at fixed tax on profit rate, as well as the dependence of WACC
and ke on company lifetime (age), is made. We have introduced the concept of tax
operation leverage. For companies with finite lifetime (finite age), a number of
important qualitative effects, which have no analogies for perpetuity companies,
are found.
In Chap. 2, it has been noted that Modigliani and Miller in their paper in 1958
(Мodigliani and Мiller 1958) have come to conclusions, which are fundamentally
different from the conclusions of traditional approach. They have shown that, in the
framework of assumptions made by them, the ratio between equity and debt capital
in the company neither affects the cost of capital nor the company value.
In the context of the study of the impact of tax on profit rate on the cost of capital
and on the company capitalization, we raised among the numerous assumptions of
Modigliani and Miller two of the most important:
1. Corporate taxes and taxes on personal income of investors are absent.
2. All financial flows are perpetuity ones.
From the first of these assumptions, Modigliani and Miller subsequently refused
themselves and have modified their theory to the case of the presence of corporate
taxes and taxes on personal income of investors that have significantly altered the
conclusions of their theory (Мodigliani and Мiller 1963, 1966).
The failure of the second assumption has led to the creation of modern theory of
capital cost and capital structure by Brusov–Filatova–Orekhova (BFO theory)

https://doi.org/10.1007/978-3-319-99686-8_7
126 7 The Role of Taxing and Leverage in Evaluation of Capital Cost and. . .
(Brusov and Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b,
2015, 2018a, b, c, d; Filatova et al. 2008; Brusova 2011).
7.1 The Role of Taxes in Modigliani–Miller Theory
We analyze now the role of taxes in the Modigliani–Miller theory, studying the
dependence of weighted average cost of capital (WACC) and the equity cost ke of tax
on profit rate T.
With this purpose, we analyze the following formulas:
1. For weighted average cost of capital (WACC), one has
WACC ¼ k 0 ð1 wd T Þ, ð7:1Þ
WACC ¼ k0 ð1 LT=ð1 þ LÞÞ;
2. For the equity cost ke, one has
ke ¼ k 0 þ Lð1 T Þðk 0 kd Þ: ð7:2Þ
Both dependences are linear: both costs of capital decrease linearly with the
increase of tax on profit rate T.
For dependence of weighted average cost of capital (WACC) on tax on profit rate
T, negative tangent of tilt angle in tgβ ¼ k0L/(1 + L) is growing in the module with
the increase of the leverage level, L, achieving maximum, equal to k0 at an infinite
leverage level L ¼ 1 (share of equity capital is insignificantly small compared with
the fraction of debt funds) (Fig. 7.1).
Let us give a few examples:
1. In accordance with expression tgβ ¼ k0L/(1 + L ), one gets that at k0 ¼ 10% and
L ¼ 1, i.e., D ¼ S, increase of tax on profit rate T on 10% leads to decrease of
weighted average cost of capital (WACC) on 0.5%.
2. This dependence of weighted average cost of capital (WACC) on tax on profit
rate T will be even more significant at a higher leverage level L and higher value
k0. For example, at k0 ¼ 20% and L ¼ 2, the increase in T on 10% leads to a
decrease in WACC on 1.33%.
For dependence of the equity cost ke on tax on profit rate T (from the analysis
of formula ke ¼ k0 + L(1 T )(k0 kd)), it is seen that negative tangent of tilt
angle tgγ ¼ L(k0 kd) also increases in the module with the increase of the
leverage level; in this connection all dependences at the different leverage levels
Li, based on the different points ke ¼ k0 + Li(k0 kd) when T ¼ 0, at T ¼ 1
converge at the point k0.
7.1 The Role of Taxes in Modigliani–Miller Theory 127
Fig. 7.1 The dependence of WACC

capital (WACC) on tax on
profit rate T at different fixed
leverage level L k0 L=0
L1
L1 < L2
L2
L=
0 1 T
3. In accordance with the formula tgγ ¼ L(k0 kd), we get that when k0 kd ¼ 6%
and L ¼ 1, i.е., D ¼ S, the increase of tax on profit rate T on 10% leads to a
reduction in the equity capital cost ke on 0.6%.
4. This dependence of the equity cost ke on tax on profit rate T will be even more
significant at a higher leverage level L and higher value k0 kd. For example, at
k0 kd ¼ 10% and L ¼ 2, the increase in T on 10% leads to a decrease in ke on
2%.
It should be noted that with the rising of tax on profit rate T, the difference in the
equity cost ke at various levels of leverage decreases, disappearing at T ¼ 1.
This procedure recalls operational analysis, which examined dependence of
financial results of the activities of the company on the costs and volumes of
production and the implementation of the products, goods, and services. The key
elements of operational analysis of any enterprise are operating lever, the threshold
of cost-effectiveness, and stock financial strength of enterprise. The operational arm
is reflected in the fact that any change proceeding from the disposal always gives rise
to a more severe change in earnings.
In the present case, as the effects of tax operational lever can be taken as the ratio
of change of weighted average cost of capital (WACC) to the change of tax on profit
rate T, and the ratio of change of equity capital cost ke to the change of tax on profit
rate T, i.е., we can introduce for the first time two tax operating levers:
– For weighted average cost of capital (WACC)
LWACC ¼ ΔWACC=ΔT;
– For equity capital cost ke

Lke ¼ Δke =ΔT:
For the earlier examples, the power of the lever is

1.
LWACC ¼ 0:05;
2.
LWACC ¼ 0:133;
3.
Lke ¼ 0:06;
4.
Lke ¼ 0:2:
The higher value of the tax operational lever causes the greater change in capital
cost of the company at fixed change of tax on profit rate T (Fig. 7.2).
Fig. 7.2 Dependence of ke

equity capital cost ke on tax
on profit rate T at different
leverage level L
L1
L1 > L2
L2
k0
0 1 T
7.2 The Role of Taxes in Brusov–Filatova–Orekhova Theory 129
7.2 The Role of Taxes in Brusov–Filatova–Orekhova

Theory
The solution of the problem of evaluation of the weighted average cost of capital
(WACC) for companies of arbitrary age or with arbitrary lifetime, as it was noted in
Chap. 3, has been done for the first time by Brusov–Filatova–Orekhova (Brusov and
Filatova 2011, Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b, and Filatova
et al. 2008).
Following them, consider the situation for the arbitrary age of the company. In
this case, the Modigliani–Miller theorem
V L ¼ V 0 þ DT
is changed by
V ¼ V 0 þ ðPVÞTS ¼ V 0 þ DT ½1 ð1 þ kd Þn , ð7:3Þ
where
X
n
ðPVÞTS ¼ kd DT ð1 þ k d Þt ¼ DT ½1 ð1 þ kd Þn , ð7:4Þ
t¼1
represents a tax shield for n years.

It is seen that the capitalization of financially dependent (leverage) company
linearly increases with the growth of the tax on profit rate (as well as in the limited
case of Modigliani–Miller); however, the tilt angle of the linear function VL(T ) is
less than in the perpetuity case:
tgδ ¼ T ½1 ð1 þ kd Þn T: ð7:5Þ
We will carry out the study of the dependence of weighted average cost of capital
(WACC) of the company and its equity cost ke on tax on profit rate in two ways:
1. We will study the dependence of weighted average cost of capital (WACC) of the
company and its equity cost ke on tax on profit rate at fixed leverage level and at
different ages of the company.
2. We will study the dependence of weighted average cost of capital (WACC) of the
company and its equity cost ke on leverage level at fixed tax on profit rate and at
different ages of the company.
In both cases, we will use Brusov–Filatova–Orekhova formula for weighted
average cost of capital (WACC) of the company (Brusov and Filatova 2011; Brusov
et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b; Filatova et al. 2008):
Fig. 7.3 Dependence of WACC

capital (WACC) of the 1
company on tax on profit 0.1500
rate Т at fixed leverage level 2
L (fraction of debt capital 3
wd): (1) wd ¼ 0; 0.1000
(2) wd ¼ 0.2; (3) wd ¼ 0.4; 4
(4) wd ¼ 0.6; (5) wd ¼ 0.8; 0.0500
(6) wd ¼ 1 5
0.0000
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 6 1.1
–0.0500
T
¼ : ð7:6Þ
7.2.1 Weighted Average Cost of Capital (WACC)

of the Company
Dependence of Weighted Average Cost of Capital (WACC) of the Company

on Tax on Profit Rate Т at Fixed Leverage Level L
For n ¼ 2, k0 ¼ 18 % , kd ¼ 10%, the dependences of weighted average cost of
capital (WACC) of the company on tax on profit rate Т at fixed leverage level
L (fraction of debt capital wd) are shown at Fig. 7.3.
It is quite obvious that dependences are very similar to that in Fig. 7.1, differing
by the tilt angle α and the distance between curves (in fact, the dependences are very
close to the linear ones). With the increase of debt capital fraction wd (or leverage
level L ), the curves become more steep, and the relevant tax operating lever
decreases, which means the rise of the impact of the change of the tax on profit
rate on the weighted average cost of capital.
on Debt Capital Fraction wd at Fixed Tax on Profit Rate Т
Dependences of weighted average cost of capital (WACC) of the company on debt
capital fraction wd at fixed tax on profit rate Т turn out to be linear ones as well. For
example, for n ¼ 3, k0 ¼ 24 % , kd ¼ 20%, we got the dependences, represented at
Fig. 7.4.
The dependences shown at Fig. 7.4 are not surprising because the fraction of debt
capital and tax on profit rate are included in the Brusov–Filatova–Orekhova formula
(Eq. 7.5) in a symmetrical manner. With the increase of the tax on profit rate Т, the

capital (WACC) of the 0.2500
company on debt capital 1
fraction wd at different tax 0.2000
2
on profit rates Т: (1) Т ¼ 0; 0.1500
(2) Т ¼ 0.2; (3) Т ¼ 0.4; 3
(4) Т ¼ 0.6; (5) Т ¼ 0.8; 0.1000
(6) Т ¼ 1 4
0.0500
5
0.0000
0 0.2 0.4 0.6 0.8 1 1.2
–0.0500
6
–0.1000
Wd

capital (WACC) of the 0.1800 1
company on leverage level 0.1600
L at different fixed tax on 0.1400 2
profit rates Т: (1) Т ¼ 0; 0.1200
(2) Т ¼ 0.2; (3) Т ¼ 0.4; 3
0.1000
(4) Т ¼ 0.6; (5) Т ¼ 0.8; and 0.0800 4
(6) Т ¼ 1 0.0600
0.0400 5
0.0200
6
0.0000
0 1 2 3 4 5 6 7 8 9 10
L
curves become more steep, which means the rise of the impact of the change of the
debt capital fraction wd on the weighted average cost of capital (WACC).
on Leverage Level L at Fixed Tax on Profit Rate Т
Dependence of weighted average cost of capital (WACC) of the company on
leverage level L at fixed tax on profit rate Т becomes an essentially nonlinear.
For example, for n ¼ 3; k0 ¼ 18 % , kd ¼ 12%, we got the dependences,
represented at Fig. 7.5.
With the increase of the tax on profit rate Т, the curve of the dependence of
weighted average cost of capital (WACC) of the company on leverage level
L becomes more steep, i.e., at the same leverage level L; its change leads to bigger
change of WACC at higher tax on profit rate Т.
At tax on profit rate T 40%, weighted average cost of capital (WACC) of the
company locates within kd WACC k0.
At tax on profit rate T 40%, weighted average cost of capital (WACC) of the
company falls below kd at certain leverage level L*, which decreases with increase
of T.
Fig. 7.6 Dependence of Ke

equity cost ke of the 0.2700
rate Т at fixed debt capital
fraction wd (n ¼ 5, 0.2300
k0 ¼ 10 % , kd ¼ 6%): 0.2100
(1) wd ¼ 0; (2) wd ¼ 0.2; 0.1900
(3) wd ¼ 0.4; (4) wd ¼ 0.6;
and (5) wd ¼ 0.8 0.1700
5
0.1500
4
0.1300 3
0.1100 2
0.0900 1
0.0700 T
0 0.2 0.4 0.6 0.8 1 1.2

company on tax on profit
rate Т at fixed debt capital 0.1500
fraction wd (n ¼ 10,
k0 ¼ 10 % , kd ¼ 8%):
(1) wd ¼ 0; (2) wd ¼ 0.2; 0.1000 1
2
(3) wd ¼ 0.4; (4) wd ¼ 0.6; 3
and (5) wd ¼ 0.8 0.0500
4
0.0000
0 0.2 0.4 0.6 0.8 1 1.2
–0.0500
5
–0.1000
T
7.2.2 Equity Cost ke of the Company
Dependence of Equity Cost ke of the Company on Tax on Profit Rate Т at Fixed

Leverage Level L
Here are three figures, showing the dependence of equity cost ke on tax on profit rate
at different (fixed) leverage levels (debt capital fraction wd) for different parameter
sets n, k0, and kd (Figs. 7.6, 7.7, and 7.8).
It should be noted that:
1. All dependencies are linear, and ke decreases with increasing tax on profit rate Т.
2. With the increase of the debt capital fraction wd, initial values ke significantly
grow and exceed k0.

rate Т at fixed debt capital
fraction wd (n ¼ 3, 0.5500
k0 ¼ 20 % , kd ¼ 10%): 0.5000
(1) wd ¼ 0; (2) wd ¼ 0.2;
0.4500
(3) wd ¼ 0.4; (4) wd ¼ 0.6;
and (5) wd ¼ 0.8 0.4000
0.3500
5
0.3000
0.2500 4
3
0.2000 2
1
0.1500 T
0 0.2 0.4 0.6 0.8 1 1.2
3. Lines, corresponding to the different values of the debt capital fraction wd,
intersect at the same point (at a certain value of tax on profit rate T*), dependent
on parameters n, k0, and kd (Figs. 7.6 and 7.7).
4. At some values of parameters n, k0, and kd, the crossing of all lines at a single
point cannot take a place at any tax on profit rate 0 < T 100%. With a large gap
between k0 and kd, a point of crossing of all the lines lies in the nonexistent (the
“nonfinancial”) region T∗ > 100% (Fig. 7.8). For data of Fig. 7.8, T∗ 162%.
Dependence of Equity Cost ke of the Company on Leverage Level L on Fixed
Tax on Profit Rate Т
The results of the calculations of dependence of equity cost ke of the company on the
leverage level L in Excel for the case, n ¼ 7, k0 ¼ 20 % , kd ¼ 10% (at a fixed tax on
profit rate Т), are presented in the Table 7.1 and in the Fig. 7.9.
Dependence of equity cost ke of the company on leverage level L at fixed tax on
profit rate Т with a good accuracy is linear, and the tilt angle decreases with
increasing tax on profit rate Т, as in the perpetuity case (Fig. 7.9).
However, for companies of finite age, along with the behavior ke(L ), similar to
behavior in case of Modigliani–Miller perpetuity companies (Fig. 7.9), for some sets
of parameters n, k0, and kd, there is a different dependence ke(L ).
For example, starting with some of the values of tax on profit rate T* (in this case,
T∗ ¼ 40%, although for the other parameter sets n, k0, and kd, a critical tax on profit
rate T* could be even less), one has not the growth of the equity capital cost of the
company with leverage level but it is descending (Fig. 7.10). Note, that from the
formula (7.2) it follows that even at maximum value of taxes T ¼ 1(100%), equity
cost ke is not changed with leverage: ke ¼ k0, i.e., descending of equity cost ke with
leverage does not occur at any tax on profit rate T. Thus, this discovered effect does
not take place in perpetuity Modigliani–Miller limit. See Chap. 8 for more details.
Note that this is a principally new effect, which may take place only for the
company of finite age and which is not observed in perpetuity limit. For example,
from the formula
134
Table 7.1 Dependence of equity cost ke of the company on leverage level L on fixed tax on profit rate Т for the case n ¼ 7, k0 ¼ 20 % , kd ¼ 10%
L
T 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10
0.0 0.2000 0.3000 0.4000 0.5000 0.6000 0.7000 0.8000 0.9000 1.0000 1.1000 1.2000
0.2 0.2000 0.2842 0.3682 0.4522 0.5362 0.6202 0.7042 0.7874 0.8713 0.9551 1.0389
0.4 0.2000 0.2677 0.3344 0.4008 0.4672 0.5335 0.5998 0.6661 0.7323 0.7986 0.8649
0.6 0.2000 0.2504 0.2984 0.3457 0.3928 0.4397 0.4865 0.5334 0.5802 0.6265 0.6731
0.8 0.2000 0.2323 0.2601 0.2861 0.3117 0.3369 0.3619 0.3867 0.4116 0.4364 0.4612
1.0 0.2000 0.2132 0.2185 0.2210 0.2223 0.2229 0.2231 0.2233 0.2231 0.2228 0.2224
7 The Role of Taxing and Leverage in Evaluation of Capital Cost and. . .

company on leverage level
L on fixed tax on profit rate 1.2000 1
Т for the case n ¼ 7, 2
1.0000
k0 ¼ 20 % , kd ¼ 10%:
(1) T ¼ 0; (2) T ¼ 0.2; 3
0.8000
(3) T ¼ 0.4; (4) T ¼ 0.6; 4
(5) T ¼ 0.8; and (6) T ¼ 1 0.6000
0.4000 5
0.2000 6
0.0000
0 1 2 3 4 5 6 7 8 9 10 11
L

company on leverage level
L on fixed tax on profit rate
Т for the case: n ¼ 5, 0.3000 1
k0 ¼ 10 % , kd ¼ 8%:
(1) T ¼ 0; (2) T ¼ 0.2; 0.2000 2
(3) T ¼ 0.4; (4) T ¼ 0.6;
(5) T ¼ 0.8; and (6) T ¼ 1 0.1000 3
4
0.0000
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6 6.5 7 7.5 8 8.5 9 9.5 1010.5
–0.1000
5
–0.2000
6
–0.3000
L
ke ¼ k0 þ Lð1 T Þðk 0 kd Þ, ð7:7Þ
it follows that at T ¼ 1(100%), equity cost ke does not change with leverage: ke ¼ k0,
i.e., descending of equity cost ke with leverage, does not occur at any tax on profit
rate T. Thus, discovered effect does NOT take place in perpetuity Modigliani–Miller
limit.
7.2.3 Dependence of WACC and ke on the Age of Company
The issue of dependency of WACC and ke on the age of the company or on the
lifetime of the company within the theory of Modigliani–Miller even can not be put:

company on company age at 2
different fixed tax on profit 0.0800
rate T (wd ¼ 0.7, k0 ¼ 10 % , 3
0.0600
kd ¼ 8%): (1) T ¼ 0; 4
(2) T ¼ 0.2; (3) T ¼ 0.4; 0.0400
(4) T ¼ 0.6; (5) T ¼ 0.8; 5
0.0200
(6) T ¼ 1
6
0.0000
0 5 10 15 20 25 30
n

0.1200
company on company age at 2
different fixed fraction of 0.0800 3
4
debt capital wd (T ¼ 40 % , 0.0600 5
k0 ¼ 10 % , kd ¼ 8%): 6
(1) wd ¼ 0; (2) wd ¼ 0.2; 0.0400
(3) wd ¼ 0.4; (4) wd ¼ 0.6; 0.0200
(5) wd ¼ 0.8
0.0000
0 5 10 15 20 25 30
n
in Modigliani–Miller theory, the parameter “time” is absent, since all the companies
are perpetuity ones.
Within the modern Brusov–Filatova–Orekhova theory, it becomes possible to
study the dependence of WACC and ke on the company’s age. Below, we will
undertake a detailed study of this problem: the dependences WACC (n) and ke (n)
will be examined at different tax on profit rate T and leverage level L for different
sets of parameters k0, kd, T, and wd.
on Company Age at Different Fixed Tax on Profit Rate T
Considering dependence is shown at Fig. 7.11.
Weighted average cost of capital (WACC) of the company decreases with the
increase of the company age n tending to its perpetuity limit (see, however, in Chaps.
18 and 19 qualitatively new effect of “Golden age of the company” and its modifi-
cations, discovered by authors). The initial values WACC (at n ¼ 1) will decrease
with the increase of tax on profit rate T (in accordance with the previously received
dependences WACC(T )), and a range of WACC changes is growing with
increasing T.
on the Company Age at Different Fixed Fraction of Debt Capital wd
Considering dependence is shown at Fig. 7.12.

equity cost of the company 0.2000
ke on company age n at
0.1800
different fixed fraction of
0.1600
debt capital wd (T ¼ 20 % , 5
k0 ¼ 10 % , kd ¼ 8%): 0.1400
(1) wd ¼ 0; (2) wd ¼ 0.2; 0.1200 4
3
(3) wd ¼ 0.4; (4) wd ¼ 0.6; 0.1000 2
1
and (5) wd ¼ 0.8 0.0800
0.0600
0.0400
0.0200
0.0000
0 5 10 15 20 25 30
n

equity cost of the company
0.1900
different fixed fraction of
debt capital wd (T ¼ 40 % , 0.1700
k0 ¼ 10 % , kd ¼ 8%):
(1) wd ¼ 0; (2) wd ¼ 0.2; 0.1500
(3) wd ¼ 0.4; (4) wd ¼ 0.6;
and (5) wd ¼ 0.8 0.1300
5
0.1100 4
3
2
1
0.0900
0 5 10 15 20 25 30
n
The weighted average cost of capital (WACC) of the company decreases with the
lifetime of company n, tending to its perpetuity limit. The initial values WACC
(at n ¼ 1) decrease with the increase of fraction of debt capital [in accordance with
the previously received dependences WACC(wd)], and a range of WACC changes is
growing with increasing of wd.
Dependence of Equity Cost of the Company ke on the Company Age n at
Different Fixed Fraction of Debt Capital wd
Considering dependence is represented at Fig. 7.13.
The equity cost of the company ke decreases with the company age n, tending to
its perpetuity limit. The initial values ke (at n ¼ 1) decrease significantly with the
increase of fraction of debt capital wd. A range of ke changes is growing with
increasing of wd.
It should be noted that the differences in equity cost of the company at a fixed n,
starting from wd ¼ 0.5, become and remain significant (and constant for a fixed
change in the fraction of debt capital Δwd and at n 6).

equity cost of the company 0.3000
different fixed tax on profit
0.2500 1
rates T (wd ¼ 0.7, 2
k0 ¼ 16 % , kd ¼ 12%): 3
(1) T ¼ 0; (2) T ¼ 0.2; 0.2000
(3) T ¼ 0.4; (4) T ¼ 0.6; 4
(5) T ¼ 0.8; and (6) T ¼ 1 0.1500
5
0.1000
6
0.0500
0.0000
0 5 10 15 20 25 30
n
The situation will change with increase of tax on profit rate T. To demonstrate this
fact, we show the similar data, increasing tax on profit rate T twice (from 20% up to
40%) (Fig. 7.14).
It can be observed that with increase in tax on profit rates in two times, the region
of company age n, where the differences in equity cost of capital ke of the company
are feeling at various fractions of debt capital wd have narrowed down to 6 years,
while at n 6, equity cost of capital ke remains virtually equal to ko and only slightly
fluctuates around this value.
Dependence of Equity Cost of the Company ke on Company Age n at Different
Fixed Tax on Profit Rate T
Considering dependence is represented at Fig. 7.15.
The equity cost of the company ke decreases with the company age, n, tending to
its perpetuity limit. Under growing of tax on profit rates T, the equity cost of the
company ke decreases (at fixed fraction of debt capital wd), while range of ke changes
increases.
7.3 Conclusions
In this chapter, the role of tax shields, taxes, and leverage is investigated within the
theory of Modigliani–Miller as well as within the modern theory of corporate finance
by Brusov–Filatova–Orekhova (Brusov and Filatova 2011; Brusov et al. 2011a, b, c,
2012a, b, 2013a, b, 2014a, b; Filatova et al. 2008). It is shown that equity cost of the
company as well as weighted average cost of capital decreases with the growth of tax
on profit rates. A detailed study of the dependence of weighted average cost of
capital (WACC) and equity cost of the company ke on tax on profit rates at fixed
leverage level (fixed debt capital fraction wd) as well as on leverage level (debt
References 139
capital fraction wd) at fixed tax on profit rate has been done. The dependences of
weighted average cost of capital (WACC) and equity cost of the company ke on
company’s age have been investigated as well.
The concept “tax operating lever” has been introduced. For companies of arbi-
trary age, a number of important qualitative effects that do not have analogues for
perpetuity companies have been detected.
One such effect—decreasing of equity cost with leverage level at values of tax on
profit rate T, which exceeds some critical value T*—is described in detail in
Chap. 10 (at certain ratios between the debt cost and equity capital cost, discovered
effect takes place at tax on profit rate, existing in the Western countries and in
Russia, which provides practical value of the effect). Taking it into account is
important in improving tax legislation and may change dividend policy of the
company significantly.
For more detailed investigation of the dependence of attracting capital cost on the
age of company n at various leverage levels and at various values of capital costs
with the aim of defining minimum cost of attracting capital, see Chap. 18, where new
qualitative effects have been discovered.
References
(11):815–824
org/10.1080/23322039.2014.946150
perpetuity limit–Modigliani–Miller theory. J Rev Global Econ 3:175–185
7:37–62
1954–1957. Am Econ Rev 56:333–391
Econ Rev 53:147–175
Chapter 8
A Qualitatively New Effect in Corporate
Finance: Abnormal Dependence of Equity
Cost of Company on Leverage
8.1 Introduction
The structure of this chapter is as follows: first, we consider the value of the equity
cost ke in the theory of Modigliani and Miller, its dependence on leverage L, and tax
on profit rate T to show that in this perpetuity limit, the equity cost ke is always
growing with leverage (for any tax on profit rate T).
Then, we consider the equity cost ke within the modern Brusоv–Filаtоvа–
Orekhоvа theory and show that for companies of arbitrary age, a qualitatively new
effect takes place: decreasing of the equity cost with the leverage. The effect takes
place at tax on profit rate T, exceeding some critical value T*.
Next, we make a complete study of the discovered effect: we investigate the
dependence of T* on company’s age n on equity cost of financially independent
company k0 and on debt cost kd as well as on ratio of these parameters.
We separately consider a 1-year company and analyze its special feature in
connection with the discussed effect. An explanation of the absence of this effect
for such companies will be given. In conclusion, the importance of the discovered
effect in various areas, including improving tax legislation and dividend policies of
companies, as well as the practical value of the effect, is discussed.
8.2 Equity Cost in the Modigliani–Miller Theory
For weighted average cost of capital (WACC) in the Modigliani–Miller theory, the
following expression has been obtained (Мodigliani and Мiller 1958, 1963, 1966):
WACC ¼ k0 ð1 wd T Þ: ð8:1Þ

https://doi.org/10.1007/978-3-319-99686-8_8
142 8 A Qualitatively New Effect in Corporate Finance: Abnormal Dependence. . .
Dependence of WACC on financial leverage L ¼ D/S is described by the formula
WACC ¼ k0 ð1 LT=ð1 þ LÞÞ : ð8:2Þ
In accordance with the definition of the weighted average cost of capital with
accounting for the tax shield, one has
WACC ¼ k0 we þ k d wd ð1 T Þ: ð8:3Þ
Equating (Eqs. 8.1–8.3), we get
k 0 ð1 wd T Þ ¼ k 0 we þ k d wd ð1 T Þ: ð8:4Þ
From where, for equity cost, one has
Note that the formula (Eq. 8.5) is different from the corresponding formula
without tax only by multiplier (1 – T ) in the term, indicating premium for risk. As
the multiplier is less than a unit, the appearance of corporate tax on profit leads to the
fact that equity cost increases with leverage slower than in the case of taxes absence.
Analysis of formulas (Eqs. 8.1 and 8.5) leads to the following conclusions.
With the increasing of financial leverage:
1. Value of the company is increased.
2. Weighted average cost of capital is decreased from k0 (at L ¼ 0) up to k0(1 T )
(at L ¼ 1, when the company is funded solely by borrowing or its equity capital
is negligible).
3. Equity cost is increased linearly from k0 (at L ¼ 0) up to 1 (at L ¼ 1).
Let us analyze now the influence of taxes on equity cost in Modigliani–Miller
theory by studying the dependence of equity cost on tax on profit rate.
For this, we will analyze the formula (Fig. 8.1)
It is seen that dependence is linear: equity cost is decreased linearly with tax on
profit rate. The module of negative tilt angle tangent tgγ ¼ L(k0 kd) is increased
with leverage, and besides, all dependences at different leverage levels Li, coming
from different points ke ¼ k0 + Li(k0 kd) at T ¼ 0 and at T ¼ 1, are converged at the
point k0 (Fig. 8.2).
This means that the difference in equity cost at different leverage levels Li is
decreased with tax on profit rate T, disappearing at T ¼ 1.
8.2 Equity Cost in the Modigliani–Miller Theory 143
Fig. 8.1 Dependence of CC

Ke=K0+L(K0-Kd)
equity cost, debt cost, and
WACC on leverage without
Ke=K0+L(K0-Kd)(1-t)
taxes (t ¼ 0) and with taxes
(t 6¼ 0)
K0 WACC(t=0)
WACC(t≠0)
K0(1-t)
Kd
0 L= D
S
Fig. 8.2 Dependence of ke

equity cost on tax on profit
rate T at different leverage
levels Li
L1
L1 > L 2
L2
k0
0 1 T
Let us illustrate these general considerations by the example k0 ¼ 10 % ; kd ¼ 8%

(Figs. 8.3, 8.4, and 8.5).
From Fig. 8.2, it is seen that dependence is linear: equity cost is decreased linearly
with tax on profit rate. The module of negative tilt angle tangent tgγ ¼ L(k0 kd)
is increased with leverage, and besides, all dependences at different leverage levels
Li, coming from different points ke ¼ k0 + Li(k0 kd) at T ¼ 0 and at T ¼ 1, are
converged at the point k0 (Fig. 8.2).
Fig. 8.3 Dependence of Ke (T), at fixed L Ke

equity cost on tax on profit 0.3000
rate T at different leverage
levels Li for the case 5 0.2500
k0 ¼ 10%; kd ¼ 8%:
(1) L ¼ 0; (2) L ¼ 2; 4
0.2000
(3) L ¼ 4; (4) L ¼ 6; and
3
(5) L ¼ 8
0.1500
2
1 0.1000
0.0500
0.0000
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1
T
Fig. 8.4 Dependence of Ke Ke (L), at fixed T

equity cost on leverage L at 0.3000
different tax on profit rates
T for the case k0 ¼ 10%; 0.2500 1
kd ¼ 8%: (1) T ¼ 0; 2
(2) T ¼ 0.1; (3) T ¼ 0.2; 3
0.2000 4
(4) T ¼ 0.3; (5) T ¼ 0.4; 5
(6) T ¼ 0.5; (7) T ¼ 0.6; 6
0.1500 7
(8) T ¼ 0.7; (9, 10) T ¼ 0.9; 8
and (11) T ¼ 1 9
0.1000 10
11
0.0500
0.0000
0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0
L
From Fig. 8.4, it is seen that equity cost is increased linearly from k0 (at L ¼ 0) up
to 1 (at L ¼ 1), and besides, tilt angle tangent is decreased with tax on profit rate
T becoming zero at T ¼ 100%.
In other words, with increase of tax on profit rate T, dependence of equity cost on
leverage L becomes smaller, disappearing at T ¼ 100%, i.e., within perpetuity
Modigliani–Miller theory, any anomaly effect, announced in the title of this chapter,
is absent.
In conclusion, here is a three-dimensional graph of dependence of equity cost on
leverage L and on tax on profit rate T for the case k0 ¼ 10 % ; kd ¼ 8%.
8.3 Equity Cost Capital Within Brusov–Filatova–Orekhova Theory 145

equity cost on leverage
L and on tax on profit rate
T for the case k0 ¼ 10 % ;
kd ¼ 8%
8.3 Equity Cost Capital Within Brusov–Filatova–Orekhova

Theory
The general solution of the problem of weighted average cost of capital and the
equity cost for the company of arbitrary age or with finite lifetime has been received
for the first time by Brusov–Filatova–Orekhova (Brusov and Filatova 2011; Brusov
et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b, 2015, 2018a, b, c, d; Filatova et al.
2008; Brusova 2011). They have gotten (now already famous) formula for WACC
(BFO formula):
¼ : ð8:7Þ
At n ¼ 1, one gets Myers formula (Myers 2001) for a 1-year company, which is a
particular case of Brusov–Filatova–Orekhova formula (Eq. 8.7):
1 þ k0
WACC ¼ k0 k d wd T: ð8:8Þ
1 þ kd
We will study the dependence of equity cost ke on tax on profit rate T and on
leverage level L by three methods:
1. We will study the dependence of equity cost ke on tax on profit rate T at fixed
leverage level L for different lifetime (age) n of the company.
2. We will study the dependence of equity cost ke on leverage level L at fixed tax on
profit rate T for different lifetime (age) n of the company.
3. We will explore the influence of simultaneous change of leverage level L and tax
on profit rate T on equity cost ke for different lifetime (age) n of the company. In
this case, the results will be presented as 3D graphs.
In these studies, a qualitatively new effect has been discovered, and it is visible in
each of the applicable types of studies (1–3).
8.3.1 Dependence of Equity Cost ke on Tax on Profit Rate

T at Different Fixed Leverage Level L
Dependence of Equity Cost ke on Tax on Profit Rate T at Fixed Leverage Level

L Below we show three figures (Figs. 8.6, 8.7, and 8.8) of the dependence of equity
cost ke on tax on profit rate T at different fixed leverage L for different sets of
parameters n, k0, and kd.
On the basis of the analysis of the three figures (Figs. 8.6, 8.7, and 8.8) and other
data, we come to the following conclusions:
1. All dependences are linear: equity cost decreases linearly with tax on profit rate.
2. The initial values of ke grow significantly with the level of leverage (the share of
debt capital wd) and exceed k0.
3. Lines corresponding to the different values of leverage level (the share of debt
capital wd) intersect at one point (at some value of tax on profit rate T *),
depending on parameters n, k0, and kd (Figs. 8.7 and 8.8).
At fixed tax on profit rate T > T∗ increasing of leverage level corresponds to
moving from line 1 to 2, 3, 4, and 5, i.е., decreasing ke; this means the discovery of
qualitatively new effect in corporate finance: decreasing of equity cost ke with
leverage. In a more obvious form, it will manifest itself in studies depending on
equity cost of the company on the leverage level, carried out by us below.
Fig. 8.6 Dependence of Ke Ke (T), at fix Wd

equity cost ke on tax on 0.2700
profit rate T at different fixed 0.2500
leverage levels L (n ¼ 5,
k0 ¼ 10 % , kd ¼ 6%): 0.2300
(1) wd ¼ 0; (2) wd ¼ 0.2; 0.2100
(3) wd ¼ 0.4; (4) wd ¼ 0.6;
and (5) wd ¼ 0.8 0.1900
0.1700
0.1500
0.1300
0.1100
1
2
0.0900 3
4
5
0.0700
0 0.2 0.4 0.6 0.8 1 1.2
T
8.3 Equity Cost Capital Within Brusov–Filatova–Orekhova Theory 147
Fig. 8.7 Dependence of Ke Ke (T), at fixed Wd

leverage levels L (n ¼ 10,
0.1500
k0 ¼ 10 % , kd ¼ 8%):
(1) wd ¼ 0; (2) wd ¼ 0.2;
(3) wd ¼ 0.4; (4) wd ¼ 0.6; 0.1000 1
2
and (5) wd ¼ 0.8) 3
0.0500
4
0.0000
0 0.2 0.4 0.6 0.8 1 1.2
–0.0500
5
–0.1000
T
Fig. 8.8 Dependence of Ke Ke (T), at fixed Wd

leverage level L (n ¼ 3, 0.6000
k0 ¼ 20 % , kd ¼ 10%): 0.5500
(1) wd ¼ 0; (2) wd ¼ 0.2;
0.5000
(3) wd ¼ 0.4; (4) wd ¼ 0.6;
and (5) wd ¼ 0.8) 0.4500
0.4000
0.3500
5
0.3000
0.2500 4
3
0.2000 2
1
0.1500
0 0.2 0.4 0.6 0.8 1 1.2
T
At some values of parameters n, k0, and kd, the intersection of all lines at one point
could not happen at any tax on profit rate 0 < T 100%. From Fig. 8.9, it is seen that
with a large gap between k0 and kd, the intersection of the lines lies in the nonexistent
(“nonfinancial”) region T∗ > 100% (for data of Fig. 8.9 T∗ 162%).
Fig. 8.9 Dependence of Ke Ke (L), at fixed T

equity cost ke on leverage 1.4000
level L at different tax on 1.2000 1
profit rate T (n ¼ 7, 2
1.0000
k0 ¼ 20 % , kd ¼ 10%):
3
(1) T ¼ 0; (2) T ¼ 0.2; 0.8000
(3) T ¼ 0.4; (4) T ¼ 0.6; 0.6000 4
(5) T ¼ 0.8; and (6) T ¼ 1 0.4000 5
0.2000 6
0.0000
0 1 2 3 4 5 6 7 8 9 10 11
L
8.3.2 Dependence of Equity Cost ke on Leverage Level L (the

Share of Debt Capital wd) at Different Fixed Tax
on Profit Rate T
Below we show the results of calculation of dependence of equity cost ke on leverage

level L (the share of debt capital wd) in Excel at different fixed tax on profit rate T in
the form of a table and in the form of a graph for the case n ¼ 7, k0 ¼ 20 % ,
kd ¼ 10%, as well as in the form of a graph for the case n ¼ 5, k0 ¼ 10 % , kd ¼ 8%
(Table 8.1).
From Fig. 8.9, it is seen that dependence of equity cost ke on leverage level L with
a good accuracy is linear. The tilt angle decreases with tax on profit rate like the
perpetuity case.
However, for the companies of arbitrary age along with the behavior ke(L ),
similar to the perpetuity behavior of the Modigliani–Miller case (Fig. 8.9), for
some sets of parameters n, k0, and kd, there is an otherwise behavior ke(L ).
From Fig. 8.10, it is seen that starting from some values of tax on profit rate T *
(in this case, from T∗ ¼ 40%, although at other sets of parameters n, k0, and kd
critical values of tax on profit rate T * could be lower), there is no rise in the equity
cost of the company with leverage but descending. Once again, the presence or the
absence of such an effect depends on a set of parameters k0, kd, and n.
This effect has been observed above in the dependence of equity cost ke on tax on
profit rate T at fixed leverage level, but it is more clearly visible, depending on the
value of equity cost of the company on the leverage for various values of tax on
profit rate T.
Note that this is a new effect, which may take place only for the companies of
arbitrary finite age and which is not observed in perpetuity Modigliani–Miller limit.
It is easy to see from the Modigliani–Miller formula (8.5)
ke ¼ k0 þ Lð1 T Þðk 0 kd Þ,
that at T ¼ 1(100%) equity cost ke does not change with leverage, ke ¼ k0, i.е., there
is no decreasing of ke with leverage at any k0 and kd.
Table 8.1 Dependence of equity cost ke on leverage level L at different fixed tax on profit rates T for the case n ¼ 7, k0 ¼ 20 % , kd ¼ 10%
T/L 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10
0 0.2000 0.3000 0.4000 0.5000 0.6000 0.7000 0.8000 0.9000 1.0000 1.1000 1.2000
0.2 0.2000 0.2842 0.3682 0.4522 0.5362 0.6202 0.7042 0.7874 0.8713 0.9551 1.0389
0.4 0.2000 0.2677 0.3344 0.4008 0.4672 0.5335 0.5998 0.6661 0.7323 0.7986 0.8649
0.6 0.2000 0.2504 0.2984 0.3457 0.3928 0.4397 0.4865 0.5334 0.5802 0.6265 0.6731
0.8 0.2000 0.2323 0.2601 0.2861 0.3117 0.3369 0.3619 0.3867 0.4116 0.4364 0.4612
1 0.2000 0.2132 0.2185 0.2210 0.2223 0.2229 0.2231 0.2233 0.2231 0.2228 0.2224
8.3 Equity Cost Capital Within Brusov–Filatova–Orekhova Theory
149

Ke (L), at fixed T
equity cost ke on leverage 0.4000
level L at different tax on
profit rate T (n ¼ 5, 0.3000 1
k0 ¼ 10 % , kd ¼ 8%):
(1) T ¼ 0; (2) T ¼ 0.2;
0.2000
(3) T ¼ 0.4; (4) T ¼ 0.6; 2
(5) T ¼ 0.8; and (6) T ¼ 1

0.1000 3
0.0000 4
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6 6.5 7 7.5 8 8.5 9 9.51010.5
–0.1000
5
–0.2000
6
–0.3000
L
8.4 Dependence of the Critical Value of Tax on Profit Rate

T * on Parameters n, k0, and kd of the Company
In this section, we study the dependence of the critical value of tax on profit rate T *
on parameters n, k0, and kd of the company. First, we study the dependence of the
critical value of tax on profit rate T * on the company age under variation of the
difference between k0 and kd.
The results of calculations are shown in Table 8.2; empty cells mean that the
critical value of tax on profit rate T * > 100%, i.е., we are in “nonfinancial” region.
The conclusions from Fig. 8.11 are as follows:
1. It is seen that the critical value of tax on profit rate T * increases with the
difference Δk ¼ k0 kd; therefore, a small difference between the value of equity
cost (at L ¼ 0) k0 of the company and the credit rate kd favors the existence of a
new effect.
2. The critical value of tax on profit rate T * decreases monotonically with the age of
the company (only for 10 years in case of Δk ¼ k0 kd ¼ 2% it has a minimum).
Therefore, the probability of the anomaly effect is higher for “adult” companies.
3. Recapitulating 1 and 2, one can note that a small difference between the value of
equity cost (at L ¼ 0) k0 of the company and the credit rate kd as well as old
enough age of the company favors the existence of a new effect.
We calculated as well T * at different values of k0 and kd at constant difference
between them Δk ¼ k0 kd ¼ 2%. The data are shown in Table 8.3 (Fig. 8.12).
8.4 Dependence of the Critical Value of Tax on Profit Rate. . . 151
Table 8.2 The dependence of the critical value of tax on profit rate T * on the age of the company
under variation of the difference between k0 and kd
ke(t)/n 2 3 5 7 10 15 20 25
kd ¼ 6%, 0.9575 0.6600 0.5200 0.4800 0.4640 0.4710 0.4903 0.5121
k0 ¼ 8%
kd ¼ 6%, 0.9110 0.8225 0.7650 0.7332 0.7249 0.7260
k0 ¼ 10%
kd ¼ 6%, 0.9800 0.9040 0.8693 0.8504
k0 ¼ 12%
kd ¼ 6%, 0.9671 0.9324
k0 ¼ 14%
kd ¼ 6%,
k0 ¼ 16%
kd ¼ 6%,
k0 ¼ 20%
kd ¼ 6%,
k0 ¼ 24%
Fig. 8.11 The dependence T* T*(n)

of the critical value of tax on 1.0
profit rate T * on the age of
4
the company under variation 0.9
of the difference between k0 3
and kd (Δk ¼ k0 kd ¼ 2 % ; 0.8
4 % ; 6 % ; 8%): 2
0.7
(1) kd ¼ 6%, k0 ¼ 8%;
(2) kd ¼ 6%, k0 ¼ 10%; 0.6
(3) kd ¼ 6%, k0 ¼ 12%;
and (4) kd ¼ 6%, k0 ¼ 14% 0.5 1
0.4
0.3
0.2
0.1
n
0.0
0 1 2 3 4 5 6 7 8 9 10111213141516171819202122232425
The conclusions in the current case are as follows:

1. All curves are convex, and the critical value of tax on profit rate T* reaches
minimum, the value of which decreases with k0.
Min T* ¼ 22.2% at k0 ¼ 24%, min T* ¼ 24.35% at k0 ¼ 20%, min
T* ¼ 28.1% at k0 ¼ 16%, min T* ¼ 30.43% at k0 ¼ 14%, min
T* ¼ 33.92% at k0 ¼ 12%, min T* ¼ 38.92% at k0 ¼ 10%, and min
T* ¼ 46.4% at k0 ¼ 8%. Therefore, the higher value of k0 and the higher
Table 8.3 The dependence of the critical value of tax on profit rate T * on the age of the company
under different values of k0 and kd at constant difference between them Δk ¼ k0 kd ¼ 2%
ke(t)/n 2 3 5 7 10 15 20 25
kd ¼ 6% 0.9575 0.6600 0.5200 0.4800 0.4640 0.4710 0.4903 0.5121
k0 ¼ 8%
kd ¼ 8% 0.7313 0.5125 0.4140 0.3905 0.3892 0.4138 0.4453 0.4803
k0 ¼ 10%
kd ¼ 10% 0.6000 0.4280 0.3510 0.3392 0.3467 0.3840 0.4285 0.4733
k0 ¼ 12%
kd ¼ 12% 0.5125 0.3687 0.3110 0.3043 0.3218 0.3697 0.4239 0.4788
k0 ¼ 14%
kd ¼ 14% 0.4437 0.3266 0.2810 0.2821 0.3043 0.3636 0.4277 0.4904
k0 ¼ 16%
kd ¼ 18% 0.3625 0.2710 0.2435 0.2549 0.2895 0.3677 0.4468 0.5221
k0 ¼ 20%
kd ¼ 22% 0.3100 0.2370 0.2220 0.2400 0.2875 0.3818 0.4759 0.5588
k0 ¼ 24%
Fig. 8.12 The dependence T* T*(n)

of the critical value of tax on 1.0
profit rate T * on the age of 1
the company under different
0.9
values of k0 and kd at
constant difference between
them Δk ¼ k0 kd ¼ 2%: 0.8
(1) k0 ¼ 8%; (2) k0 ¼ 10%;
(3) k0 ¼ 12%; (4) k0 ¼ 14%; 2
(5) k0 ¼ 16%; (6) k0 ¼ 20%; 0.7

and (7) k0 ¼ 24%
3
0.6
7
4 6
0.5 1
45
2
3
5
0.4
6
7
0.3
0.2
0 1 2 3 4 5 6 7 8 9 10111213141516171819202122232425
n
value of kd at constant difference between them Δk ¼ k0 kd ¼ const favor the

existence of a new effect.
2. The critical value of tax on profit rate T * reaches minimum at company age,
decreasing with k0: n ¼ 4.5 years at k0 ¼ 24%, n ¼ 5.5 years at k0 ¼ 16%, n ¼ 6.5
years at k0 ¼ 12%, and n ¼ 10.5 years at k0 ¼ 8%.
8.5 Practical Value of Effect 153
Fig. 8.13 The dependence T*(k0)

T*
of the critical value of tax on 80
profit rate T * on k0 at
constant difference between 70
k0 and kd
Δk ¼ k0 kd ¼ 2%: 60
(1) n ¼ 2; (2) n ¼ 3; 8
(3) n ¼ 5; (4) n ¼ 7; 50
7
(5) n ¼ 10; (6) n ¼ 15;
(7) n ¼ 20; and (8) n ¼ 25 40
6
1
30 5
2
4
20 3
10
k0
0
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
3. Thus, a parallel shift up of rates k0 and kd favors a new effect, while the
company’s age, favorable for a new effect, decreases with k0.
Now let us investigate the dependence of critical value of tax on profit rate T * on
k0 for the second considerable case (at constant difference between k0 and kd
Δk ¼ k0 kd ¼ 2%).
For this, we consider Fig. 8.13.
For companies with age up to 10–15 years, the decreasing of critical value of tax
on profit rate T * with k0 is observed. On further increase of a company’s age, one
observes in dependence of T * on k0 a smooth transition to a low growing function
T * on k0.
So, for companies with age up to 10–15 years, monotonic growth of k0 favors a
new effect, while for companies with bigger age, rates of order k0 12–15% favor a
new effect.
8.5 Practical Value of Effect
What is the practical value of effect? Does it exist in real life or its discovery has a
purely theoretical interest?
Because a new effect takes place at tax on profit rate, which exceeds some value
T*, it is necessary to compare this value with real tax on profit rates established in the
different countries.
The biggest tax on profit rate for a corporation is in the USA (39.2%). In Japan, it
exceeds a little bit, 38%. In France, tax on profit rate varies from 33.3% for small-
and medium-sized companies up to 36% for the major. In England, tax on profit rate
is in the range of 21–28%. In the Russian Federation, tax on profit rate amounts to
20%.
In the examples considered by us, the value of T* strongly depends on the ratio
between k0, kd, and n and reaches a minimal value of 22.2%, and it is quite likely for
even lower values of T* with other ratios of values k0, kd, and n.
In this way, we come to the conclusion that at some ratios of values of equity cost,
debt cost, and company’s age k0, kd, and n, the effect discovered by us takes place at
tax on profit rate established in most developed countries, which provides the
practical value of the effect.
Taking it into account is important in improving tax legislation and may change
dividend policies of the company.
Opening the effect expands our view of the rules of the game in the economy.
If prior to that it was widely known that with the rising of leverage the equity cost
is always growing, which is associated with the decrease of financial sustainability of
the companies, with an increase in the share of borrowing, then the shareholders
require a higher rate of return on the share.
But now it becomes clear that this is not always the case, and the dependence of
equity cost on leverage depends on the ratio between the parameters k0, kd, and
n and, ultimately, on the tax on profit rate.
This effect has never been known; therefore, it was not taken into account by
controls tax legislation, but opportunities here are tremendous.
The effect is also important for the development of the dividend policy of the
company.
It turns out that the rule taken by the shareholders since time immemorial—to
require higher rate of return on the share with an increase of the portion of debt
capital—now does not always work. This will allow the company management to
hold a more realistic dividend policy, limiting appetites of shareholders by econom-
ically founded value of dividends.
8.6 Equity Cost of a 1-Year Company
The dependence of the equity cost on tax on profit rate T for a 1-year company has
some features, considered below. Interest in the 1-year companies is associated also
with the fact that a great number of companies, both in developed countries and in
developing ones, are becoming bankrupt or no longer exist in the first year or two
after the creation.
For a 1-year company, the Brusov–Filatova–Orekhova (BFO) equation for
weighted average cost of capital is simplified and can be expressed in apparent
form (Brusov and Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b,
2014a, b; Filatova et al. 2008) (Eq. 8.8):
8.6 Equity Cost of a 1-Year Company 155
1 þ k0
WACC ¼ k0 k d wd T:
1 þ kd
This formula has been obtained for the first time by Myers (2001) and represents
the particular case of the Brusov–Filatova–Orekhova (BFO) equation at n ¼ 1.
By definition, for weighted average cost of capital with accounting for “the tax
shield,” one has
WACC ¼ ke we þ kd wd ð1 T Þ: ð8:9Þ
Substituting here the expression for WACC of a 1-year company, let us find the
expression for equity cost ke of the company:

WACC wd kd ð1 T Þ kd
ke ¼ ¼ k 0 þ Lð k 0 k d Þ 1 T : ð8:10Þ
we 1 þ kd
It is seen that equity cost ke decreases linearly with tax on profit rate. The module
of negative tilt angle tangent is equal to
kd
tgα ¼ Lðk0 k d Þ ð8:11Þ
1 þ kd
However, the calculation for the case k0 ¼ 10 % , kd ¼ 8% gives practically

independence of equity cost ke of the company’s tax on profit rate T at fixed leverage
level (Fig. 8.14).
This is due to the low value of coefficient ðk0 k d Þ1þk
kd
d
, which in our case is equal
to 0.00148. Therefore, descending becomes visible only at significantly higher
leverage (Fig. 8.14).
Note that such a weak dependence (virtually independence) of equity cost ke of
the company on tax on profit rate T at fixed leverage level takes place for a 1-year
company only.
Fig. 8.14 Dependence of Ke (T) Ke

rate T at fixed leverage level 5 0.2500
for a 1-year company 4
0.2000
(n ¼ 1, k0 ¼ 10 % , kd ¼ 8%) 3
0.1500
2
1 0.1000
0.0500
0.0000
0 0.2 0.4 0.6 0.8 1 1.2
T
Fig. 8.15 Dependence of Ke (t), n = 2, Kd = 22%, K0 = 24% Ke

rate T at fixed leverage level
for a 2-year company 0.3000
(n ¼ 2, k0 ¼ 24 % ,
kd ¼ 22%) 0.2000
0.1000
0.0000
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1
-0.1000
-0.2000
T
Already for a 2-year company with the same parameters, dependence of equity
cost ke of the company on tax on profit rate T at fixed leverage level becomes
significant.
Below we give an example for a 2-year company with other parameters: n ¼ 2,
k0 ¼ 24 % , kd ¼ 22% (Fig. 8.15).
Finding a Formula for T*
In case of a 1-year company, it is easy to find a formula for T*.
Putting in (Eq. 8.10) ke ¼ k0, one gets

kd
k 0 ¼ k 0 þ Lð k 0 k d Þ 1 T ð8:12Þ
1 þ kd
From where
1 þ kd
T∗ ¼ ð8:13Þ
kd
It is seen that T * does not depend on L, i.е., all the direct lines, corresponding to
different L, intersect at a single point. From the data for the older companies (n > 1
year), it follows that similar situation takes place for them as well; however, it
becomes more difficult to prove this fact and, in case n > 3, practically impossible.
Note that Eq. (8.13) allows us to evaluate the value of T *, which depends now on
credit rate only and is equal to
8.7 Conclusions 157
Fig. 8.16 Dependence of Ke (t), n = 2, Kd = 22%, K0 = 24% Ke

rate T and leverage level
L (n ¼ 1, k0 ¼ 10 % , 0.3000
kd ¼ 8%)
0.2000
0.1000
0.0000
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1
-0.1000
-0.2000
T
for kd ¼ 8%T ∗ ¼ 13:5

for kd ¼ 10% T ∗ ¼ 11
for kd ¼ 15% T ∗ ¼ 7:7
for kd ¼ 25% T∗ ¼ 5
It is clear that for all (reasonable and unreasonable) credit rate values, tax on profit
rate T* is situated in “nonfinancial” region (which exceeds 1 (100%)), which is the
cause of the absence of effect.
Analysis of the formula (Eq. 8.13) shows that at very large credit rate values T, T*
tends to be 1(100%), always remaining greater than 1. This means that the effect
found by us is absent for a 1-year company.
Let us show the 3D picture for dependence of equity cost ke of the company on
tax on profit rate T and leverage level L for a 1-year company (Fig. 8.16).
It is seen that all dependences of equity cost ke of the company on tax on profit
rate T and leverage level L are linear, and abnormal effect for a 1-year company
(as well as for perpetuity one) is absent.
8.7 Conclusions
Qualitatively new effect in corporate finance is discovered: decreasing of equity cost

ke with leverage L. This effect, which is absent in perpetuity Modigliani–Miller limit,
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, 2015, 2018a, b, c, d; Filatova et al. 2008).
At some ratios between debt cost and equity cost, the discovered effect takes
place at tax on profit rate, existing in Western countries and Russia. This provides the
practical meaning of discovered effect. Taking it into account is important for the
modification of tax law and can change the dividend policy of the company.
In this chapter, the complete and detailed investigation of discussed effect,
discovered within Brusov–Filatova–Orekhova (BFO) theory, has been done (Brusov
2018a, b, c, d; Filatova et al. 2008). It has been shown that the absence of the effect at
some particular set of parameters is connected to the fact that in these cases, T*
exceeds 100% (tax on profit rate is situated in a “nonfinancial” region).
In the future, the papers and monographs will be devoted to discussion of
discovered abnormal effect, but it is already clear now that we will have to abandon
some of the established views in corporate finance.
References
(11):815–824
abnormal dependence of equity cost of company on leverage. J Rev Global Econ 2:183–193
org/10.1080/23322039.2014.946150
References 159
7:37–62
Econ Rev 53:147–175
1954–1957. Am Econ Rev 56:333–391
Chapter 9
Inflation in Brusov–Filatova–Orekhova
Theory and in Its Perpetuity Limit
Modigliani–Miller Theory
In this chapter, the influence of inflation on capital cost and capitalization of the
company within modern theory of capital cost and capital structure, Brusov–
Filatova–Orekhova theory (BFO theory) (Brusov and Filatova 2011; Brusov et al.
2011a, b, c, 2012a, b, 2013a, b, 2014a, b, 2015, 2018a, b, c, d; Filatova et al. 2008;
Brusova 2011), and within its perpetuity limit, Modigliani–Miller theory (Мodi-
gliani and Мiller 1958, 1963, 1966), is investigated. By direct incorporation of
inflation into both theories, it is shown for the first time that inflation not only
increases the equity cost and the weighted average cost of capital, but also it changes
their dependence on leverage. In particular, it increases the growing rate of equity
cost with leverage. Capitalization of the company is decreased under inflation
(Fig. 9.1).
9.1 Introduction
Created more than half a century ago by Nobel Prize winners Modigliani and Miller,
the theory of capital cost and capital structure (Мodigliani and Мiller 1958, 1963,
1966) did not take into account a lot of factors of a real economy, such as taxing,
bankruptcy, unperfected capital markets, inflation, and many others. But while taxes
have been included into consideration by the authors themselves and some other
limitations have been taken off by their followers, direct incorporation of inflation to
Modigliani–Miller theory was absent until now.
In this chapter, the influence of inflation on valuation of capital cost of the
company and its capitalization is investigated within the Modigliani–Miller theory
(ММ) (Мodigliani and Мiller 1958, 1963, 1966), which is now outdated but still
widely used in the West, as well as within modern theory of capital cost and capital
structure, Brusov–Filatova–Orekhova theory (BFO theory) (Brusov and Filatova
Filatova et al. 2008), which should replace Modigliani–Miller theory (Мodigliani

https://doi.org/10.1007/978-3-319-99686-8_9
162 9 Inflation in Brusov–Filatova–Orekhova Theory and in Its Perpetuity. . .
Fig. 9.1 Dependence of the C.C. k e*

equity cost and the weighted
average cost of capital on
leverage in the Modigliani–
Miller theory without taxing
under inflation. It is seen
that the growing rate of
equity cost increases with ke
leverage. Axis y means
capital costs (CC)
WACC*
k 0*
WACC
k0
0 L
and Мiller 1958, 1963, 1966). It is shown that inflation not only increases the equity
cost and the weighted average cost of capital, but also it changes their dependence on
leverage. In particular, it increases the growing rate of equity cost with leverage.
Capitalization of the company is decreased under inflation.
We start from the study of inflation within the Modigliani–Miller theory without
taxes (Мodigliani and Мiller 1958) and then with taxes (Мodigliani and Мiller
1963) and finally within modern theory of capital cost and capital structure, Brusov–
2011a, b, c, 2012a, b, 2013a, b, 2014a, b, 2015, 2018a, b, c, d; Filatova et al. 2008).
9.2 Accounting of Inflation in the Modigliani–Miller

Theory Without Taxes
Note that any modification of Modigliani–Miller theory, as well as of any other one,
requires going beyond the frame of modifying theory. Thus, in the current case, we
should go beyond the frame of perpetuity of the company (to remind the reader that
Modigliani–Miller theory describes only perpetuity companies—companies with
infinite lifetime), consider the companies with finite lifetime, make necessary calcu-
lations, and then use the perpetuity limit.
As known, in profit approach, capitalization of the company is equal to
discounted sum of profits of the company. Suppose that profit is constant for all
periods and equal to CF, one gets for capitalization of the financially independent
company V0, existing n years at market
9.2 Accounting of Inflation in the Modigliani–Miller Theory Without Taxes 163
CF CF CF
V0 ¼ þ þ þ , ð9:1Þ
1 þ k 0 ð1 þ k 0 Þ2 ð1 þ k 0 Þn
where k0 is the capital cost of the financially independent company.

Under inflation with rate α, the capitalization of the financially independent
company V ∗ 0 becomes equal to
CF CF CF
V∗
0 ¼ þ þ þ : ð9:2Þ
ð1 þ k 0 Þð1 þ αÞ ½ð1 þ k 0 Þð1 þ αÞ2 ½ð1 þ k0 Þð1 þ αÞn
Using the formula for sum of the terms of indefinitely diminishing geometrical
progression with the first term
CF
a1 ¼ ð9:3Þ
ð1 þ k0 Þð1 þ αÞ
and denominator
1
q¼ , ð9:4Þ
ð1 þ k 0 Þð1 þ αÞ
one gets for capitalization of the financially independent company V ∗

0 the following
expression:
a1 CF
V∗
0 ¼ ¼ h i
1 q ð1 þ k 0 Þð1 þ αÞ 1 ðð1 þ k0 Þð1 þ αÞÞ1
CF CF
¼ ¼ : ð9:5Þ
ð1 þ k 0 Þð1 þ αÞ 1 k 0 ð1 þ αÞ þ α
CF
V∗
0 ¼ :
k0 ð1 þ αÞ þ α
It is seen that under inflation, the capitalization of the company decreases.

At discount rate k0 ¼ 10% and inflation rate α ¼ 3%, the decrease is equal to
5.7%, and at discount rate k0 ¼ 15% and inflation rate α ¼ 7%, the decrease is equal
to 35%. One can see that influence of inflation on the company capitalization could
be significant enough and is always negative.
For leverage company (using debt capital) capitalization, one has without
inflation
CF CF CF
VL ¼ þ þ þ ð9:6Þ
1 þ WACC ð1 þ WACCÞ2 ð1 þ WACCÞn
and in perpetuity limit

CF
VL ¼ : ð9:7Þ
WACC
Under inflation, the capitalization of the company is equal to
CF CF
V∗
L ¼ þ þ
ð1 þ WACCÞð1 þ αÞ ½ð1 þ WACCÞð1 þ αÞ2
ð9:8Þ
CF
þ :
½ð1 þ WACCÞð1 þ αÞn
Summing the infinite set, we get for leverage company capitalization under
inflation in Modigliani–Miller limit
a1 CF
V∗
L ¼ ¼ h i
1 q ð1 þ WACCÞð1 þ αÞ 1 ðð1 þ WACCÞð1 þ αÞÞ1
CF CF ð9:9Þ
¼ ¼ ,
ð1 þ WACCÞð1 þ αÞ 1 WACCð1 þ αÞ þ α
CF
V∗
L ¼ :
WACCð1 þ αÞ þ α
It is seen that similar to the case of the financially independent company, inflation
decreases the company capitalization, and the decrease could be significant. From
the formulas (Eqs. 9.7 and 9.9), it follows that effective values of capital costs
(equity cost and WACC) are equal to
k∗
0 ¼ k 0 ð1 þ αÞ þ α, ð9:10Þ
WACC∗ ¼ WACC ð1 þ αÞ þ α: ð9:11Þ
Note that both capital costs increase under inflation.

We can compare obtained results with Fisher formula for inflation:
iα
i∗ ¼ : ð9:12Þ
1þα
Solving this equation with respect to nominal rate i, one gets an equation similar
to (Eqs. 9.10 and 9.11):
i ¼ i∗ ð1 þ αÞ þ α: ð9:13Þ
Thus, effective capital costs in our case have meaning of nominal ones, account-
ing inflation.
9.2 Accounting of Inflation in the Modigliani–Miller Theory Without Taxes 165
From the Modigliani–Miller theorem that the weighted average cost of capital
(WACC) does not depend on leverage level (without taxing), formulating under
inflation, it is easy to get expression for the equity cost:
WACC∗ ¼ k∗ ∗ ∗
0 ¼ k e we þ k d wd : ð9:14Þ
Finding from here k∗

e , one gets
k∗ wd k∗ ðS þ DÞ D ∗
∗ D
k∗
e ¼
0
k∗ ¼ 0 k∗ ¼ k∗
0 þ k0 kd
we d
we S d
S S ð9:15Þ
¼ k∗ ∗ ∗
0 þ k0 kd L
Putting instead of k∗ ∗
0 , k d in their expressions, one gets finally
∗
k∗ ∗ ∗
e ¼ k 0 þ k 0 k d L ¼ k 0 ð1 þ αÞ þ α
þ Lðk0 kd Þð1 þ αÞ ¼ ð1 þ αÞ½k0 þ α þ Lðk 0 kd Þ ð9:16Þ
k∗
e ¼ k 0 ð1 þ αÞ þ α þ Lðk 0 k d Þð1 þ αÞ:
It is seen that inflation not only increases the equity cost, but also it changes its
dependence on leverage. In particular, it increases the growing rate of equity cost
with leverage by multiplier (1 + α). The growing rate of equity cost with leverage,
which is equal to (k0 kd) without inflation, becomes equal to (k0 kd)(1 + α) with
accounting of inflation.
Thus, we come to the conclusion that it is necessary to modify the second
statement of the Modigliani–Miller theory (Мodigliani and Мiller 1958) concerning
the equity cost of the leverage company.
Second Original MM Statement
Equity cost of the leverage company ke could be found as equity cost of financially
independent company k0 of the same group of risk, plus premium for risk, the value
of which is equal to production of difference (k0 kd) on leverage level L.
Second Modified MM-BFO Statement
Under existence of inflation with rate α, equity cost of leverage company ke could be
found as equity cost of financially independent company k0 of the same group of risk,
multiplied by (1 + α), plus inflation rate α and plus premium for risk, the value of
which is equal to production of difference (k0 kd) on leverage level L and on
multiplier (1 + α).
9.3 Accounting of Inflation in Modigliani–Miller Theory

with Corporate Taxes
Let us calculate first the tax shield for perpetuity company under inflation:
X
1 t
ðPVÞTS ¼ k∗
d DT 1 þ k∗
d ¼ DT: ð9:17Þ
t¼1
It is interesting to note that in spite of dependence of each term of set on effective

credit rate k ∗
d , tax shield turns out to be independent of it and equal to “inflationless”
value DТ, and Modigliani–Miller theorem under inflation takes the following form
(Мodigliani and Мiller 1963):
V∗ ∗
L ¼ V 0 þ DT: ð9:18Þ
Substituting D ¼ wd V ∗
L , one gets
V∗ ∗ ∗
L ¼ CF=k 0 þ wd V L T ð9:19Þ
or
V∗ ∗
L ð1 wd T Þ ¼ CF=k 0 : ð9:20Þ
Because leverage company capitalization is equal to

V∗ ∗
L ¼ CF=WACC , for the weighted average cost of capital, one has
WACC∗ ¼ k ∗
0 ð1 wd T Þ: ð9:21Þ
From (Eq. 9.21), we get the dependence of WACC* on leverage level L ¼ D/S :
WACC∗ ¼ k∗
0 ð1 LT=ð1 þ LÞÞ, ð9:22Þ
WACC∗ ¼ ½k 0 ð1 þ αÞ þ α ð1 wd T Þ:
On definition of the weighted average cost of capital with accounting of the tax
shield, one has
WACC∗ ¼ k∗ ∗
0 we þ k d wd ð1 T Þ: ð9:23Þ
Equating right-hand parts of expressions (Eqs. 9.21 and 9.23), we get

9.3 Accounting of Inflation in Modigliani–Miller Theory with Corporate Taxes 167
k∗ ∗ ∗
0 ð1 wd T Þ ¼ k 0 we þ k d wd ð1 T Þ, ð9:24Þ
from where one obtains the following expression for equity cost:
ð1 wd T Þ wd 1 wd D
k∗ ∗
e ¼ k0 k∗d ð1 T Þ ¼ k ∗
e k∗
0 T k∗
d ð1 T Þ
we w e w e we S
D þ S D D
¼ k∗
0 k∗ ∗ ∗ ∗
0 T k d ð1 T Þ ¼ k 0 þ Lð1 T Þ k 0 k d ,
∗
S S S
∗
k∗ ∗
e ¼ k 0 þ L ð1 T Þ k 0 k d
∗
¼ ½k0 ð1 þ αÞ þ α þ Lð1 T Þðk 0 kd Þð1 þ αÞ: ð9:25Þ
It is seen that similar to the case without taxes, inflation not only increases the
equity cost, but also it changes its dependence on leverage (Fig. 9.2). In particular,
it increases the growing rate of equity cost with leverage by multiplier (1 + α).
The growing rate of equity cost with leverage, which is equal to (k0 kd)(1 T )
without inflation, becomes equal to (k0 kd)(1 + α)(1 T ) with accounting of
inflation.
We can now reformulate the fourth statement of the Modigliani–Miller theory
(Мodigliani and Мiller 1963) concerning the equity cost of leverage company for
case of accounting of inflation.
Fig. 9.2 Dependence of the C.C. k e*

equity cost and the weighted
average cost of capital on
leverage in the Modigliani–
Miller theory with taxes
under inflation. It is seen
that the growing rate of
equity cost increases with ke
leverage. Axis y means
capital costs (CC)
WACC*
k 0*
WACC
k0
0 L
Fourth Original MM Statement

Equity cost of leverage company ke paying tax on profit could be found as equity cost
of financially independent company k0 of the same group of risk, plus premium for
risk, the value of which is equal to production of difference (k0 kd) on leverage
level L, on tax shield (1-T), and on multiplier (1 + α).
Fourth Modified MM-BFO Statement
Equity cost of leverage company ke paying tax on profit under existence of inflation
with rate α could be found as equity cost of financially independent company k0 of
the same group of risk, multiplied by (1 + α), plus inflation rate α and plus premium
for risk, the value of which is equal to production of difference (k0 kd) on leverage
level L, on tax shield (1 T), and on multiplier (1 + α).
9.4 Accounting of Inflation in Brusov–Filatova–Orekhova

Theory with Corporate Taxes
9.4.1 Generalized Brusov–Filatova–Orekhova Theorem
Brusov, Filatova, and Orekhova generalized the Modigliani–Miller theory for the
case of the companies with arbitrary lifetime (or arbitrary age) (Brusov and Filatova
2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b; Filatova et al. 2008)
and have proved the following important theorem in case of absence of corporate
taxing:
Without corporate taxing, the equity cost k0, as well as the weighted average cost
of capital (WACC), does not depend on company’s lifetime and is equal to
ke ¼ k 0 þ Lðk0 k d Þ and WACC ¼ k0 : ð9:26Þ
consequently.
Thus, the theorem has proved that without corporate taxes (say, in offshore
zones), the Modigliani–Miller results for capital costs, in spite of the fact that they
have been obtained in perpetuity limit, remain in force for companies with arbitrary
lifetime, described by Brusov–Filatova–Orekhova theory (BFO theory). To prove
this theorem, Brusov, Filatova, and Orekhova, of course, had to go beyond
Modigliani–Miller approximation.
Under inflation, we can generalize this theorem (Brusov and Filatova 2011;
Generalized Brusov–Filatova–Orekhova Theorem
Under inflation without corporate taxing, the equity cost k∗
0 , as well as the weighted
average cost of capital (WACC*), does not depend on company’s lifetime and is
equal to
9.5 Generalized Brusov–Filatova–Orekhova Formula Under Existence of Inflation 169
∗
k∗ ∗ ∗
e ¼ k 0 þ L k 0 k d ¼ k 0 ð1 þ αÞ þ α þ Lðk 0 k d Þð1 þ αÞ
and
WACC∗ ¼ k∗
0 ¼ k 0 ð1 þ αÞ þ α ð9:27Þ
consequently.
Following Brusov–Filatova–Orekhova (Brusov and Filatova 2011; Brusov et al.
2011a, b, c, 2012a, b, 2013a, b, 2014a, b; Filatova et al. 2008), let us consider the
situation for companies of arbitrary age with accounting of corporate taxing. They
have derived the famous formula for weighted average cost of capital of companies
of arbitrary age
¼ : ð9:28Þ
The application of BFO formula (9.29) is very wide: authors have applied it in
corporate finance, in investments, in taxing, in business valuation, in banking, and in
some other areas (Brusov et al. 2011a, b, 2013a). Using this formula (9.28), one can
study the dependence of the weighted average cost of capital, WACC, as well as the
equity cost, ke, on leverage level, L, on tax on profit rate, t, on lifetime of the
company, n, and on relation between equity and debt cost. The qualitatively new
effect in corporate finance has been discovered: decrease of the equity cost ke with
leverage level L, which is quite important for corporate finance in general and, in
particular, for creating the adequate dividend policy.
Below we generalize formula (9.28) under existence of inflation.
9.5 Generalized Brusov–Filatova–Orekhova Formula

Under Existence of Inflation
Under existence of inflation, it is necessary to replace all capital costs, the equity, the
debt, and the weighted average cost of capital k0, kd, WACC, by effective ones k∗ 0,
k∗
d , and WACC*, where
k∗
0 ¼ k 0 ð1 þ αÞ þ α,
k∗
d ¼ k d ð1 þ αÞ þ α,
WACC∗ ¼ WACC ð1 þ αÞ þ α:
Rewriting the equations for tax shield (TS)n, for capitalization of financially
independent company V ∗ ∗
0 , as well as for financially dependent company V L for
the case of existence of inflation, one gets
X
n t n
ðPVÞTS ¼ ðTSÞn ¼ k∗
d DT 1 þ k∗
d ¼ DT 1 1 þ k∗
d ð9:29Þ
t¼1
X
n t n ∗
V∗
0 ¼ CF 1 þ k∗
0 ¼ CF 1 1 þ k ∗
0 =k0 , ð9:30Þ
t¼1
X
n
t n
V∗
L ¼ CF ð1 þ WACC∗ Þ ¼ CF 1 ð1 þ WACC∗ Þ =WACC∗ , ð9:31Þ
t¼1
V∗ ∗
L ¼ V 0 þ ðTSÞn : ð9:32Þ
After substitution D ¼ wd V ∗
L we have
V∗ ∗ ∗
L ¼ CF=k 0 þ wd V L T: ð9:33Þ
From here, after some transformations, we get generalized Brusov–Filatova–

Orekhova formula under existence of inflation:
n n
1 ð1 þ WACC∗ Þ 1 1 þ k∗
¼ ∗ 0
n , ð9:34Þ
WACC∗ k 0 1 ωd T 1 1 þ k ∗
d
or after substitutions,
k∗
0 ¼ k 0 ð1 þ αÞ þ α; k∗
d ¼ k d ð1 þ αÞ þ α,
one gets finally

n
1 ð1 þ WACC∗ Þ 1 ½ð1 þ k 0 Þð1 þ αÞn
¼ :
WACC∗ ðk 0 ð1 þ αÞ þ αÞ ½1 ωd T ð1 ðð1 þ kd Þð1 þ αÞÞn Þ
ð9:35Þ
Formula (9.35) is the generalized Brusov–Filatova–Orekhova formula under

existence of inflation.
Let us show some figures illustrating obtained results.
In Figs. 9.3 and 9.4, the dependence of the weighted average cost of capital
(WACC) on debt fraction wd at different inflation rate α (1, α ¼ 3%; 2, α ¼ 5%;
3, α ¼ 7%; 4, α ¼ 9%) for a 5-year company as well as for a 2-year company is seen.
It is seen that with increase of inflation rate lines, showing the dependence, WACC
(wd) shifts practically homogeneously to higher values.
Fig. 9.3 Dependence of the WACC(wd), k0=20%, kd=12%, T=20%

WACC
0.35
capital (WACC) on debt
fraction wd at different
inflation rate α (1, α ¼ 3%; 0.30
2, α ¼ 5%; 3, α ¼ 7%; and
4, α ¼ 9%) for a 5-year
0.25
company 4
3
0.20 2
1
0.15
0.10
0.05
Wd
0.00
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1
Fig. 9.4 Dependence of the WACC(wd), k0=20%, kd=12%, T=20%

WACC
0.35
capital (WACC) on debt
fraction wd at different
inflation rate α (1, α ¼ 3%; 0.30
2, α ¼ 5%; 3, α ¼ 7%; and
4, α ¼ 9%) for a 2-year 0.25 4
company 3
2
0.20 1
0.15
0.10
0.05
Wd
0.00
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1
It is seen that difference in results for a 2-year company and 5-year company is
very small. More obviously, it could be observed from Tables 9.1 and 9.2.
Below we show the dependences of the weighted average cost of capital (WACC)
on debt fraction wd at different tax on profit rate from T ¼ 10% up to T ¼ 100% at
different inflation rate α ¼ 3%, 5%, 7%, and 9% for a 5-year company (Figs. 9.5, 9.6,
9.7, and 9.8) as well as for a 2-year company (Figs. 9.9, 9.10, 9.11, and 9.12). Tax on
172
Table 9.1 Dependence of the weighted average cost of capital (WACC) on debt fraction wd at different inflation rate α ¼ 3%, 5%, 7%, and 9% for a 2-year
company
α/wd 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
0.03 0.2318 0.2276 0.2233 0.2191 0.2149 0.2106 0.2064 0.2021 0.1979 0.1937
0.05 0.2557 0.2503 0.2455 0.2406 0.2358 0.2309 0.2261 0.2212 0.2164 0.2115
0.07 0.2786 0.2733 0.2679 0.2626 0.2573 0.2514 0.2459 0.2404 0.2350 0.2295
0.09 0.3020 0.2960 0.2900 0.2839 0.2779 0.2720 0.2661 0.2602 0.2537 0.2476
9 Inflation in Brusov–Filatova–Orekhova Theory and in Its Perpetuity. . .
Table 9.2 Dependence of the weighted average cost of capital (WACC) on debt fraction wd at different inflation rate α ¼ 3%, 5%, 7%, and 9% for a 5-year
company
α/wd 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
0.03 0.2311 0.2262 0.2213 0.2163 0.2113 0.2064 0.2013 0.1963 0.1912 0.1863
0.05 0.2546 0.2491 0.2434 0.2379 0.2323 0.2267 0.2210 0.2154 0.2097 0.2040
0.07 0.2781 0.2718 0.2657 0.2595 0.2534 0.2472 0.2408 0.2346 0.2283 0.2219
0.09 0.3015 0.2947 0.2879 0.2812 0.2744 0.2676 0.2608 0.2539 0.2471 0.2400
9.5 Generalized Brusov–Filatova–Orekhova Formula Under Existence of Inflation
173
Fig. 9.5 Dependence of the WACC WACC(wd), k0=20%, kd=12%,

capital (WACC) on debt α = 3%
fraction wd at different tax
on profit rate at inflation rate 0.25
α ¼ 3% for a 5-year
company. Tax on profit rate
increases from T ¼ 0.1 0.15
(upper line) up to T ¼ 1
(lower line) with step 0.1
0.05
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1
–0.05
–0.15
Wd

increases from T ¼ 0.1 0.15
0.05
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1
–0.05
–0.15
Wd

on profit rate at inflation rate
α ¼ 7% for a 5-year 0.15
0.05 Wd
increases from T ¼ 0.1
(lower line) with step 0.1 –0.05 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1
–0.15
Fig. 9.8 Dependence of the WACC

WACC(wd), k0=20%, kd=12%,
0.30
α ¼ 9% for a 5-year 0.20
0.15
(upper line) up to T ¼ 1 0.10
(lower line) with step 0.1 0.05 Wd
0.00
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1
–0.05
–0.10
–0.15

0.25
company. Tax on profit rate 0.20
0.10
0.05
Wd
0.00
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1
–0.05
Fig. 9.10 Dependence of WACC WACC(wd), k0=20%, kd=12%,

the weighted average cost of 0.35
0.25
(upper line) up to T ¼ 1 0.05 Wd
–0.05 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1

0.15
(lower line) with step 0.1 0.10
0.05
Wd
0.00
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1
–0.05

(lower line) with step 0.1 0.10
0.05
Wd
0.00
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1
–0.05
profit rate increases from T ¼ 0.1 (upper line) up to T ¼ 1 (lower line) with the step
0.1.
The analysis of Figs. 9.5, 9.6, 9.7, 9.8, 9.9, 9.10, 9.11, and 9.12 shows that the
weighted average cost of capital (WACC) decreases with debt fraction wd and faster
with increase of tax on profit rate. The space between lines, corresponding to
different tax on profit rates, increases with inflation rate. The variation range of
WACC increases with inflation rate as well as with the company’s age.
9.6 Irregular Inflation
Above we considered inflation rate as constant. Really, as a rule, the inflation rate is a
variable. It is possible to generalize all above considerations for the case of
nonhomogeneous inflation, introducing effective inflation for a few periods.
9.7 Inflation Rate for a Few Periods 177
The effective inflation rate for a few periods t ¼ t1 + t2 + + tn is equal to
α ¼ ð1 þ α1 Þð1 þ α2 Þ . . . ð1 þ αn Þ 1, ð9:36Þ
where α1, α2, . . ., αn are inflation rates for periods t1, t2, . . ., tn.
The proof of the formula (9.36) will be done below in Sect. 9.6.
In the case of nonhomogeneous inflation, it could be accounted in both theories,
Modigliani–Miller and Brusov–Filatova–Orekhova theory (BFO theory), either
through effective inflation rate or directly upon discounting of financial flow.
9.7 Inflation Rate for a Few Periods
Suppose that the inflation rate for the consistent time periods t1, t2, . . ., tn is equal to
α1, α 2, . . ., αn consequently. Let us find the inflation rate α for total time period.
t ¼ t1 + t2 + + tn
Common sense dictates that inflation rate is an additive value, so that α, at least
approximately, is equal to the sum of the inflation rates α1, α2, . . ., αn.
α α1 þ α2 þ þ αn : ð9:37Þ
Below we will get an exact expression for inflation rate for the total period of
time, t, and will see how it is different from an intuitive result (9.37).
At the end of the first commitment period, the gained sum will be equal
to the amount S1 ¼ S0(1 + i) and with accounting of inflation
S1α ¼ S0 ð1 þ iÞt1 =ð1 þ α1 Þ. At the end of the second commitment period, the gained
sum will be equal to the amount S2 ¼ S0 ð1 þ iÞt1 þt2 and with accounting of inflation
S2α ¼ S0 ð1 þ iÞt1 þt2 =ð1 þ α1 Þð1 þ α2 Þ. At the end of the n–th commitment period,
the gained sum will be equal to the amount Sn ¼ S0 ð1 þ iÞt1 þt2 þ...þtn and with
accounting of inflation
Snα ¼ S0 ð1 þ iÞt1 þt2 þ...þtn =ð1 þ α1 Þð1 þ α2 Þ . . . ð1 þ αn Þ: ð9:38Þ
On the other hand, at inflation rate α for the total period at t ¼ t1 + t2 + + tn at

the end of this period t, gained sum will be equal to
Snα ¼ S0 ð1 þ iÞt =ð1 þ αÞ: ð9:39Þ
Equating the right-hand part of (9.38 and 9.39), we get
ð1 þ α1 Þð1 þ α2 Þ . . . ð1 þ αn Þ ¼ 1 þ α: ð9:40Þ
From where,
α ¼ ð1 þ α1 Þð1 þ α2 Þ . . . ð1 þ αn Þ 1: ð9:41Þ
It is easy to get a strict proof of this formula by the method of mathematical

induction. Note that inflation rate for the n-periods does not depend on both the
length of constituting periods and on the period t.
For equal inflation rates α1 ¼ α2 ¼ ¼ αn (it is interesting to note that herewith
the time intervals t1, t2, . . ., tn can be arbitrary and do not equal each other), one has
α ¼ ð1 þ α1 Þn 1: ð9:42Þ
9.8 Conclusions
In this chapter, the influence of inflation on capital cost and capitalization of the
company within modern theory of capital cost and capital structure, Brusov–
2011a, b, c, 2012a, b, 2013a, b, 2014a, b; Filatova et al. 2008), and in its perpetuity
limit, Modigliani–Miller theory (Мodigliani and Мiller 1958, 1963, 1966), which is
now outdated but still widely used in the West, is investigated. All basic results of
Modigliani–Miller theory were modified. It is shown that inflation not only increases
the equity cost and the weighted average cost of capital, but also it changes their
dependence on leverage. In particular, it increases the growth rate of equity cost with
leverage. Capitalization of the company is decreased with accounting of inflation.
Within modern theory of capital cost and capital structure, Brusov–Filatova–
Orekhova theory (BFO theory), the modified equation for the weighted average cost
of capital, WACC, applicable to companies with arbitrary lifetime under inflation
has been derived. Modified BFO equation allows us to investigate the dependence of
the weighted average cost of capital, WACC, and equity cost, ke, on leverage level,
L, on tax on profit rate, t, on age of the company, n, on equity cost of financially
independent company, k0, and debt cost, kd, as well as on inflation rate α.
Using modified BFO equation, the analysis of the dependence of the weighted
average cost of capital, WACC, on debt fraction, wd, at different tax on profit rate t,
as well as inflation rate α, has been done.
It has been shown that WACC decreases with debt fraction, wd, and decreases
faster at bigger tax on profit rates t. The space between lines, corresponding to
different values of tax on profit rate at the same step (10%), increases with inflation
rate α. The variation region (with change of tax on profit rate t) of the weighted
average cost of capital, WACC, increases with inflation rate α, as well as with the age
of the company n.
References 179
References
(11):815–824
org/10.1080/23322039.2014.946150
7:37–62
Econ Rev 53:147–175
1954–1957. Am Econ Rev 56:333–391
Part II
Investments
Next chapters (Chaps. 10–17) are devoted to study of different problems of invest-
ments: dependence of efficiency of investments on debt financing, on tax on profit
rate, on investment capital structure (leverage level); the existence of optimal
investment capital structure etc. We will present a different investment models,
developed by us and will study mentioned above problems using these models.
We start from the portfolio analysis in its simplest form: we study in this chapter
(Chap. 10) a portfolio of two securities.
Chapter 10
A Portfolio of Two Securities
The main objective of any investor is to ensure the maximum return on investment.
During the realization of this goal, at least two major problems appear: the first is in
which of the available assets and in what proportions an investor should invest. The
second problem is related to the fact that, in practice, as is well known, a higher level
of profitability is associated with a higher risk. Therefore, an investor can select an
asset with a high yield and high risk or a more or less guaranteed low yield. These
two selection problems constitute a problem of investment portfolio formation, the
decision which is given by portfolio theory, described in this chapter. We study in
detail the portfolio of the two securities (Brusov and Filatova 2014; Brusov et al.
2010, 2012), which represents a more simple case, containing, however, all the main
features of more common Markowitz and Tobin portfolios. It appears that when
selecting anticorrelated or noncorrelated securities, you can create a portfolio with
the risk lower than the risk of any of the securities of portfolio, or even zero-risk
portfolio (for anticorrelated securities).
10.1 A Portfolio of Two Securities
10.1.1 A Case of Complete Correlation
In a case of complete correlation,
ρ12 ¼ ρ ¼ 1: ð10:1Þ
For the square of the portfolio risk (dispersion), we have

https://doi.org/10.1007/978-3-319-99686-8_10
184 10 A Portfolio of Two Securities
σ 2 ¼ σ 21 x21 þ σ 22 x22 þ 2ρ12 σ 1 σ 2 x1 x2 ¼ σ 21 x21 þ σ 22 x22 þ 2σ 1 σ 2 x1 x2

¼ ð σ 1 x1 þ σ 2 x2 Þ 2 : ð10:2Þ
Extracting the square root from both sides, we obtain for portfolio risk
σ ¼ jσ 1 x1 þ σ 2 x2 j: ð10:3Þ
Since all variables are nonnegative, the sign of the module can be omitted:
σ ¼ σ 1 x1 þ σ 2 x2 : ð10:4Þ
Substituting x1 ! 1 t; x2 ! t, accounting x1 + x2 ¼ 1, we get
σ ¼ σ 1 ð1 t Þ þ σ 2 t: ð10:5Þ
This is the equation of the segment (АВ), where points A and B have the following
coordinates: ()A ¼ (μ1, σ 1); ()B ¼ (μ2, σ 2). t runs from 0 to 1. At t ¼ 0, portfolio is at
point A, and at t ¼ 1—at the point B. Thus, the admissible set of portfolios in the case
of complete correlation of the securities is a segment (AB) (Fig. 10.1).
If an investor forms a portfolio of minimal risk, he must incorporate in it one type
of paper that has less risk, in this case, the paper A, and the portfolio in this case is
X ¼ (1, 0). Portfolio yield (effectiveness) μ ¼ μ1.
With a portfolio of maximum yield, it is necessary to include in it only securities
with higher income, in this case, the paper B, and the portfolio in this case is
X ¼ (0, 1). Portfolio yield μ ¼ μ2.
Fig. 10.1 The dependence σ

of the risk of the portfolio of
two securities on its σ2 B
effectiveness for fixed r =1
parameters of both securities
A r =0,5
and with increase in the σ1
correlation coefficient σ" r=0
from –1 to 1 σ'
r = –1
r = –1
C
μ1 μ" μ ' μ0 μ2 μ
10.1 A Portfolio of Two Securities 185
10.1.2 Case of Complete Anticorrelation
In the case of complete anticorrelation,
ρ12 ¼ ρ ¼ 1: ð10:6Þ
For the square of the portfolio risk (dispersion), we have
σ 2 ¼ σ 21 x21 þ σ 22 x22 þ 2ρ12 σ 1 σ 2 x1 x2 ¼ σ 21 x21 þ σ 22 x22 2σ 1 σ 2 x1 x2

¼ ð σ 1 x1 σ 2 x2 Þ 2 : ð10:7Þ
Extracting the square root of both sides, we obtain for portfolio risk
σ ¼ jσ 1 x1 σ 2 x2 j: ð10:8Þ
Admissible set of portfolios in the case of complete anticorrelation of securities

consists of two segments (А, С) and (В, С) (Fig. 10.1). In this case, a risk-free
portfolio (point C) can exist.
Let us find a risk-free portfolio and its profitability.
From (10.8), one has
σ 1 x1 σ 2 x2 ¼ 0: ð10:9Þ
Substituting in (10.9) x2 ¼ 1 x1, we get
σ 1 x1 σ 2 ð1 x1 Þ ¼ 0,
σ2
x1 ¼ : ð10:10Þ
σ1 þ σ2
And
σ2
x2 ¼ 1 x1 ¼ : ð10:11Þ
σ1 þ σ2
Thus, risk-free portfolio has the form

σ2 σ1
X¼ ; , ð10:12Þ
σ1 þ σ2 σ1 þ σ2
and its yield is equal to
μ1 σ 2 þ μ2 σ 1
μ0 ¼ : ð10:13Þ
σ1 þ σ2
Note that the risk-free portfolio does not depend on the yield of securities and is
determined solely by their risks, and the pricing share of one security is proportional
to the risk of another.
Since |ρ| 1, then, all admissible portfolios are located inside (|ρ| < 1), or on the
boundary (|ρ| ¼ 1), of the triangle ABC (Fig. 10.1).
Example 10.1
For a portfolio of two securities with yield and risk, respectively, (0.2; 0.5) and (0.4;
0.7) in the case of complete anticorrelation find risk-free portfolio and its
profitability.
First, using Formula (4.30), we find a risk-free portfolio:

σ2 σ1 0:7 0:5
X0 ¼ ; ¼ ; ¼ ð0:583; 0:417Þ:
σ1 þ σ2 σ1 þ σ2 0:5 þ 0:7 0:5 þ 0:7
Then by Formula (4.31), we find its yield:
μ1 σ 2 þ μ2 σ 1 0:2 0:7 þ 0:4 0:5

μ0 ¼ ¼ ¼ 0:283:
σ1 þ σ2 0:5 þ 0:7
It is seen that the portfolio yield has an intermediate value between the yields
of both securities (but portfolio is risk-free!). One can check the results for
portfolio yield, calculating it by the formula (4.8) μ ¼ x1μ1 + x2μ2 ¼
0.583 0.2 + 0.417 0.4 ¼ 0.283.
10.1.3 Independent Securities
For independent securities,
ρ12 ¼ ρ ¼ 0: ð10:14Þ
For the square of the portfolio risk (variance), we have
σ 2 ¼ σ 21 x21 þ σ 22 x22 : ð10:15Þ
Let us find a minimum-risk portfolio and its profitability and risk. For this, it is
necessary to minimize the objective function
σ 2 ¼ σ 21 x21 þ σ 22 x22 ð10:16Þ
under condition
x1 þ x2 ¼ 1: ð10:17Þ
This is the task of a conditional extremum which is solved using the Lagrange
function
L ¼ σ 21 x21 þ σ 22 x22 þ λðx1 þ x2 1Þ: ð10:18Þ
To find the stationary points, we have the system

8
>
> ∂L
>
> ¼ 2σ 21 x1 þ λ ¼ 0
>
> ∂x
>
>
1
<
∂L
¼ 2σ 22 x2 þ λ ¼ 0 , ð10:19Þ
>
> ∂x
>
>
2
>
>
>
> ∂L
: ¼ x1 þ x2 1 ¼ 0
∂λ
Subtracting the first equation from the second, we obtain
σ 21 x1 ¼ σ 22 x2 : ð10:20Þ
Next, using the third equation, we have
σ 21 x1 ¼ σ 22 ð1 x1 Þ: ð10:21Þ
Hence
σ 22 σ 21
x1 ¼ , x2 ¼ : ð10:22Þ
σ 21 þ σ 22 σ 21 þ σ 22
Portfolio

σ 22 σ 21
X¼ ; , ð10:23Þ
σ 21 þ σ 22 σ 21 þ σ 22
and its yield
μ1 σ 22 μ σ2
μ¼ þ 22 12: ð10:24Þ
σ 21þ σ2 σ1 þ σ2
2
The portfolio risk is equal to

sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi σ 21 σ 42 þ σ 41 σ 42
σ ¼ σ 21 x21 þ σ 22 x22 ¼ 2 2 ¼
σ 1 þ σ 22
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
ð10:25Þ
σ 21 σ 22 σ 21 þ σ 22 σ1σ2
¼ 2 2 ¼ pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi :
σ1 þ σ2 2 σ 2 þ σ2
1 2
Note that in the case of three securities, there is no direct analogy with (10.22)
(see Sect. 10.1.4).
Example 10.2
Using formula (4.40), it is easy to demonstrate the effect of diversification on
portfolio risk. Suppose a portfolio consists of two independent securities with risks
σ 1 ¼ 0.1 and σ 2 ¼ 0.2, respectively. Let us calculate the portfolio risk by using
Formula (10.24)
σ1σ2 0:1 0:2

σ ¼ pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi ¼ pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi 0:0894:
σ1 þ σ2
2 2 0:01 þ 0:04
Thus, the portfolio risk σ 0.0894 turns out to be lower than the risk of each of
the securities (0.1; 0.2). This is an illustration of the principle of diversification: with
“smearing” of the portfolio on an independent security, risk is reduced.
10.1.4 Three Independent Securities
Although this case goes beyond the issue of a portfolio of two securities, we consider
it here as a generalization of the case of a portfolio of two securities.
For independent securities,
ρ12 ¼ ρ13 ¼ ρ23 ¼ 0: ð10:26Þ

σ 2 ¼ σ 21 x21 þ σ 22 x22 þ σ 23 x23 : ð10:27Þ
We find a minimum-risk portfolio, its profitability, and risk. For this, it is

necessary to minimize the objective function
σ 2 ¼ σ 21 x21 þ σ 22 x22 þ σ 23 x23 , ð10:28Þ
under condition
x1 þ x2 þ x3 ¼ 1: ð10:29Þ
This is a task on conditional extremum, which is solved using the Lagrange

function.
Let us write the Lagrange function and find its extremum:
L ¼ σ 21 x21 þ σ 22 x22 þ σ 23 x23 þ λðx1 þ x2 þ x3 1Þ: ð10:30Þ
To find the stationary points, we have the system

8
>
> ∂L
>
> ¼ 2σ 21 x1 þ λ ¼ 0
>
> ∂x
>
> ∂L
1
>
>
< ¼ 2σ 22 x2 þ λ ¼ 0
∂x2 ð10:31Þ
>
> ∂L
>
> ¼ 2σ 23 x3 þ λ ¼ 0
>
> ∂x
>
>
3
>
> ∂L
: ¼ x1 þ x2 1 ¼ 0:
∂λ
Subtracting from the first equation the second one and then the third one, we
obtain
σ 21 x1 ¼ σ 22 x2 ,
σ 21 x1 ¼ σ 22 x3 :
Hence
σ 21 σ2
x2 ¼ x1 , x3 ¼ 12 x1 : ð10:32Þ
σ2 2 σ3
Substituting (10.32) into the normalization condition
x1 þ x2 þ x3 ¼ 1, ð10:33Þ
we get
σ 21 σ 21
x1 þ x 1 þ x1 ¼ 1: ð10:34Þ
σ 22 σ 23
Hence
1 σ 22 σ 23
x1 ¼ ¼ : ð10:35Þ
1þ
σ 21
þ
σ 21 σ 22 σ 23 þ σ 21 σ 23 þ σ 21 σ 22
σ 22 σ 23
Substituting this x1 value in (10.32), we get the rest two components of the
portfolio:
σ 21 σ 23
x2 ¼ , ð10:36Þ
σ 22 σ 23 þ σ 21 σ 23 þ σ 21 σ 22
σ 21 σ 22
x3 ¼ : ð10:37Þ
σ 22 σ 23 þ σ 21 σ 23 þ σ 21 σ 22
The portfolio has the form
1
X¼ σ 22 σ 23 ; σ 21 σ 23 ; σ 21 σ 22 , ð10:38Þ
σ 22 σ 23 þ σ 21 σ 23 þ σ 21 σ 22
and its yield is equal to
μ1 σ 22 σ 23 þ μ2 σ 21 σ 23 þ μ3 σ 21 σ 22
μ¼ : ð10:39Þ
σ 22 σ 23 þ σ 21 σ 23 þ σ 21 σ 22
Portfolio risk is equal to

pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
σ ¼ σ 21 x21 þ σ 22 x22 þ σ 23 x23 ¼ ffi
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
σ1σ2σ3
σ 21 σ 42 σ 43 þ σ 22 σ 41 σ 43 þ σ 23 σ 41 σ 42 ¼ pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi : ð10:40Þ
2 2 2 σ 2 σ 3 þ σ 21 σ 23 þ σ 21 σ 22
2 2
σ2 σ3 þ σ1 σ3 þ σ1σ2
2 2 2 2
Example 10.3
For a portfolio of three independent securities with yield and risk of (0.1; 0.4),
(0.2; 0.6), and (0.4; 0.8), respectively, find the minimum-risk portfolio, its risk, and
yield. Portfolio of minimum risk is given by (10.38):
1
X¼ σ 22 σ 23 ; σ 21 σ 23 ; σ 21 σ 22 ¼
σ 22 σ 23 þ σ 21 σ 23 þ σ 21 σ 22

0:62 0:82 ; 0:42 0:82 ; 0:42 0:62 ð0:2304; 0:1024; 0:0576Þ
¼ ¼
0:6 0:8 þ 0:4 0:8 þ 0:4 0:6
2 2 2 2 2 2 0:2304 þ 0:1024 þ 0:0576
ð0:2304; 0:1024; 0:0576Þ
¼ ¼ ð0:590; 0:263; 0:147Þ:
0:3904
So, X ¼ (0.590; 0.263; 0.147).

Risk of portfolio of minimum risk is found by Formula (10.40)
10.2 Risk-Free Security 191
σ1σ2σ3 0:4 0:6 0:8

σ ¼ pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi ffi ¼ pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi ¼
σ2σ3 þ σ1σ3 þ σ1 σ2
2 2 2 2 2 2
0:6 0:8 þ 0:42 0:82 þ 0:42 0:62
2 2
0:192 0:192 0:192

¼ pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi ¼ pffiffiffiffiffiffiffiffiffiffiffiffiffiffi ¼ ¼ 0:307:
0:2304 þ 0:1024 þ 0:0576 0:3904 0:6348
Finally, yield of portfolio of minimum risk is found by Formula (10.39):
μ1 σ 22 σ 23 þ μ2 σ 21 σ 23 þ μ3 σ 21 σ 22
μ¼ ¼
σ 22 σ 23 þ σ 21 σ 23 þ σ 21 σ 22
0:1 0:62 0:82 þ 0:2 0:42 0:82 þ 0:4 0:42 0:62
¼ ¼
0:62 0:82 þ 0:42 0:82 þ 0:42 0:62
0:02304 þ 0:02048 þ 0:02304 0:06656
¼ ¼ 0:1705:
0:2304 þ 0:1024 þ 0:0576 0:3904
It is seen that the portfolio risk is less than the risk of each individual security, and
a portfolio yield is more than the first security yield, a little less than the yield of the
second security, and less than the yield of third security.
10.2 Risk-Free Security
Let one of the two portfolio securities be risk-free. Portfolio of n-securities, includ-
ing risk-free one, is named after Tobin, who has investigated this case for the first
time. Considering portfolio has properties which are substantially different from
those of the portfolio consisting only of risky securities. Here we consider the effect
of the inclusion of a risk-free security into the portfolio of two securities.
Thus, we have two securities, (1) (μ1, 0) and (2) (μ2, σ 2), with μ1 < μ2 (otherwise
it would be necessary to form a portfolio (1, 0) consisting only of the risk-free
securities, and we would have a risk-free portfolio of maximum yield).
We have the following equations:
μ ¼ μ 1 x1 þ μ 2 x2
σ ¼ σ 2 x2 ð10:41Þ
x1 þ x2 ¼ 1:
From these equations, it is easy to get an admissible set of portfolios
σ
μ ¼ μ1 ð1 x2 Þ þ μ2 x2 ¼ μ1 þ ðμ2 μ1 Þx2 ¼ μ1 þ ðμ2 μ1 Þ ,
σ2
which is a segment
σ
μ ¼ μ1 þ ðμ2 μ1 Þ , 0 σ σ2 : ð10:42Þ
σ2
At σ ¼ 0, portfolio is at a point 1 (μ1, 0) and at σ ¼ σ 2, at a point 2 (μ2, σ 2)

(Fig. 10.2).
Although this case is very simple, it is nevertheless possible to draw two
conclusions:
1. The admissible set of portfolios does not depend on the correlation coefficient
(although usually risk-free securities are considered to be uncorrelated with the
other (risky) securities).
2. The admissible set of portfolios has been narrowed from a triangle to the interval.
Note that a similar effect occurs in the case of Tobin’s portfolio.
In conclusion, we present the dependence of yield and risk of the portfolio on the
share of the risk-free securities (Fig. 10.3).
Fig. 10.2 Admissible set of σ

portfolios, consisting of two
securities, one of which is
2
risk-free σ2
1
μ1 μ2 μ

yield and risk of the
portfolio on the share of the
risk-free security x1
10.3 Portfolio of a Given Yield (or Given Risk) 193
It is evident that the portfolio risk decreases linearly with x1, from σ 2 at x1 ¼ 0 to
zero at x1 ¼ 1; at the same time yield also decreases linearly with x1, from μ2 at
x1 ¼ 0 to μ1 at x1 ¼ 1.
10.3 Portfolio of a Given Yield (or Given Risk)
In the case of a portfolio of two securities, given yield or its risk identifies portfolio
uniquely (except the case μ1 ¼ μ2, when only the given portfolio risk uniquely
identifies portfolio itself, see below for details).
Under the given yield (effectiveness) of the portfolio, it is uniquely defined as the
solution of the system:

μ ¼ μ 1 x1 þ μ 2 x2
ð10:43Þ
x1 þ x2 ¼ 1,
and under the given portfolio risk, it is uniquely defined as the solution of the
system:

σ 2 ¼ σ 21 x21 þ σ 22 x22 þ 2ρ12 σ 1 σ 2 x1 x2
ð10:44Þ
x1 þ x2 ¼ 1:
Therefore, in the case of a portfolio of two securities, it is not necessary to talk

about the minimal boundary (minimal risk portfolio for its given effectiveness).
Let us consider the first case—the given yield of the portfolio.
We will assume that μ1 6¼ μ2. The portfolio is uniquely defined as the solution of
the system (10.43):

μ ¼ μ 1 x1 þ μ 2 x2
x1 þ x2 ¼ 1,
Expressing x2 from the second equation and substituting it in the first equation,
we get
μ ¼ x1 μ1 þ x2 μ2 ¼ x1 μ1 þ ð1 x1 Þμ2 ¼ x1 ðμ1 μ2 Þ þ μ2 :
Hence, we find
μ μ2 μ μ
x1 ¼ , x2 ¼ 1 : ð10:45Þ
μ1 μ2 μ1 μ2
Substituting these expressions into the expression for the squared portfolio risk,
we obtain
σ 21 ðμ μ2 Þ2 þ σ 22 ðμ μ1 Þ2 2σ 1 σ 2 ρ12 ðμ μ1 Þðμ μ2 Þ
σ2 ¼ : ð10:46Þ
ðμ 2 μ 1 Þ2
Sometimes this equation mistakenly is called by the equation of the minimum

boundary. In fact, this equation describes the connection of portfolio risk to its
effectiveness.
Only at μ1 ¼ μ2, when the equality μ ¼ μ1 ¼ μ2 is valid for all the values of x1 and
x2 and the feasible set of portfolios is narrowing from the triangle to (vertical)
segment, we can speak of the minimal boundary, which in this case consists of a
single point (μ, σ 1) (at σ 1 < σ 2) or (μ, σ 2) (at σ 1 > σ 2).
Let us consider different limiting cases, considered by us above.
10.3.1 Case of Complete Correlation (ρ12 ¼ 1) and Complete

Anticorrelation (ρ12 ¼ 1)
As it is known, the correlation coefficient, ρ, does not exceed unity on absolute

value, so let us study equation (10.46) for the extreme values ρ ¼ 1.
First, we present general considerations.
For ρ ¼ 1, it is known that random variables R1 and R2 are linearly dependent.
Without loss of generality, we can assume that R2 ¼ aR1 + b. Then, a portfolio yield
can be written as follows:
RX ¼ x1 R1 þ ð1 x1 ÞR2 ¼ ðx1 þ að1 x1 ÞÞR1 þ ð1 x1 Þb: ð10:47Þ
Therefore
σ 2 ¼ ðx1 þ að1 x1 ÞÞ2 σ 21 , μ ¼ ðx1 þ að1 x1 ÞÞμ1 þ ð1 x1 Þb: ð10:48Þ
After elimination of the parameter x1, we obtain the following relation:
σ 2 ¼ ðcμ þ d Þ2 , ð10:49Þ
i.e., risk, as a function of yield will take the form of a segment or angle (Fig. 10.1).
Now let’s examine the equation (10.46) in cases ρ ¼ 1.
Case of complete correlation (ρ12 ¼ 1)

σ 1 ðμ μ 2 Þ σ 2 ðμ μ 1 Þ

σ¼ ð10:50Þ
ðμ 2 μ 1 Þ
Case of complete anticorrelation (ρ12 ¼ 1)

References 195

σ 1 ðμ μ 2 Þ þ σ 2 ðμ μ 1 Þ

σ¼ ð10:51Þ
ðμ 2 μ 1 Þ
Independent securities (ρ12 ¼ 0)

Equation (10.46) takes the form
σ 21 ðμ μ2 Þ2 þ σ 22 ðμ μ1 Þ2
σ2 ¼ : ð10:52Þ
ðμ2 μ1 Þ2
It could be shown that for intermediate values of the correlation coefficient ρ,

portfolio risk as a function of its efficiency has the form
αμ2 2βμ þ γ
σ2 ¼ : ð10:53Þ
δ
If one finds the shape of the dependence of risk portfolio on its effectiveness for a
given portfolio {(μ1, σ 1), (μ2, σ 2)}, but for different values of the correlation coeffi-
cient, ρ, then we can come to the following conclusion: μM decreases when the
correlation coefficient increases from –1 to 1.
In this case, a plot of the risk portfolio of its effectiveness is becoming more
elongated along the horizontal axis, i.e., for a fixed change in the expected yield μ,
increase in the risk σ becomes smaller (Fig. 10.1).
If we also assume that x1 2 [0, 1], and therefore x2 2 [0, 1], it is implied from the
first formula (10.43) that μ 2 [μ1, μ2] under the assumption μ1 < μ2, as μ is their
convex combination. Portfolios are part of the boundary of AMB, namely, the part
that connects the points (μ1, σ 1) and (μ2, σ 2) (Fig. 10.1).
Thus, in the case n ¼ 2 and under the additional assumption that x1 0, x2 0,
the set of portfolios is a hyperbola or pieces of broken lines connecting the points (μ1,
σ 1) and (μ2, σ 2).
References
Brusov P, Filatova T (2014) Financial mathematics for masters. KNORUS, Moscow, p 480
Brusov P, Brusov PP, Orehova N, Skorodulina S (2010) Financial mathematics for bachelor.
KNORUS, Moscow, p 224
Brusov P, Brusov PP, Orehova N, Skorodulina S (2012) Tasks on financial mathematics for
bachelor. KNORUS, Moscow, p 285
Chapter 11
Investment Models with Debt Repayment
at the End of the Project and Their
Application
In this Chapter, we build modern investment models, which will be used in the
following chapters for investigation of different problems of investments, such as
influence of debt financing, leverage level, taxing, project duration, method of
financing, and some other parameters on efficiency of investments and other
problems.
11.1 Investment Models
The effectiveness of the investment project is considered from two perspectives: the
owners of equity and debt and the equity holders only. For each of these cases, NPV
is calculated in two ways: with the division of credit and investment flows (and thus
discounting of the payments using two different rates) and without such a division
(in this case, both flows are discounted using the same rate, as which can be,
obviously, chosen WACC). For each of the four situations, two cases are considered:
(1) a constant value of equity S and (2) a constant value of the total invested capital
I ¼ S + D (D is value of debt funds).
As it was stated above, the effectiveness of the investment project is considered
from two perspectives: the owners of equity and debt and the equity holders only. In
the first case, the interest and duty paid by owners of equity (negative flows) returned
to the project because they are exactly equal to the flow (positive) obtained by
owners of debt capital. The only effect of leverage in this case is the effect of the tax
shield, generated from the tax relief: interest on the loan is entirely included into the
cost and thus reduces the tax base. After-tax flow of capital for each period in this
case is equal to
NOIð1 t Þ þ kd Dt ð11:1Þ
and the value of investments at the initial time moment T ¼ 0 is equal to –I ¼ –S – D.

https://doi.org/10.1007/978-3-319-99686-8_11
198 11 Investment Models with Debt Repayment at the End of the Project and. . .
Here NOI stands for net operating income (before taxes).

In the second case, investments at the initial time moment T ¼ 0 are equal to –S
and the flow of capital for the period (in addition to the tax shields kd Dt, it includes a
payment of interest on a loan kdD):
ðNOI kd DÞð1 t Þ: ð11:2Þ
Here, for simplicity, we suppose that interest on the loan will be paid in equal
shares kd D during all periods. Note that principal repayment is made at the end of the
last period.
Some variety of repayment of long-term loans will be considered below (see in
Chap. 14).
We will consider two different ways of discounting:
1. Operating and financial flows are not separated and both are discounted, using the
general rate (as which, obviously, the weighted average cost of capital (WACC)
can be selected). In this case for perpetuity projects, the Modigliani–Miller
formula (Мodigliani and Мiller 1958, 1963, 1966) for WACC will be used and
for projects of finite (arbitrary) duration, Brusov–Filatova–Orekhova formula
(Brusov and Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b,
2014a, b, 2015, 2018a, b, c, d; Filatova et al. 2008; Brusova 2011).
2. Operating and financial flows are separated and are discounted at different rates:
the operating flow at the rate which is equal to the equity cost ke, depending on
leverage and credit flow at the rate which is equal to the debt cost kd, which until
fairly large values of leverage remain constant and start to grow only at high
values of leverage L, when there is a danger of bankruptcy.
Note that loan capital is the least risky, because interest on credit is paid after
taxes in the first place. Therefore, the cost of credit will always be less than the equity
cost, whether of ordinary or of preference shares ke > kd; kp > kd. Here ke is the
equity cost of ordinary shares and kp is the equity cost of preference shares.
11.2 The Effectiveness of the Investment Project from

the Perspective of the Equity Holders Only
11.2.1 With the Division of Credit and Investment Flows
Projects of Finite (Arbitrary) Duration

In this case, the expression for NPV has a view:
11.2 The Effectiveness of the Investment Project from the Perspective of. . . 199
X
n
NOIð1 t Þ X
n
kd Dð1 t Þ D
NPV ¼ S þ þ
ð1 þ k e Þ
i¼1
i
i¼1 ð1 þ k d Þ i ð1 þ k d Þn

NOIð1 t Þ 1 1 D
¼ S þ 1 n D ð 1 t Þ 1 n :
ke ð1 þ k e Þ ð1 þ k d Þ ð1 þ k d Þn
ð11:3Þ
The last term in the first line-discounted (present) value of credit extinguished a
one-off payment at the end of the last period n.
Below we will look at two cases:
1. A constant value of the invested capital I ¼ S + D (D–debt value)
2. A constant value of equity capital S
We will start with the first case.
At a Constant Value of the Invested Capital (I ¼ const)
In the case of a constant value of the invested capital (I ¼ const), taking into account
D ¼ IL/(1 + L ) and S ¼ I/(1 + L ), one gets

I 1 1
NPV ¼ 1 þ L ð1 t Þ 1 þ
1þL ð1 þ k d Þn ð1 þ k d Þn
ð11:4Þ
NOIð1 t Þ 1
þ 1 :
ke ð1 þ k e Þn
For a 1-Year Project

Putting into Eq. (11.4) n ¼ 1, one gets for NPV

I 1 þ k d ð1 t Þ NOIð1 t Þ
NPV ¼ 1þL þ : ð11:5Þ
1þL ð1 þ k d Þ 1 þ ke
At a Constant Value of Equity Capital (S ¼ const)

Accounting that in case S ¼ const NOI is proportional to the invested capital,
NOI ¼ βI ¼ βS(1 + L ), we get

1 1
NPV ¼ S 1 þ L ð1 t Þ 1 þ
ð1 þ kd Þn ð1 þ k d Þn
ð11:6Þ
βSð1 þ LÞð1 t Þ 1
þ 1 :
ke ð1 þ k e Þn


1 þ kd ð1 t Þ βSð1 þ LÞð1 t Þ
NPV ¼ S 1 þ L þ : ð11:7Þ
1 þ kd 1 þ ke
11.3 Without Flows Separation
In this case operating and financial flows are not separated and are discounted, using
the general rate (as which, obviously, WACC can be selected).
The credit reimbursable at the end of the project (at the end of the period (n)) can
be discounted either at the same rate WACC or at the debt cost rate kd. Now we
choose a uniform rate and the first option.
X
n
NOIð1 t Þ kd Dð1 t Þ D
NPV ¼ S þ
ð1 þ WACCÞ i ð 1 þ WACC Þn
i¼1
NOIð1 t Þ k d Dð1 t Þ 1 D
¼ S þ 1 :
WACC ð1 þ WACCÞn ð1 þ WACCÞn
ð11:8Þ

In case of a constant value of the invested capital (I ¼ const), taking into account
D ¼ IL/(1 + L ) and S ¼ I/(1 + L ), one gets

I k d ð1 t Þ 1 L
NPV ¼ 1þL 1 þ
1þL WACC ð1þ WACCÞn ð1 þ WACCÞn
NOIð1 t Þ 1
þ 1 :
WACC ð1 þ WACCÞn
ð11:9Þ

Putting into Eq. (11.9) n ¼ 1, one gets for NPV:

I 1 þ k d ð1 t Þ NOIð1 t Þ
NPV ¼ 1þL þ : ð11:10Þ
1þL 1 þ WACC 1 þ WACC

Accounting that in case S ¼ const NOI is proportional to the invested capital, I,
NOI ¼ βI ¼ βS(1 + L ), and substituting D ¼ LS, we get

NOIð1 t Þ kd Dð1 t Þ 1
NPV ¼ S þ 1
WACC ð1 þ WACCÞn
D
, ð11:11Þ
ð1 þ WACCÞn
11.4 Modigliani–Miller Limit (Perpetuity Projects) 201

Lk d ð1 t Þ 1 L
NPV ¼ S 1 þ 1 þ
ð11:12Þ
þ 1 :
WACC ð1 þ WACCÞn


Lk d ð1 t Þ 1 L
NPV ¼ S 1 þ 1 þ
þ 1 :
WACC ð1 þ WACCÞn
NOIð1 t Þ k d Dð1 t Þ D
NPV ¼ S þ : ð11:13Þ
1 þ WACC
Substituting D ¼ LS, NOI ¼ βI ¼ βS(1 + L ), we get

Lðkd ð1 t Þ 1Þ βSð1 þ LÞð1 t Þ
NPV ¼ S 1 þ þ : ð11:14Þ
1 þ WACC 1 þ WACC
11.4 Modigliani–Miller Limit (Perpetuity Projects)

11.4.1 With Flows Separation
In perpetuity limit (Modigliani–Miller limit) (turning to the limit n ! 1 in the

relevant equations), we have
NOIð1 t Þ
NPV ¼ S þ Dð1 t Þ: ð11:15Þ
ke

At a constant value of the invested capital (I ¼ const), accounting D ¼ IL/(1 + L ),
S ¼ I/(1 + L ), we get
I NOIð1 t Þ
NPV ¼ ð1 þ Lð1 t ÞÞ þ : ð11:16Þ
1þL ke
I NOIð1 t Þ
1þL k 0 þ ðk0 k d ÞLð1 t Þ
In order to obtain Eqs. (11.17) from (11.16), we used the Modigliani–Miller

formula (Мodigliani and Мiller 1963a) for equity cost ke for perpetuity projects:
k e ¼ k0 þ ðk0 kd ÞLð1 t Þ: ð11:18Þ

Accounting D ¼ LS, we get in perpetuity limit (n ! 1) (Modigliani–Miller limit)
βSð1 þ LÞð1 t Þ
NPV ¼ Sð1 þ Lð1 t ÞÞ þ : ð11:19Þ
k0 þ ðk 0 kd ÞLt
11.4.2 Without Flows Separation
In perpetuity limit (n ! 1) (Modigliani–Miller limit) (turning to the limit n ! 1 in

the relevant equations), we have
NOIð1 t Þ k d Dð1 t Þ
NPV ¼ S þ : ð11:20Þ
WACC

S ¼ I/(1 + L ), we get
L
NOIð1 t Þ I k d ð1 t Þ
NPV ¼ I
1
þ 1 þ L
1 þ L WACC ð11:21Þ
1 Lk d ð1 t Þ NOIð1 t Þ
¼ I 1þ þ :
1þL k0 ð1 Lt=ð1 þ LÞÞ k0 ð1 Lt=ð1 þ LÞÞ

NOIð1 t Þ kd Dð1 t Þ
NPV ¼ S þ ð11:22Þ
WACC
Substituting D ¼ LS, we get

Lk d ð1 t Þ NOIð1 t Þ
NPV ¼ S 1 þ þ
WACC WACC
ð11:23Þ
Lk d ð1 t Þ βSð1 þ LÞð1 t Þ
¼ S 1 þ þ :
k0 ð1 Lt=ð1 þ LÞÞ k0 ð1 Lt=ð1 þ LÞÞ

the Perspective of the Owners of Equity and Debt
Projects of Arbitrary (Finite) Duration

In this case, operating and financial flows are separated and are discounted, using
different rates: the operating flow at the rate equal to the equity cost ke, depending on
leverage, and credit flow at the rate equal to the debt cost kd, which until fairly large
values of leverage remain constant and start to grow only at high values of leverage
L, when there is a danger of bankruptcy.
X
n
NOIð1 t Þ X
n
k d Dt
NPV ¼ I þ i þ
ð1 þ k e Þ i¼1 ð1 þ kd Þi ð11:24Þ
i¼1
NOIð1 t Þ 1 1
¼ I þ 1 þ Dt 1 :
ke ð1 þ k e Þn ð1 þ k d Þn
Below we will consider two cases:

1. At a constant value of the invested capital (I ¼ S + D (D is the debt value))
2. At a constant value of equity capital S
We will start with the first case.
S ¼ I/(1 + L ), we get

NOIð1 t Þ 1 ILt 1
NPV ¼ I þ 1 þ 1
ke ð1 þ ke Þn 1þL ð1 þ k d Þ
n

Lt 1 NOIð1 t Þ 1
¼ I 1 1 þ 1 :
1þL ð1 þ k d Þn ke ð1 þ k e Þn
ð11:25Þ

Accounting D ¼ LS, I ¼ S(1 + L ), we get

NOIð1 t Þ 1 1
NPV ¼ S LS þ 1 þ Dt 1 : ð11:26Þ
ke ð1 þ k e Þn ð1 þ k d Þn
Accounting that in the case S ¼ const NOI is not a constant, but is proportional to
the invested capital, NOI ¼ βI ¼ βS(1 + L ), we get

1
NPV ¼ S 1 þ L tL 1
ð1 þ kd Þn

þ 1 : ð11:27Þ
ke ð1 þ k e Þn
For 1-Year Project

kd βSð1 þ LÞð1 t Þ
NPV ¼ S 1 þ L tL þ : ð11:28Þ
1 þ kd 1 þ ke
In this case operating and financial flows are not separated, and both are discounted,
using the general rate (as which, obviously, WACC can be selected):
X
n
NOIð1 t Þ þ kd Dt
NPV ¼ I þ
ð1 þ WACCÞi ð11:29Þ
i¼1
NOIð1 t Þ þ kd Dt 1
¼ I þ 1 :
WACC ð1 þ WACCÞn

At a constant value of the invested capital (I ¼ const), we have

NOIð1 t Þ þ k d Dt 1
NPV ¼ I þ 1 :
WACC ð1 þ WACCÞn
Accounting D ¼ IL/(1 + L ), S ¼ I/(1 + L ), we get

2 0 13
L
6 kd t 7
NPV ¼ I 6 1 þ L B1 1
n C
41 @ A75
L 1 þ k0 1 γ 1þLt
L
k0 1 γ t
0 1þL 1 ð11:30Þ
NOIð1 t Þ B
n C
1
þ @1 A:
L þ γ L
k0 1 γ t 1 k 0 1 1þL t
1þL
For 1-Year Project

11.6 Modigliani–Miller Limit 205

L
kd t 1þL NOIð1 t Þ
NPV ¼ I 1 þ : ð11:31Þ
1 þ WACC 1 þ WACC

NOIð1 t Þ þ kd Dt 1
NPV ¼ I þ 1 n
WACC ð1 þ WACC Þ
kd Lt 1
¼ S 1 þ L 1 ð11:32Þ
WACC ð 1 þ WACC
Þn
þ 1 :
WACC ð1 þ WACCÞn
For 1-Year Project
NOIð1 t Þ þ k d Dt
NPV ¼ I þ
1 þ WACC ð11:33Þ
kd Lt NOIð1 t Þ
¼ S 1 þ L þ :
1 þ WACC 1 þ WACC
11.6 Modigliani–Miller Limit

In perpetuity limit (n ! 1) (Modigliani–Miller limit), we have
NOIð1 t Þ
NPV ¼ I þ þ Dt: ð11:34Þ
ke

we have

L NOIð1 t Þ
NPV ¼ I 1 t þ : ð11:35Þ
1þL ke
For equity cost ke and WACC in Modigliani–Miller theory, we have consequently
k e ¼ k0 þ ðk 0 kd ÞLð1 t Þ, ð11:36Þ
WACC ¼ k0 ð1 wd t Þ ¼ k0 ð1 Lt=ð1 þ LÞÞ: ð11:37Þ
Putting Eqs. (11.36) into (11.37), we get


L NOIð1 t Þ
NPV ¼ I 1 t þ : ð11:38Þ
1þL k0 þ ðk0 kd ÞLð1 t Þ

Accounting D ¼ LS, I ¼ S(1 + L ), in perpetuity limit
(n ! 1) (Modigliani–Miller limit), we have
NOIð1 t Þ
k0 þ ðk 0 kd ÞLt
Note that in the case S ¼ const NOI is not a constant, but is proportional to the
invested capital, NOI ¼ βI ¼ βS(1 + L ).
In this case, Eq. (11.38) is replaced by
NPV ¼ Sð1 þ Lð1 t ÞÞ þ , ð11:40Þ
k0 þ ðk0 kd ÞLt
NPV ¼ I þ : ð11:41Þ
WACC
At a constant value of the invested capital (I ¼ const), we have
NOIð1 t Þ þ k d Dt
NPV ¼ I þ
0 1
WACC
L
B kd t C NOIð1 t Þ ð11:42Þ
¼ I B
@1 1 þ L C Aþ :
L L
k0 1 t k0 1 t
1þL 1þL


kd Lt NOIð1 t Þ
NPV ¼ S 1 þ L þ : ð11:43Þ
WACC WACC
References 207
2 3
kd Lt βSð1 þ LÞð1 t Þ
NPV ¼ S41 þ L 5 þ : ð11:44Þ
k0 1 1þL
L
t k 0 1 1þL
L
t
References
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org/10.1080/23322039.2014.946150
7:37–62
Econ Rev 53:147–175
1954–1957. Am Econ Rev 56:333–391
Chapter 12
Influence of Debt Financing
on the Efficiency of Investment Projects:
The Analysis of Efficiency of Investment
Projects Within the Perpetuity (Modigliani–
Miller) Approximation

In this chapter, we conduct the analysis of effectiveness of investment projects

within the perpetuity (Modigliani–Miller) approximation (Modigliani and Miller
1958, 1963, 1966). In the next chapter we make the analysis of effectiveness of
investment projects within modern theory of capital cost and capital structure by
Brusov-Filatova-Orekhova (BFO theory) (Brusov et al. 2011a, b, c, 2012a, b, 2013a,
b, 2014a, b, 2015, 2018a, b, c, d; Brusov and Filatova 2011; Brusova 2011; Filatova
et al. 2008).
At a Constant Value of the Total Invested Capital (I ¼ Const)
I NOIð1 t Þ
NPV ¼ ð1 þ Lð1 t ÞÞ þ ð12:1Þ
1þL k0 þ ðk 0 kd ÞLð1 t Þ
1. At the constant values of Δk ¼ k0 kd, NPV practically always decreases with

leverage. At small L for many pairs of values k0 and kd (e.g., k0 (14%) and kd
(12%), k0 (18%) and kd (16%), and many others), there is an optimum in the
dependence of NPV(L ) at small L 2.
For higher values of k0 (and, accordingly, kd), curves NPV(L ) lie below. With
increase of NOI, all curves NPV(L ) are shifted in parallel upward.
2. At the constant values of k0, NPV practically always decreases with leverage,
passing through (most often), or not passing (more rarely) through, optimum in
the dependence of NPV(L ) at small L 2.
All curves NPV(L ) at the constant values of k0 are started (at L ¼ 0) from a
single point, and with the increasing of kd (and, respectively, a decrease of Δk),

https://doi.org/10.1007/978-3-319-99686-8_12
210 12 Influence of Debt Financing on the Efficiency of Investment Projects:. . .
curves NPV(L ) lie above. With increase of NOI, all curves NPV(L) are shifted in
parallel upward practically.
3. At the constant values of kd, NPV practically always decreases with leverage;
optimum in the dependence of NPV(L ) is absent.
All curves NPV(L ) at the constant values of k0 are started (at L ¼ 0) from a
single point. With the increasing of k0 (and, respectively, an increase of Δk),
curves NPV(L ) are shifted into region of higher NPV values. With increase of
NOI, all curves NPV(L) are shifted in parallel upward practically (Table 12.1;
Figs. 12.1 and 12.2).
At a Constant Equity Value (S ¼ Const)
NPV ¼ Sð1 þ Lð1 t ÞÞ þ ð12:2Þ
k 0 þ ðk0 k d ÞLt
leverage. The optimum in the dependence of NPV(L) has been found for one pair
of k0 and kd [k0 (8%) and kd (6%)] only.
All curves NPV(L ) at the constant values of k0 are started (at L ¼ 0) from one
point, and with growth of k0 (and, accordingly, kd), all curves NPV(L ) lie below.
With growth of Δk, density of curves NPV(L ) increases.
2. At the constant values of k0, NPV practically always decreases with leverage.
Optimum in the dependence of NPV(L ) is absent.
point, and with growth of kd (and, respectively, a decrease of Δk), all curves NPV
(L ) are shifted upward. With growth of Δk, density of curves NPV(L ) increases.
3. At the constant values of kd, NPV practically always decreases with leverage. The
optimum in the dependence of NPV(L ) has been found for one pair of k0 and kd
[k0 (8%) and kd (6%)] only.
point, and with growth of k0 (and, respectively, an increase of Δk), curves NPV
(L ) are shifted into region of smaller NPV values. With growth of Δk, density of
curves NPV(L ) increases (Table 12.2; Figs. 12.3 and 12.4).
Table 12.1 NOI ¼ 1200, I ¼ 2000, k0kd ¼ const
12.1
L
k0 kd 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5
1 0.08 0.06 10,000.0 9042.4 8200.0 7470.8 6838.1 6285.7 5800.0 5369.9 4986.7 4643.1
2 0.10 0.08 7600.0 7022.2 6475.9 5981.9 5539.4 5142.9 4786.5 4465.0 4173.7 3908.7
3 0.14 0.12 4857.1 4619.8 4353.8 4093.7 3848.1 3619.0 3406.4 3209.1 3025.9 2855.6
4 0.18 0.16 3333.3 3239.7 3098.0 2945.9 2795.0 2649.4 2510.5 2378.9 2254.4 2136.8
5 0.24 0.22 2000.0 2004.3 1950.0 1876.4 1796.1 1714.3 1633.3 1554.4 1477.9 1404.2
6 0.30 0.28 1200.0 1250.2 1238.0 1203.0 1158.2 1109.2 1058.6 1007.7 957.4 907.9
7 0.36 0.34 666.7 742.0 753.2 740.0 715.6 685.7 652.9 618.8 584.2 549.5
8 0.40 0.38 400.0 486.3 507.7 504.2 488.9 467.5 442.9 416.4 389.0 361.2
9 0.44 0.42 181.8 276.2 305.3 309.0 300.6 285.7 267.2 246.6 224.8 202.3
10 0.10 0.06 7600.0 6409.2 5472.7 4726.5 4120.3 3619.0 3198.0 2839.4 2530.5 2261.7
11 0.12 0.08 6000.0 5192.2 4515.8 3954.3 3484.1 3085.7 2744.4 2449.0 2191.0 1963.6
12 0.16 0.12 4000.0 3587.9 3200.0 2855.4 2552.4 2285.7 2050.0 1840.5 1653.3 1485.2
13 0.20 0.16 2800.0 2577.8 2337.9 2111.0 1903.0 1714.3 1543.2 1388.0 1246.8 1118.0
14 0.24 0.20 2000.0 1883.3 1729.4 1573.3 1424.6 1285.7 1157.1 1038.4 928.7 827.3
15 0.30 0.26 1200.0 1171.3 1091.6 998.6 904.0 812.0 724.2 641.2 563.0 489.4
16 0.36 0.32 666.7 686.5 649.0 592.9 530.8 467.5 405.3 345.0 287.2 232.0
17 0.40 0.36 400.0 441.0 422.2 382.9 335.6 285.7 235.5 186.1 138.2 92.0
18 0.44 0.40 181.8 238.6 233.9 207.2 171.4 131.9 91.0 50.2 10.1 28.9
(continued)
The Effectiveness of the Investment Project from the Perspective of. . .
211
212
L
k0 kd 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0
1 0.08 0.06 4333.3 4052.7 3797.4 3564.1 3350.0 3152.9 2970.9 2802.3 2645.7 2499.8 2363.6
2 0.10 0.08 3666.7 3444.8 3240.8 3052.5 2878.3 2716.6 2566.1 2425.7 2294.4 2171.4 2055.9
3 0.14 0.12 2697.0 2549.0 2410.7 2281.1 2159.5 2045.2 1937.6 1836.2 1740.3 1649.6 1563.6
12
4 0.18 0.16 2025.6 1920.6 1821.1 1726.9 1637.7 1552.9 1472.4 1395.9 1323.0 1253.5 1187.2
5 0.24 0.22 1333.3 1265.3 1200.0 1137.4 1077.3 1019.6 964.3 911.1 860.0 810.9 763.6
6 0.30 0.28 859.6 812.7 767.1 722.9 680.1 638.7 598.5 559.7 522.2 485.8 450.6
7 0.36 0.34 515.2 481.3 448.1 415.6 383.9 352.9 322.8 293.4 264.8 236.9 209.8
8 0.40 0.38 333.3 305.7 278.3 251.4 225.0 199.1 173.7 148.9 124.7 101.0 77.9
9 0.44 0.42 179.5 156.6 133.9 111.4 89.1 67.2 45.7 24.6 3.8 16.5 36.4
10 0.10 0.06 2025.6 1816.7 1630.5 1463.5 1313.0 1176.5 1052.2 938.5 834.2 738.1 649.4
11 0.12 0.08 1761.9 1581.7 1419.8 1273.5 1140.7 1019.6 908.7 806.9 712.9 626.1 545.5
12 0.16 0.12 1333.3 1195.6 1070.1 955.4 850.0 752.9 663.2 580.1 502.9 430.9 363.6
13 0.20 0.16 1000.0 891.7 791.8 699.6 614.2 534.8 460.8 391.8 327.2 266.7 209.8
14 0.24 0.20 733.3 646.2 565.1 489.5 419.0 352.9 291.0 232.9 178.2 126.6 77.9
15 0.30 0.26 420.3 355.3 294.1 236.4 182.1 130.7 82.2 36.2 7.3 48.7 88.0
16 0.36 0.32 179.5 129.5 82.0 36.8 6.2 47.1 86.0 123.1 158.5 192.3 224.6
17 0.40 0.36 47.6 5.1 35.5 74.4 111.5 147.1 181.0 213.5 244.7 274.5 303.0
18 0.44 0.40 66.7 103.1 138.2 171.9 204.2 235.3 265.1 293.8 321.3 347.8 373.2
Influence of Debt Financing on the Efficiency of Investment Projects:. . .
Fig. 12.1 Dependence of NPV(L), NOI=1200, t = 20% NPV

NPV on leverage level at 12000
fixed values of k0 and kd
1 10000
2
8000
6000
3
4000
4
5 2000
6
7
8
9 0
0 1 2 3 4 5 6 7 8 9 10 11
–2000
L

10
7000
11 6000
5000
12 4000
13 3000
14 2000
15
1000
16
17
18
0
0 1 2 3 4 5 6 7 8 9 10 11
–1000
L
Table 12.2 S ¼ 1000, β ¼ 0.1, k0kd ¼ const
214
L
k0 kd 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5
1 0.08 0.06 0.0 63.4 104.8 125.6 127.3 111.1 78.3 29.8 33.3 110.2
2 0.10 0.08 200.0 223.5 261.5 313.2 377.8 454.5 542.9 642.1 751.7 871.2
3 0.14 0.12 428.6 554.9 688.9 830.1 978.4 1133.3 1294.7 1462.3 1635.9 1815.2
12
4 0.18 0.16 555.6 740.7 930.4 1124.7 1323.4 1526.3 1733.3 1944.3 2159.2 2377.8
5 0.24 0.22 666.7 904.1 1144.3 1387.0 1632.3 1880.0 2130.2 2382.7 2637.5 2894.6
6 0.30 0.28 733.3 1002.6 1273.7 1546.4 1820.8 2096.8 2374.4 2653.5 2934.2 3216.4
7 0.36 0.34 777.8 1068.5 1360.4 1653.6 1947.8 2243.2 2539.8 2837.4 3136.2 3436.0
8 0.40 0.38 800.0 1101.5 1404.0 1707.4 2011.8 2317.1 2623.3 2930.4 3238.5 3547.4
9 0.44 0.42 818.2 1128.5 1439.6 1751.6 2064.3 2377.8 2692.0 3007.0 3322.8 3639.3
10 0.10 0.06 200.0 246.2 318.5 414.3 531.0 666.7 819.4 987.5 1169.7 1364.7
11 0.12 0.08 333.3 432.3 550.0 684.8 835.3 1000.0 1177.8 1367.6 1568.4 1779.5
12 0.16 0.12 500.0 668.3 847.6 1037.2 1236.4 1444.4 1660.9 1885.1 2116.7 2355.1
13 0.20 0.16 600.0 811.8 1030.8 1256.6 1488.9 1727.3 1971.4 2221.1 2475.9 2735.6
14 0.24 0.20 666.7 908.2 1154.8 1406.3 1662.5 1923.1 2187.9 2456.7 2729.4 3005.8
15 0.30 0.26 733.3 1005.3 1280.5 1559.0 1840.5 2125.0 2412.3 2702.4 2995.2 3290.5
16 0.36 0.32 777.8 1070.3 1365.2 1662.4 1961.7 2263.2 2566.7 2872.2 3179.6 3488.9
17 0.40 0.36 800.0 1103.0 1407.8 1714.6 2023.1 2333.3 2645.3 2958.9 3274.1 3590.8
18 0.44 0.40 818.2 1129.7 1442.9 1757.5 2073.7 2391.3 2710.3 3030.8 3352.5 3675.6
L
12.1
k0 kd 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0
1 0.08 0.06 200.0 302.0 415.4 539.6 674.1 818.2 971.4 1133.3 1303.4 1481.4 1666.7
2 0.10 0.08 1000.0 1137.7 1283.9 1438.1 1600.0 1769.2 1945.5 2128.4 2317.6 2513.0 2714.3
3 0.14 0.12 2000.0 2190.1 2385.4 2585.5 2790.5 3000.0 3214.0 3432.2 3654.5 3880.9 4111.1
4 0.18 0.16 2600.0 2825.7 3054.9 3287.4 3523.1 3761.9 4003.8 4248.6 4496.3 4746.8 5000.0
5 0.24 0.22 3153.8 3415.3 3678.8 3944.4 4211.9 4481.5 4752.9 5026.3 5301.4 5578.4 5857.1
6 0.30 0.28 3500.0 3785.1 4071.6 4359.5 4648.8 4939.4 5231.3 5524.6 5819.0 6114.8 6411.8
7 0.36 0.34 3736.8 4038.7 4341.7 4645.6 4950.5 5256.4 5563.3 5871.1 6179.8 6489.4 6800.0
8 0.40 0.38 3857.1 4167.8 4479.2 4791.5 5104.7 5418.6 5733.3 6048.8 6365.1 6682.2 7000.0
9 0.44 0.42 3956.5 4274.5 4593.1 4912.4 5232.5 5553.2 5874.6 6196.6 6519.3 6842.7 7166.7
10 0.10 0.06 1571.4 1788.9 2016.2 2252.6 2497.4 2750.0 3009.8 3276.2 3548.8 3827.3 4111.1
11 0.12 0.08 2000.0 2229.3 2466.7 2711.6 2963.6 3222.2 3487.0 3757.4 4033.3 4314.3 4600.0
12 0.16 0.12 2600.0 2851.0 3107.7 3369.8 3637.0 3909.1 4185.7 4466.7 4751.7 5040.7 5333.3
13 0.20 0.16 3000.0 3268.9 3541.9 3819.0 4100.0 4384.6 4672.7 4964.2 5258.8 5556.5 5857.1
14 0.24 0.20 3285.7 3569.0 3855.6 4145.2 4437.8 4733.3 5031.6 5332.5 5635.9 5941.8 6250.0
15 0.30 0.26 3588.2 3888.4 4190.8 4495.5 4802.2 5111.1 5422.0 5734.8 6049.5 6366.0 6684.2
16 0.36 0.32 3800.0 4112.9 4427.5 4743.7 5061.5 5381.0 5701.9 6024.3 6348.1 6673.4 7000.0
17 0.40 0.36 3909.1 4228.8 4550.0 4872.6 5196.5 5521.7 5848.3 6176.1 6505.1 6835.3 7166.7
18 0.44 0.40 4000.0 4325.6 4652.5 4980.5 5309.7 5640.0 5971.4 6303.9 6637.5 6972.1 7307.7
215
Fig. 12.3 Dependence of NPV(L), t = 20% NPV

0
0 1 2 3 4 5 6 7 8 9 10 11
–1000
1
–2000
2
–3000
3 –4000
4 –5000
5
–6000
6
7
8
9 –7000
–8000
L

fixed values of k0 and kd 0 1 2 3 4 5 6 7 8 9 10 11
–1000
–2000
–3000
10 –4000
11
–5000
12
13
–6000
14
15
16
17
–7000
18
–8000
L
At a Constant Investment Value (I ¼ Const)

1 Lkd ð1 t Þ NOIð1 t Þ
NPV ¼ I 1þ þ ð12:3Þ
1þL k 0 ð1 Lt=ð1 þ LÞÞ k 0 ð1 Lt=ð1 þ LÞÞ
1. At the constant values of Δk ¼ k0 kd, NPV demonstrates a limited growth with

leverage with output into saturation regime. The main increase in NPV occurs
when L 3 6. With growth of k0 (and kd), the сurves NPV(L ) are lowered.
With growth of NOI, all curves NPV(L ) are shifted practically parallel
upward.
2. At the constant values of k0, NPV demonstrates a limited growth with leverage
with output into saturation regime. All curves NPV(L ) at the constant values of k0
and different values of kd are started (at L ¼ 0) from one point; the higher values
of kd correspond to more low-lying curves NPV(L ). Optimum in dependence of
NPV(L ) is absent. With growth of NOI, all curves NPV(L ) are shifted practically
parallel upward.
3. At the constant values of kd, NPV grows with leverage with output into saturation
regime. All curves NPV(L) at the constant values of k0 and different values of kd
are started (at L ¼ 0) from one point; the higher values of k0 (and higher values of
Δk ¼ k0 kd) correspond to more low-lying curves NPV(L ). Optimum in
dependence of NPV(L ) is absent (Table 12.3, Figs. 12.5 and 12.6).
218
L
k0 kd 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5
1 0.08 0.06 10,000.0 11,095.2 11,666.7 12,018.2 12,256.4 12,428.6 12,558.8 12,660.8 12,742.9 12,810.3
2 0.10 0.08 7600.0 8495.2 8955.6 9236.4 9425.6 9561.9 9664.7 9745.0 9809.5 9862.5
3 0.14 0.12 4857.1 5523.8 5857.1 6057.1 6190.5 6285.7 6357.1 6412.7 6457.1 6493.5
12
4 0.18 0.16 3333.3 3873.0 4135.8 4290.9 4393.2 4465.6 4519.6 4561.4 4594.7 4621.9
5 0.24 0.22 2000.0 2428.6 2629.6 2745.5 2820.5 2873.0 2911.8 2941.5 2965.1 2984.2
6 0.30 0.28 1200.0 1561.9 1725.9 1818.2 1876.9 1917.5 1947.1 1969.6 1987.3 2001.6
7 0.36 0.34 666.7 984.1 1123.5 1200.0 1247.9 1280.4 1303.9 1321.6 1335.4 1346.5
8 0.40 0.38 400.0 695.2 822.2 890.9 933.3 961.9 982.4 997.7 1009.5 1019.0
9 0.44 0.42 181.8 458.9 575.8 638.0 676.0 701.3 719.3 732.6 742.9 751.0
10 0.10 0.06 7600.0 8609.5 9133.3 9454.5 9671.8 9828.6 9947.1 10039.8 10114.3 10175.5
11 0.12 0.08 6000.0 6857.1 7296.3 7563.6 7743.6 7873.0 7970.6 8046.8 8107.9 8158.1
12 0.16 0.12 4000.0 4666.7 5000.0 5200.0 5333.3 5428.6 5500.0 5555.6 5600.0 5636.4
13 0.20 0.16 2800.0 3352.4 3622.2 3781.8 3887.2 3961.9 4017.6 4060.8 4095.2 4123.3
14 0.24 0.20 2000.0 2476.2 2703.7 2836.4 2923.1 2984.1 3029.4 3064.3 3092.1 3114.6
15 0.30 0.26 1200.0 1600.0 1785.2 1890.9 1959.0 2006.3 2041.2 2067.8 2088.9 2105.9
16 0.36 0.32 666.7 1015.9 1172.8 1260.6 1316.2 1354.5 1382.4 1403.5 1420.1 1433.5
17 0.40 0.36 400.0 723.8 866.7 945.5 994.9 1028.6 1052.9 1071.3 1085.7 1097.2
18 0.44 0.40 181.8 484.8 616.2 687.6 731.9 761.9 783.4 799.6 812.1 822.1
L
12.1
k0 kd 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0
1 0.08 0.06 12,866.7 12,914.5 12,955.7 12,991.4 13,022.7 13,050.4 13,075.1 13,097.2 13,117.1 13,135.1 13,151.5
2 0.10 0.08 9906.7 9944.2 9976.4 10,004.3 10,028.8 10,050.4 10,069.7 10,086.9 10,102.4 10,116.5 10,129.3
3 0.14 0.12 6523.8 6549.5 6571.4 6590.5 6607.1 6621.8 6634.9 6646.6 6657.1 6666.7 6675.3
4 0.18 0.16 4644.4 4663.5 4679.8 4693.9 4706.2 4717.1 4726.7 4735.3 4743.1 4750.1 4756.5
5 0.24 0.22 3000.0 3013.3 3024.6 3034.4 3042.9 3050.4 3057.1 3063.0 3068.3 3073.1 3077.4
6 0.30 0.28 2013.3 2023.2 2031.5 2038.7 2044.9 2050.4 2055.3 2059.6 2063.4 2066.9 2070.0
7 0.36 0.34 1355.6 1363.1 1369.5 1374.9 1379.6 1383.8 1387.4 1390.6 1393.5 1396.1 1398.4
8 0.40 0.38 1026.7 1033.0 1038.4 1043.0 1047.0 1050.4 1053.5 1056.1 1058.5 1060.7 1062.6
9 0.44 0.42 757.6 763.0 767.6 771.5 774.8 777.7 780.2 782.5 784.5 786.3 787.9
10 0.10 0.06 10,226.7 10,270.1 10,307.4 10,339.8 10,368.2 10,393.3 10,415.6 10,435.6 10,453.7 10,470.0 10,484.8
11 0.12 0.08 8200.0 8235.5 8266.0 8292.5 8315.7 8336.1 8354.4 8370.7 8385.4 8398.7 8410.8
12 0.16 0.12 5666.7 5692.3 5714.3 5733.3 5750.0 5764.7 5777.8 5789.5 5800.0 5809.5 5818.2
13 0.20 0.16 4146.7 4166.4 4183.3 4197.8 4210.6 4221.8 4231.8 4240.8 4248.8 4256.0 4262.6
14 0.24 0.20 3133.3 3149.1 3162.6 3174.2 3184.3 3193.3 3201.2 3208.3 3214.6 3220.4 3225.6
15 0.30 0.26 2120.0 2131.8 2141.9 2150.5 2158.1 2164.7 2170.6 2175.8 2180.5 2184.7 2188.6
16 0.36 0.32 1444.4 1453.6 1461.4 1468.1 1473.9 1479.0 1483.5 1487.5 1491.1 1494.3 1497.2
17 0.40 0.36 1106.7 1114.5 1121.2 1126.9 1131.8 1136.1 1139.9 1143.3 1146.3 1149.1 1151.5
18 0.44 0.40 830.3 837.1 842.8 847.7 851.9 855.6 858.9 861.7 864.3 866.6 868.7
219

fixed values of k0 and kd 1
12000
2
10000
8000
3
6000
4
4000
5
6 2000
7
8
9
0
0 1 2 3 4 5 6 7 8 9 10 11
L

10
10000
11
8000
12 6000
13
4000
14
15
2000
16
17
18
0
0 1 2 3 4 5 6 7 8 9 10 11
L

NPV ¼ S 1 þ þ ð12:4Þ
k0 ð1 Lt=ð1 þ LÞÞ k 0 ð1 Lt=ð1 þ LÞÞ
1. At the constant values of Δk ¼ k0 kd, NPV shows as an unlimited growth with
leverage and unlimited descending with leverage. It is interesting to note that the
credit rate value kd 10% turns out to be a border at all surveyed values of
Δk ¼ k0 kd, equal to 2, 4, 6, and 10% (it separates the growth of NPV with
leverage from descending of NPV with leverage). In other words, with growth of
kd, the transition from the growth of NPV with leverage to its descending with
leverage takes place, and at the credit rate kd 10%, NPV does not depend on the
leverage at all surveyed values of k0.
Thus, we come to conclusion that for perpetuity projects, NPV grows with
leverage at a credit rate kd < 10%, and NPV decreases with leverage at a credit
rate kd > 10% (the project remains effective up to leverage levels L ¼ L0, NPV
(L0) ¼ 0). Optimum in the dependence of NPV(L) is absent.
2. At the constant values of kd, NPV shows an unlimited growth with leverage as
well as unlimited descending with leverage. NPV grows with leverage at a credit
rate kd < 10%, and NPV decreases with leverage at a credit rate kd > 10% (the
project remains effective up to leverage levels L ¼ L0, NPV(L0) ¼ 0). All curves
NPV(L ) at the constant values of k0 and different values of kd are started (at L ¼ 0)
from one point; the higher values of k0 (and higher values of Δk ¼ k0 kd)
correspond to more low-lying curves NPV(L ). Optimum in dependence of NPV
(L ) is absent.
3. At the constant values of k0, NPV as well as in the case of constant values of
Δk ¼ k0 kd shows an unlimited growth with leverage as well as unlimited
descending with leverage. An analysis of the data leads to the same conclusion
that (1) NPV grows with leverage at a credit rate kd < 10% and (2) NPV decreases
with leverage at a credit rate kd > 10% (the project remains effective up to
leverage levels L ¼ L0, NPV(L0) ¼ 0).
It should be noted that this pattern should be taken into account by the regulator
which should regulate the normative base in such a way that credit rates of banks that
depend on basic rate of the Central Bank should not exceed, say, 10% (see Chap. 20,
where this problem is discussed in details).
All curves NPV(L ) at the constant values of k0 and different values of kd are
started (at L ¼ 0) from one point; the higher values of kd (and lower values of
Δk ¼ k0 kd) correspond to more low-lying curves NPV(L ). Optimum in depen-
dence of NPV(L) is absent (Table 12.4, Figs. 12.7 and 12.8).
222
L
k0 kd 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5
1 0.08 0.06 0.0 285.7 555.6 818.2 1076.9 1333.3 1588.2 1842.1 2095.2 2347.8
2 0.10 0.08 200.0 57.1 66.7 181.8 292.3 400.0 505.9 610.5 714.3 817.4
3 0.14 0.12 428.6 449.0 492.1 545.5 604.4 666.7 731.1 797.0 863.9 931.7
12
4 0.18 0.16 555.6 666.7 802.5 949.5 1102.6 1259.3 1418.3 1578.9 1740.7 1903.4
5 0.24 0.22 666.7 857.1 1074.1 1303.0 1538.5 1777.8 2019.6 2263.2 2507.9 2753.6
6 0.30 0.28 733.3 971.4 1237.0 1515.2 1800.0 2088.9 2380.4 2673.7 2968.3 3263.8
7 0.36 0.34 777.8 1047.6 1345.7 1656.6 1974.4 2296.3 2620.9 2947.4 3275.1 3603.9
8 0.40 0.38 800.0 1085.7 1400.0 1727.3 2061.5 2400.0 2741.2 3084.2 3428.6 3773.9
9 0.44 0.42 818.2 1116.9 1444.4 1785.1 2132.9 2484.8 2839.6 3196.2 3554.1 3913.0
10 0.10 0.06 200.0 28.6 244.4 454.5 661.5 866.7 1070.6 1273.7 1476.2 1678.3
11 0.12 0.08 333.3 214.3 111.1 15.2 76.9 166.7 254.9 342.1 428.6 514.5
12 0.16 0.12 500.0 517.9 555.6 602.3 653.8 708.3 764.7 822.4 881.0 940.2
13 0.20 0.16 600.0 700.0 822.2 954.5 1092.3 1233.3 1376.5 1521.1 1666.7 1813.0
14 0.24 0.20 666.7 821.4 1000.0 1189.4 1384.6 1583.3 1784.3 1986.8 2190.5 2394.9
15 0.30 0.26 733.3 942.9 1177.8 1424.2 1676.9 1933.3 2192.2 2452.6 2714.3 2976.8
16 0.36 0.32 777.8 1023.8 1296.3 1580.8 1871.8 2166.7 2464.1 2763.2 3063.5 3364.7
17 0.40 0.36 800.0 1064.3 1355.6 1659.1 1969.2 2283.3 2600.0 2918.4 3238.1 3558.7
18 0.44 0.40 818.2 1097.4 1404.0 1723.1 2049.0 2378.8 2711.2 3045.5 3381.0 3717.4
L
12.1
k0 kd 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0
1 0.08 0.06 2600.0 2851.9 3103.4 3354.8 3606.1 3857.1 4108.1 4359.0 4609.8 4860.5 5111.1
2 0.10 0.08 920.0 1022.2 1124.1 1225.8 1327.3 1428.6 1529.7 1630.8 1731.7 1832.6 1933.3
3 0.14 0.12 1000.0 1068.8 1137.9 1207.4 1277.1 1346.9 1417.0 1487.2 1557.5 1627.9 1698.4
4 0.18 0.16 2066.7 2230.5 2394.6 2559.1 2723.9 2888.9 3054.1 3219.4 3384.8 3550.4 3716.0
5 0.24 0.22 3000.0 3246.9 3494.3 3741.9 3989.9 4238.1 4486.5 4735.0 4983.7 5232.6 5481.5
6 0.30 0.28 3560.0 3856.8 4154.0 4451.6 4749.5 5047.6 5345.9 5644.4 5943.1 6241.9 6540.7
7 0.36 0.34 3933.3 4263.4 4593.9 4924.7 5255.9 5587.3 5918.9 6250.7 6582.7 6914.7 7246.9
8 0.40 0.38 4120.0 4466.7 4813.8 5161.3 5509.1 5857.1 6205.4 6553.8 6902.4 7251.2 7600.0
9 0.44 0.42 4272.7 4633.0 4993.7 5354.8 5716.3 6077.9 6439.8 6801.9 7164.1 7526.4 7888.9
10 0.10 0.06 1880.0 2081.5 2282.8 2483.9 2684.8 2885.7 3086.5 3287.2 3487.8 3688.4 3888.9
11 0.12 0.08 600.0 685.2 770.1 854.8 939.4 1023.8 1108.1 1192.3 1276.4 1360.5 1444.4
12 0.16 0.12 1000.0 1060.2 1120.7 1181.5 1242.4 1303.6 1364.9 1426.3 1487.8 1549.4 1611.1
13 0.20 0.16 1960.0 2107.4 2255.2 2403.2 2551.5 2700.0 2848.6 2997.4 3146.3 3295.3 3444.4
14 0.24 0.20 2600.0 2805.6 3011.5 3217.7 3424.2 3631.0 3837.8 4044.9 4252.0 4459.3 4666.7
15 0.30 0.26 3240.0 3503.7 3767.8 4032.3 4297.0 4561.9 4827.0 5092.3 5357.7 5623.3 5888.9
16 0.36 0.32 3666.7 3969.1 4272.0 4575.3 4878.8 5182.5 5486.5 5790.6 6094.9 6399.2 6703.7
17 0.40 0.36 3880.0 4201.9 4524.1 4846.8 5169.7 5492.9 5816.2 6139.7 6463.4 6787.2 7111.1
18 0.44 0.40 4054.5 4392.3 4730.4 5068.9 5407.7 5746.8 6086.0 6425.4 6765.0 7104.7 7444.4
223

4000
2 2000
0
0 1 2 3 4 5 6 7 8 9 10 11
3
–2000
4
–4000
5
–6000
6
7
8 –8000
9
–10000
L

10 4000
2000
11
0
0 1 2 3 4 5 6 7 8 9 10 11
12
–2000
13
–4000
14
15 –6000
16
17
18
–8000
–10000
L

the Perspective of the Equity and Debt Owners

L NOIð1 t Þ
NPV ¼ I 1 t þ ð12:5Þ

leverage. At small L values for many pairs of values k0 and kd (e.g., k0 (24%) and
kd (22%), k0 (30%) and kd (28%), and many others), there is an optimum in the
dependence of NPV(L ) at small L 2.
For higher values of k0 (and, respectively, kd), all curves NPV(L ) lie below.
With growth of NOI, all curves NPV(L ) are shifted parallel upward.
passing through (most often), or not passing (more rarely) through, optimum in
the dependence of NPV(L ) at small L 2.
All curves NPV(L) at the constant values of k0 and different values of kd are
Δk ¼ k0 kd) correspond to higher-lying curves NPV(L ). With growth of NOI,
all curves NPV(L ) are shifted practically parallel upward.
3. At the constant values of kd, NPV practically always decreases with leverage;
optimum in the dependence of NPV(L ) is absent.
point; the higher values of k0 (and higher values of Δk ¼ k0 kd) correspond to
lower-lying curves NPV(L ). With growth of NOI, all curves NPV(L ) are shifted
practically parallel upward (Table 12.5, Figs. 12.9 and 12.10).
226
L
k0 kd 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5
1 0.08 0.06 10,000.0 9042.4 8200.0 7470.8 6838.1 6285.7 5800.0 5369.9 4986.7 4643.1
2 0.10 0.08 7600.0 7022.2 6475.9 5981.9 5539.4 5142.9 4786.5 4465.0 4173.7 3908.7
3 0.14 0.12 4857.1 4619.8 4353.8 4093.7 3848.1 3619.0 3406.4 3209.1 3025.9 2855.6
12
4 0.18 0.16 3333.3 3239.7 3098.0 2945.9 2795.0 2649.4 2510.5 2378.9 2254.4 2136.8
5 0.24 0.22 2000.0 2004.3 1950.0 1876.4 1796.1 1714.3 1633.3 1554.4 1477.9 1404.2
6 0.30 0.28 1200.0 1250.2 1238.0 1203.0 1158.2 1109.2 1058.6 1007.7 957.4 907.9
7 0.36 0.34 666.7 742.0 753.2 740.0 715.6 685.7 652.9 618.8 584.2 549.5
8 0.40 0.38 400.0 486.3 507.7 504.2 488.9 467.5 442.9 416.4 389.0 361.2
9 0.44 0.42 181.8 276.2 305.3 309.0 300.6 285.7 267.2 246.6 224.8 202.3
10 0.10 0.06 7600.0 6409.2 5472.7 4726.5 4120.3 3619.0 3198.0 2839.4 2530.5 2261.7
11 0.12 0.08 6000.0 5192.2 4515.8 3954.3 3484.1 3085.7 2744.4 2449.0 2191.0 1963.6
12 0.16 0.12 4000.0 3587.9 3200.0 2855.4 2552.4 2285.7 2050.0 1840.5 1653.3 1485.2
13 0.20 0.16 2800.0 2577.8 2337.9 2111.0 1903.0 1714.3 1543.2 1388.0 1246.8 1118.0
14 0.24 0.20 2000.0 1883.3 1729.4 1573.3 1424.6 1285.7 1157.1 1038.4 928.7 827.3
15 0.30 0.26 1200.0 1171.3 1091.6 998.6 904.0 812.0 724.2 641.2 563.0 489.4
16 0.36 0.32 666.7 686.5 649.0 592.9 530.8 467.5 405.3 345.0 287.2 232.0
17 0.40 0.36 400.0 441.0 422.2 382.9 335.6 285.7 235.5 186.1 138.2 92.0
18 0.44 0.40 181.8 238.6 233.9 207.2 171.4 131.9 91.0 50.2 10.1 28.9
L
12.2
k0 kd 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0
1 0.08 0.06 4333.3 4052.7 3797.4 3564.1 3350.0 3152.9 2970.9 2802.3 2645.7 2499.8 2363.6
2 0.10 0.08 3666.7 3444.8 3240.8 3052.5 2878.3 2716.6 2566.1 2425.7 2294.4 2171.4 2055.9
3 0.14 0.12 2697.0 2549.0 2410.7 2281.1 2159.5 2045.2 1937.6 1836.2 1740.3 1649.6 1563.6
4 0.18 0.16 2025.6 1920.6 1821.1 1726.9 1637.7 1552.9 1472.4 1395.9 1323.0 1253.5 1187.2
5 0.24 0.22 1333.3 1265.3 1200.0 1137.4 1077.3 1019.6 964.3 911.1 860.0 810.9 763.6
6 0.30 0.28 859.6 812.7 767.1 722.9 680.1 638.7 598.5 559.7 522.2 485.8 450.6
7 0.36 0.34 515.2 481.3 448.1 415.6 383.9 352.9 322.8 293.4 264.8 236.9 209.8
8 0.40 0.38 333.3 305.7 278.3 251.4 225.0 199.1 173.7 148.9 124.7 101.0 77.9
9 0.44 0.42 179.5 156.6 133.9 111.4 89.1 67.2 45.7 24.6 3.8 16.5 36.4
10 0.10 0.06 2025.6 1816.7 1630.5 1463.5 1313.0 1176.5 1052.2 938.5 834.2 738.1 649.4
11 0.12 0.08 1761.9 1581.7 1419.8 1273.5 1140.7 1019.6 908.7 806.9 712.9 626.1 545.5
12 0.16 0.12 1333.3 1195.6 1070.1 955.4 850.0 752.9 663.2 580.1 502.9 430.9 363.6
13 0.20 0.16 1000.0 891.7 791.8 699.6 614.2 534.8 460.8 391.8 327.2 266.7 209.8
14 0.24 0.20 733.3 646.2 565.1 489.5 419.0 352.9 291.0 232.9 178.2 126.6 77.9
15 0.30 0.26 420.3 355.3 294.1 236.4 182.1 130.7 82.2 36.2 7.3 48.7 88.0
16 0.36 0.32 179.5 129.5 82.0 36.8 6.2 47.1 86.0 123.1 158.5 192.3 224.6
17 0.40 0.36 47.6 5.1 35.5 74.4 111.5 147.1 181.0 213.5 244.7 274.5 303.0
18 0.44 0.40 66.7 103.1 138.2 171.9 204.2 235.3 265.1 293.8 321.3 347.8 373.2
227

1 10000
8000
2
6000
3
4000
4
5 2000
6
7
8
9 0
0 1 2 3 4 5 6 7 8 9 10 11
–2000
L

7000
11 6000
5000
12 4000
13 3000
14 2000
15
1000
16
17
18
0
0 1 2 3 4 5 6 7 8 9 10 11
–1000
L
NOIð1 t Þ
NPV ¼ Sð1 þ Lð1 t ÞÞ þ ð12:6Þ
k 0 þ ðk0 k d ÞLt
leverage; optimum in the dependence of NPV(L) is absent.
point; the higher values of k0 (and, respectively, kd) correspond to lower-lying
curves NPV(L ). With growth of Δk, the density of curves NPV(L ) increases.
2. At the constant values of k0, NPV decreases with leverage; optimum in the
dependence of NPV(L ) is absent. All curves NPV(L ) at the constant values of
k0 are started (at L ¼ 0) from one point; the higher values of kd (and, respectively,
the lower values of Δk) correspond to higher-lying curves NPV(L). With growth
of Δk, the density of curves NPV(L ) increases.
3. At the constant values of kd, NPV decreases with leverage; optimum in the
dependence of NPV(L ) is absent. All curves NPV(L ) at the constant values of
k0 are started (at L ¼ 0) from one point; the higher values of k0 (and, respectively,
the higher values of Δk) correspond to lower-lying curves NPV(L ). With
decrease of NOI, the density of curves NPV(L) increases, and they are shifted
down (Table 12.6, Figs. 12.11 and 12.12).
230
L
k0 kd 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5
1 0.08 0.06 10,000.0 8907.3 7828.6 6762.8 5709.1 4666.7 3634.8 2612.8 1600.0 595.9
2 0.10 0.08 7600.0 6611.8 5630.8 4656.6 3688.9 2727.3 1771.4 821.1 124.1 1064.4
3 0.14 0.12 4857.1 3960.6 3066.7 2175.3 1286.5 400.0 484.2 1366.2 2246.2 3124.1
12
4 0.18 0.16 3333.3 2474.7 1617.4 761.3 93.6 947.4 1800.0 2651.5 3502.0 4351.5
5 0.24 0.22 2000.0 1166.9 334.4 497.6 1329.0 2160.0 2990.5 3820.5 4650.0 5479.1
6 0.30 0.28 1200.0 378.8 442.1 1262.7 2083.1 2903.2 3723.1 4542.7 5362.0 6181.1
7 0.36 0.34 666.7 148.1 962.6 1777.0 2591.3 3405.4 4219.4 5033.2 5846.8 6660.3
8 0.40 0.38 400.0 411.9 1223.8 2035.5 2847.1 3658.5 4469.9 5281.2 6092.3 6903.3
9 0.44 0.42 181.8 628.1 1437.8 2247.5 3057.1 3866.7 4676.1 5485.5 6294.7 7103.9
10 0.10 0.06 7600.0 6430.8 5288.9 4171.4 3075.9 2000.0 941.9 100.0 1127.3 2141.2
11 0.12 0.08 6000.0 4941.9 3900.0 2872.7 1858.8 857.1 133.3 1113.5 2084.2 3046.2
12 0.16 0.12 4000.0 3053.7 2114.3 1181.4 254.5 666.7 1582.6 2493.6 3400.0 4302.0
13 0.20 0.16 2800.0 1905.9 1015.4 128.3 755.6 1636.4 2514.3 3389.5 4262.1 5132.2
14 0.24 0.20 2000.0 1134.4 271.0 590.5 1450.0 2307.7 3163.6 4017.9 4870.6 5721.7
15 0.30 0.26 1200.0 357.9 483.1 1323.1 2162.0 3000.0 3837.0 4673.2 5508.4 6342.9
16 0.36 0.32 666.7 162.6 991.3 1819.4 2646.8 3473.7 4300.0 5125.8 5951.0 6775.8
17 0.40 0.36 400.0 423.8 1247.1 2069.9 2892.3 3714.3 4535.8 5357.0 6177.8 6998.2
18 0.44 0.40 181.8 637.8 1457.1 2276.1 3094.7 3913.0 4731.0 5548.7 6366.1 7183.2
L
12.2
k0 kd 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0
1 0.08 0.06 400.0 1388.2 2369.2 3343.4 4311.1 5272.7 6228.6 7178.9 8124.1 9064.4 10,000.0
2 0.10 0.08 2000.0 2931.1 3858.1 4781.0 5700.0 6615.4 7527.3 8435.8 9341.2 10,243.5 11,142.9
3 0.14 0.12 4000.0 4874.1 5746.3 6616.9 7485.7 8352.9 9218.6 10,082.8 10,945.5 11,806.7 12,666.7
4 0.18 0.16 5200.0 6047.5 6894.1 7739.8 8584.6 9428.6 10,271.7 11,114.0 11,955.6 12,796.3 13,636.4
5 0.24 0.22 6307.7 7135.9 7963.6 8791.0 9617.9 10,444.4 11,270.6 12,096.4 12,921.7 13,746.8 14,571.4
6 0.30 0.28 7000.0 7818.6 8637.0 9455.2 10,273.2 11,090.9 11,908.4 12,725.7 13,542.9 14,359.8 15,176.5
7 0.36 0.34 7473.7 8286.9 9100.0 9913.0 10,725.8 11,538.5 12,351.0 13,163.5 13,975.8 14,787.9 15,600.0
8 0.40 0.38 7714.3 8525.1 9335.8 10,146.5 10,957.0 11,767.4 12,577.8 13,388.0 14,198.2 15,008.2 15,818.2
9 0.44 0.42 7913.0 8722.1 9531.0 10,339.9 11,148.7 11,957.4 12,766.1 13,574.7 14,383.2 15,191.6 16,000.0
10 0.10 0.06 3142.9 4133.3 5113.5 6084.2 7046.2 8000.0 8946.3 9885.7 10,818.6 11,745.5 12,666.7
11 0.12 0.08 4000.0 4946.3 5885.7 6818.6 7745.5 8666.7 9582.6 10,493.6 11,400.0 12,302.0 13,200.0
12 0.16 0.12 5200.0 6094.1 6984.6 7871.7 8755.6 9636.4 10,514.3 11,389.5 12,262.1 13,132.2 14,000.0
13 0.20 0.16 6000.0 6865.6 7729.0 8590.5 9450.0 10,307.7 11,163.6 12,017.9 12,870.6 13,721.7 14,571.4
14 0.24 0.20 6571.4 7419.7 8266.7 9112.3 9956.8 10,800.0 11,642.1 12,483.1 13,323.1 14,162.0 15,000.0
15 0.30 0.26 7176.5 8009.3 8841.4 9672.7 10503.4 11,333.3 12,162.6 12,991.3 13,819.4 14,646.8 15,473.7
16 0.36 0.32 7600.0 8423.8 9247.1 10,069.9 10,892.3 11,714.3 12,535.8 13,357.0 14,177.8 14,998.2 15,818.2
17 0.40 0.36 7818.2 8637.8 9457.1 10,276.1 11,094.7 11,913.0 12,731.0 13,548.7 14,366.1 15,183.2 16,000.0
18 0.44 0.40 8000.0 8816.5 9632.8 10,448.8 11,264.5 12,080.0 12,895.2 13,710.2 14,525.0 15,339.5 16,153.8
231

1 10000
2
3 5000
4
5
6
7
8 0
90 1 2 3 4 5 6 7 8 9 10 11
–5000
–10000
–15000
–20000
L

11
5000
12
13
14
15
16
17 0
18
0 1 2 3 4 5 6 7 8 9 10 11
–5000
–10000
–15000
–20000
L
NPV ¼ I þ
0 WACC 1
L
B k t ð12:7Þ
1 þ L C NOIð1 t Þ
d
¼ I B
@1
Cþ
A :
L L
k0 1 t k0 1 t
1þL 1þL
leverage with output into saturation regime. The main increase in NPV occurs
when L 5 6. With growth of k0 (and kd), the сurves NPV(L ) are lowered.
With growth of NOI, all curves NPV(L ) are shifted practically parallel
upward.
and different values of kd are started (at L ¼ 0) from one point; the higher values
of kd (and, respectively, the lower values of Δk ¼ k0 kd) correspond to higher-
lying curves NPV(L ). Optimum in the dependence of NPV(L ) is absent. With
growth of NOI, all curves NPV(L) are shifted practically parallel upward.
3. At the constant values of kd, NPV shows a limited growth with leverage with
output into saturation regime. All curves NPV(L) at the constant values of k0 and
different values of kd are started (at L ¼ 0) from one point; the higher values of k0
(and, respectively, the higher values of Δk ¼ k0 kd) correspond to lower-lying
curves NPV(L ). Optimum in the dependence of NPV(L) is absent (Table 12.7,
Figs. 12.13 and 12.14).
234
L
k0 kd 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5
1 0.08 0.06 10,000.0 10,964.3 11,500.0 11,840.9 12,076.9 12,250.0 12,382.4 12,486.8 12,571.4 12,641.3
2 0.10 0.08 7600.0 8400.0 8844.4 9127.3 9323.1 9466.7 9576.5 9663.2 9733.3 9791.3
3 0.14 0.12 4857.1 5469.4 5809.5 6026.0 6175.8 6285.7 6369.7 6436.1 6489.8 6534.2
12
4 0.18 0.16 3333.3 3841.3 4123.5 4303.0 4427.4 4518.5 4588.2 4643.3 4687.8 4724.6
5 0.24 0.22 2000.0 2416.7 2648.1 2795.5 2897.4 2972.2 3029.4 3074.6 3111.1 3141.3
6 0.30 0.28 1200.0 1561.9 1763.0 1890.9 1979.5 2044.4 2094.1 2133.3 2165.1 2191.3
7 0.36 0.34 666.7 992.1 1172.8 1287.9 1367.5 1425.9 1470.6 1505.8 1534.4 1558.0
8 0.40 0.38 400.0 707.1 877.8 986.4 1061.5 1116.7 1158.8 1192.1 1219.0 1241.3
9 0.44 0.42 181.8 474.0 636.4 739.7 811.2 863.6 903.7 935.4 961.0 982.2
10 0.10 0.06 7600.0 8371.4 8800.0 9072.7 9261.5 9400.0 9505.9 9589.5 9657.1 9713.0
11 0.12 0.08 6000.0 6666.7 7037.0 7272.7 7435.9 7555.6 7647.1 7719.3 7777.8 7826.1
12 0.16 0.12 4000.0 4535.7 4833.3 5022.7 5153.8 5250.0 5323.5 5381.6 5428.6 5467.4
13 0.20 0.16 2800.0 3257.1 3511.1 3672.7 3784.6 3866.7 3929.4 3978.9 4019.0 4052.2
14 0.24 0.20 2000.0 2404.8 2629.6 2772.7 2871.8 2944.4 3000.0 3043.9 3079.4 3108.7
15 0.30 0.26 1200.0 1552.4 1748.1 1872.7 1959.0 2022.2 2070.6 2108.8 2139.7 2165.2
16 0.36 0.32 666.7 984.1 1160.5 1272.7 1350.4 1407.4 1451.0 1485.4 1513.2 1536.2
17 0.40 0.36 400.0 700.0 866.7 972.7 1046.2 1100.0 1141.2 1173.7 1200.0 1221.7
18 0.44 0.40 181.8 467.5 626.3 727.3 797.2 848.5 887.7 918.7 943.7 964.4
L
12.2
k0 kd 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0
1 0.08 0.06 12,700.0 12,750.0 12,793.1 12,830.6 12,863.6 12,892.9 12,918.9 12,942.3 12,963.4 12,982.6 13,000.0
2 0.10 0.08 9840.0 9881.5 9917.2 9948.4 9975.8 10,000.0 10,021.6 10,041.0 10,058.5 10,074.4 10,088.9
3 0.14 0.12 6571.4 6603.2 6630.5 6654.4 6675.3 6693.9 6710.4 6725.3 6738.7 6750.8 6761.9
4 0.18 0.16 4755.6 4781.9 4804.6 4824.4 4841.8 4857.1 4870.9 4883.2 4894.3 4904.4 4913.6
5 0.24 0.22 3166.7 3188.3 3206.9 3223.1 3237.4 3250.0 3261.3 3271.4 3280.5 3288.8 3296.3
6 0.30 0.28 2213.3 2232.1 2248.3 2262.4 2274.7 2285.7 2295.5 2304.3 2312.2 2319.4 2325.9
7 0.36 0.34 1577.8 1594.7 1609.2 1621.9 1633.0 1642.9 1651.7 1659.5 1666.7 1673.1 1679.0
8 0.40 0.38 1260.0 1275.9 1289.7 1301.6 1312.1 1321.4 1329.7 1337.2 1343.9 1350.0 1355.6
9 0.44 0.42 1000.0 1015.2 1028.2 1039.6 1049.6 1058.4 1066.3 1073.4 1079.8 1085.6 1090.9
10 0.10 0.06 9760.0 9800.0 9834.5 9864.5 9890.9 9914.3 9935.1 9953.8 9970.7 9986.0 10,000.0
11 0.12 0.08 7866.7 7901.2 7931.0 7957.0 7979.8 8000.0 8018.0 8034.2 8048.8 8062.0 8074.1
12 0.16 0.12 5500.0 5527.8 5551.7 5572.6 5590.9 5607.1 5621.6 5634.6 5646.3 5657.0 5666.7
13 0.20 0.16 4080.0 4103.7 4124.1 4141.9 4157.6 4171.4 4183.8 4194.9 4204.9 4214.0 4222.2
14 0.24 0.20 3133.3 3154.3 3172.4 3188.2 3202.0 3214.3 3225.2 3235.0 3243.9 3251.9 3259.3
15 0.30 0.26 2186.7 2204.9 2220.7 2234.4 2246.5 2257.1 2266.7 2275.2 2282.9 2289.9 2296.3
16 0.36 0.32 1555.6 1572.0 1586.2 1598.6 1609.4 1619.0 1627.6 1635.3 1642.3 1648.6 1654.3
17 0.40 0.36 1240.0 1255.6 1269.0 1280.6 1290.9 1300.0 1308.1 1315.4 1322.0 1327.9 1333.3
18 0.44 0.40 981.8 996.6 1009.4 1020.5 1030.3 1039.0 1046.7 1053.6 1059.9 1065.5 1070.7
235

12000
2 10000
8000
3
6000
4
4000
5
6
7 2000
8
9
0
0 1 2 3 4 5 6 7 8 9 10 11
L

10 10000
11 8000
12
6000
13
4000
14
15
16 2000
17
18
0
0 1 2 3 4 5 6 7 8 9 10 11
L

kd Lt NOIð1 t Þ
NPV ¼ S 1 þ L þ , ð12:8Þ
WACC WACC
2 3
k Lt βSð1 þ LÞð1 t Þ
NPV ¼ S41 þ L 5 þ :
d
ð12:9Þ
k0 1 1þLtL
k 0 1 1þL
L
t

credit rate value kd 8% turns out to be a border at all surveyed values of
leverage from descending of NPV with leverage). In other words, with growth of
kd, the transition from the growth of NPV with leverage to its descending with
leverage takes place, and at the credit rate kd 8%, NPV does not depend on the
leverage level at all surveyed values of k0.
Thus, we come to conclusion that for perpetuity projects, NPV grows with
leverage at a credit rate kd < 8% and NPV decreases with leverage at a credit rate
kd > 8% (the project remains effective up to leverage levels L ¼ L0, NPV
2. At the constant values of kd, NPV shows an unlimited growth with leverage as
well as unlimited descending with leverage. NPV grows with leverage at a credit
rate kd < 8 10%, and NPV decreases with leverage at a credit rate kd < 8 10%
(the project remains effective up to leverage levels L ¼ L0, NPV(L0) ¼ 0). All
curves NPV(L ) at the constant values of k0 and different values of kd are started
(at L ¼ 0) from one point; the higher values of k0 (and higher values of
Δk ¼ k0 kd) correspond to more low-lying curves NPV(L ). Optimum in
dependence of NPV(L ) is absent.
3. At the constant values of k0, NPV as well as in the case of constant values of
Δk ¼ k0 kd shows mainly an unlimited growth with leverage. Unlimited
descending with leverage was shown for the pair k0 ¼ 10 % ; kd ¼ 8% only.
All curves NPV(L ) at the constant values of k0 and different values of kd are
Δk ¼ k0 kd) correspond to more high-lying curves NPV(L ). Optimum in
dependence of NPV(L ) is absent (Table 12.8, Figs. 12.15 and 12.16).
238
L
k0 kd 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5
1 0.08 0.06 0.0 187.5 388.9 596.6 807.7 1020.8 1235.3 1450.7 1666.7 1883.2
2 0.10 0.08 200.0 128.6 44.4 45.5 138.5 233.3 329.4 426.3 523.8 621.7
3 0.14 0.12 428.6 489.8 539.7 584.4 626.4 666.7 705.9 744.4 782.3 819.9
12
4 0.18 0.16 555.6 690.5 814.8 934.3 1051.3 1166.7 1281.0 1394.7 1507.9 1620.8
5 0.24 0.22 666.7 866.1 1055.6 1240.5 1423.1 1604.2 1784.3 1963.8 2142.9 2321.6
6 0.30 0.28 733.3 971.4 1200.0 1424.2 1646.2 1866.7 2086.3 2305.3 2523.8 2742.0
7 0.36 0.34 777.8 1041.7 1296.3 1546.7 1794.9 2041.7 2287.6 2532.9 2777.8 3022.3
8 0.40 0.38 800.0 1076.8 1344.4 1608.0 1869.2 2129.2 2388.2 2646.7 2904.8 3162.5
9 0.44 0.42 818.2 1105.5 1383.8 1658.1 1930.1 2200.8 2470.6 2739.8 3008.7 3277.2
10 0.10 0.06 200.0 150.0 88.9 22.7 46.2 116.7 188.2 260.5 333.3 406.5
11 0.12 0.08 333.3 357.1 370.4 378.8 384.6 388.9 392.2 394.7 396.8 398.6
12 0.16 0.12 500.0 616.1 722.2 823.9 923.1 1020.8 1117.6 1213.8 1309.5 1404.9
13 0.20 0.16 600.0 771.4 933.3 1090.9 1246.2 1400.0 1552.9 1705.3 1857.1 2008.7
14 0.24 0.20 666.7 875.0 1074.1 1268.9 1461.5 1652.8 1843.1 2032.9 2222.2 2411.2
15 0.30 0.26 733.3 978.6 1214.8 1447.0 1676.9 1905.6 2133.3 2360.5 2587.3 2813.8
16 0.36 0.32 777.8 1047.6 1308.6 1565.7 1820.5 2074.1 2326.8 2578.9 2830.7 3082.1
17 0.40 0.36 800.0 1082.1 1355.6 1625.0 1892.3 2158.3 2423.5 2688.2 2952.4 3216.3
18 0.44 0.40 818.2 1110.4 1393.9 1673.6 1951.0 2227.3 2502.7 2777.5 3051.9 3326.1
L
12.2
k0 kd 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0
1 0.08 0.06 2100.0 2317.1 2534.5 2752.0 2969.7 3187.5 3405.4 3623.4 3841.5 4059.6 4277.8
2 0.10 0.08 720.0 818.5 917.2 1016.1 1115.2 1214.3 1313.5 1412.8 1512.2 1611.6 1711.1
3 0.14 0.12 857.1 894.2 931.0 967.7 1004.3 1040.8 1077.2 1113.6 1149.8 1186.0 1222.2
4 0.18 0.16 1733.3 1845.7 1957.9 2069.9 2181.8 2293.7 2405.4 2517.1 2628.7 2740.3 2851.9
5 0.24 0.22 2500.0 2678.2 2856.3 3034.3 3212.1 3389.9 3567.6 3745.2 3922.8 4100.3 4277.8
6 0.30 0.28 2960.0 3177.8 3395.4 3612.9 3830.3 4047.6 4264.9 4482.1 4699.2 4916.3 5133.3
7 0.36 0.34 3266.7 3510.8 3754.8 3998.7 4242.4 4486.1 4729.7 4973.3 5216.8 5460.3 5703.7
8 0.40 0.38 3420.0 3677.3 3934.5 4191.5 4448.5 4705.4 4962.2 5218.9 5475.6 5732.3 5988.9
9 0.44 0.42 3545.5 3813.6 4081.5 4349.3 4617.1 4884.7 5152.3 5419.9 5687.4 5954.8 6222.2
10 0.10 0.06 480.0 553.7 627.6 701.6 775.8 850.0 924.3 998.7 1073.2 1147.7 1222.2
11 0.12 0.08 400.0 401.2 402.3 403.2 404.0 404.8 405.4 406.0 406.5 407.0 407.4
12 0.16 0.12 1500.0 1594.9 1689.7 1784.3 1878.8 1973.2 2067.6 2161.9 2256.1 2350.3 2444.4
13 0.20 0.16 2160.0 2311.1 2462.1 2612.9 2763.6 2914.3 3064.9 3215.4 3365.9 3516.3 3666.7
14 0.24 0.20 2600.0 2788.6 2977.0 3165.3 3353.5 3541.7 3729.7 3917.7 4105.7 4293.6 4481.5
15 0.30 0.26 3040.0 3266.0 3492.0 3717.7 3943.4 4169.0 4394.6 4620.1 4845.5 5070.9 5296.3
16 0.36 0.32 3333.3 3584.4 3835.2 4086.0 4336.7 4587.3 4837.8 5088.3 5338.8 5589.1 5839.5
17 0.40 0.36 3480.0 3743.5 4006.9 4270.2 4533.3 4796.4 5059.5 5322.4 5585.4 5848.3 6111.1
18 0.44 0.40 3600.0 3873.7 4147.3 4420.8 4694.2 4967.5 5240.8 5514.0 5787.1 6060.3 6333.3
239

1
4000
2 2000
0
0 1 2 3 4 5 6 7 8 9 10 11
3
–2000
4
–4000
5
6
7
8 –6000
9
–8000
L

10
1000
0
0 1 2 3 4 5 6 7 8 9 10 1111
–1000
–2000
12
–3000
13
–4000
14
–5000
15
16 –6000
17
18
–7000
L
References 241
References
(11):815–824
org/10.1080/23322039.2014.946150
perpetuity limit – Modigliani – Miller theory. J Rev Global Econ 3:175–185
7:37–62
Econ Rev 53:147–175
Мodigliani F, Мiller M (1966) Some estimates of the cost of capital to the electric utility industry
1954–1957. Am Econ Rev 56:333–391
Chapter 13
The Analysis of the Exploration
of Efficiency of Investment Projects
of Arbitrary Duration (Within
Brusov–Filatova–Orekhova Theory)
In the previous chapter, we have conducted the analysis of effectiveness of invest-

ment projects within the perpetuity (Modigliani–Miller) approximation (Мodigliani
and Мiller 1958, 1963, 1966). In this chapter the analysis of the obtained results
on the exploration of efficiency of investment projects of arbitrary duration
[within Brusov–Filatova–Orekhova theory (Brusov and Filatova 2011; Brusov
2008; Brusova 2011)] is conducted.


For NPV in this case, the following expression has been obtained (Brusov and
Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b, 2015,
2018a, b, c, d; Brusova 2011) (Table 13.1; Figs. 13.1 and 13.2):

I 1 1
NPV ¼ 1 þ L ð1 t Þ 1 n þ
1þL ð1 þ k d Þ ð1 þ k d Þn
ð13:1Þ
NOIð1 t Þ 1
þ 1 :
ke ð1 þ k e Þn

https://doi.org/10.1007/978-3-319-99686-8_13
Table 13.1 N ¼ 2, t ¼ 0.2, NOI ¼ 1200; I ¼ 1000, k0kd ¼ const
244
L
k0 kd 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5
1 0.08 0.06 711.9 700.7 686.2 670.6 654.6 638.5 622.4 606.5 590.8 575.3
2 0.10 0.08 666.6 660.2 649.4 637.0 623.9 610.5 597.0 583.6 570.2 556.9
3 0.14 0.12 580.9 581.9 576.5 568.5 559.4 549.6 539.5 529.3 519.0 508.7
13
4 0.18 0.16 503.0 510.6 509.8 505.7 499.9 493.4 486.3 478.9 471.3 463.7
5 0.24 0.22 398.5 414.0 418.6 418.9 417.1 414.0 410.2 406.0 401.4 396.6
6 0.30 0.28 306.5 328.6 337.3 340.6 344.0 344.2 343.5 342.3 340.6 338.6
7 0.36 0.34 225.0 251.3 264.7 272.0 276.4 279.0 280.5 281.3 281.6 283.5
8 0.40 0.38 175.6 206.1 221.0 229.6 235.1 236.2 238.8 240.6 242.0 242.9
9 0.44 0.42 129.7 163.0 179.5 189.5 196.1 200.7 204.3 207.0 209.1 210.9
10 0.10 0.06 666.6 635.3 602.0 568.7 536.1 504.4 473.6 443.9 415.2 387.5
11 0.12 0.08 622.6 596.5 567.1 537.1 507.3 478.2 449.9 422.4 395.7 369.9
12 0.16 0.12 541.1 524.3 501.8 477.7 453.2 428.8 404.8 381.4 358.4 336.1
13 0.20 0.16 466.2 456.8 441.5 422.5 402.5 382.2 362.1 342.1 322.5 303.2
14 0.24 0.20 398.5 396.6 385.1 370.2 353.8 336.9 319.7 302.6 285.6 268.9
15 0.30 0.26 306.5 313.4 308.1 298.0 285.9 275.8 263.0 249.9 236.7 223.6
16 0.36 0.32 225.0 237.9 238.8 234.1 226.8 218.2 208.7 198.8 188.6 178.3
17 0.40 0.36 175.6 193.9 197.2 194.7 189.3 179.9 172.2 164.0 155.5 146.7
18 0.44 0.40 129.7 151.7 157.5 157.1 153.7 148.5 142.4 135.6 128.5 121.1
The Analysis of the Exploration of Efficiency of Investment Projects. . .
L
13.1
k0 kd 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0
1 0.08 0.06 560.0 544.9 530.1 515.5 501.1 487.0 473.1 459.4 445.9 432.7 419.7
2 0.10 0.08 543.7 525.7 512.5 499.5 486.6 474.0 461.5 449.2 437.1 425.1 413.4
3 0.14 0.12 498.4 488.2 478.0 468.0 458.0 448.1 438.3 428.6 419.0 409.5 400.1
4 0.18 0.16 455.9 448.2 440.4 432.6 424.9 417.2 409.6 402.0 394.4 386.9 379.5
5 0.24 0.22 391.7 386.6 381.5 376.3 371.1 365.9 360.7 355.4 350.2 345.0 339.8
6 0.30 0.28 336.3 334.0 331.5 328.9 326.2 323.4 320.7 317.8 315.0 312.1 309.2
7 0.36 0.34 284.4 280.7 280.0 279.1 278.2 277.2 276.1 274.9 273.7 272.5 271.2
8 0.40 0.38 243.5 244.0 244.2 244.3 244.3 244.2 244.0 243.7 243.4 243.1 242.7
9 0.44 0.42 212.4 213.6 214.6 215.5 216.3 217.0 217.6 218.2 218.6 219.1 219.4
10 0.10 0.06 360.7 334.8 309.8 285.6 262.2 239.6 217.7 196.5 176.0 156.1 136.9
11 0.12 0.08 344.9 320.6 297.2 274.5 252.5 231.1 210.5 190.4 171.0 152.2 133.9
12 0.16 0.12 314.4 293.2 272.7 252.7 233.3 214.4 196.0 178.1 160.8 143.9 127.4
13 0.20 0.16 284.4 266.0 248.1 230.6 213.5 196.8 180.5 164.6 149.1 134.0 119.3
14 0.24 0.20 252.4 236.2 220.4 204.9 189.7 174.9 160.3 146.1 132.2 118.6 105.3
15 0.30 0.26 210.6 197.7 185.0 172.5 160.1 148.0 136.1 124.4 112.9 101.6 90.5
16 0.36 0.32 168.0 155.9 145.7 140.4 127.2 117.2 107.4 97.7 88.1 78.7 69.4
17 0.40 0.36 137.9 129.0 120.2 111.3 102.6 93.9 85.2 76.7 68.3 59.9 51.7
18 0.44 0.40 113.6 106.0 98.3 90.7 83.0 75.4 67.9 60.4 53.0 45.6 38.3
245
246 13 The Analysis of the Exploration of Efficiency of Investment Projects. . .

1 700
2
3
600
4 500
5 400
6 300
7
8
200
9
100
0
0 1 2 3 4 5 6 7 8 9 10 11
L

11
600
12
500
13
14 400
15 300
16
200
17
18
100
0
0 1 2 3 4 5 6 7 8 9 10 11
L
1. At the constant values of Δk ¼ k0 kd, NPV decreases with leverage at low

values of k0 (up to 20%) and grows at higher values of k0 (from 25 to 30%). All
curves NPV(L) are shifted down with growth of k0. At small leverage levels L,
there is an optimum in the dependence of NPV(L ).
Higher values of kd (at the same value of k0) correspond to higher-lying curves
NPV(L ). At small leverage levels L at high value of k0 (36–40%), there is an
optimum in the dependence of NPV(L ).
3. At the constant values of kd, NPV practically always decreases with
leverage. Higher values of k0 (at the same value of kd) correspond to lower-
lying curves NPV(L ). At small leverage levels L for some pairs of values k0
and kd [e.g., k0 (18%) and kd (16%)], there is an optimum in the dependence of
NPV(L ).
At the Constant Equity Value (S ¼ Const)
Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b)
(Table 13.2; Figs. 13.3 and 13.4):

1 1
NPV ¼ S 1 þ L ð1 t Þ 1 n þ n
ð1 þ k d Þ ð1 þ kd Þ ð13:2Þ
þ 1 :
ke ð1 þ k e Þn
1. At the constant values of Δk ¼ k0 kd, NPV, as a rule, decreases with leverage.

All curves NPV(L) are shifted down with growth of k0, and sometimes at small
leverage level L values, there is an optimum in the dependence of NPV(L). As it
will be shown in Chap. 17 at the example with “Nastcom Plus” company, the
dependence of NPV(L ) strongly depends on the β parameter value and can have a
marked optimum.
Higher values of kd (lower values of Δk ¼ k0 kd) at the same value of k0
correspond to higher-lying curves NPV(L ). Like the previous paragraph, the
dependence of NPV(L) strongly depends on the β parameter value and can
have a marked optimum.
3. At the constant values of kd, NPV practically always decreases with leverage.
Higher values of k0 (higher values of Δk ¼ k0 kd) at the same value of kd
correspond to lower-lying curves NPV(L). At small leverage levels L for projects
with durations above 2 years for some pairs of values k0 and kd [e.g., for 5-year
and 7-year projects with k0 (8%) and kd (6%) and k0 (10%) and kd (6%)], there is
an optimum in the dependence of NPV(L). This optimum could be a marked one
at other values of parameter β.
Table 13.2 N ¼ 2, t ¼ 0.2, S ¼ 1000; β ¼ 0.7, k0kd ¼ const
248
L
k0 kd 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5
1 0.08 0.06 1.4 7.3 23.6 50.0 86.1 131.8 186.8 250.8 323.5 404.7
2 0.10 0.08 27.8 41.4 63.8 94.9 134.4 182.1 237.9 301.5 372.8 451.5
3 0.14 0.12 77.8 107.4 143.9 187.3 237.3 294.0 357.0 426.4 501.9 583.5
13
4 0.18 0.16 123.2 167.5 217.2 272.2 332.3 397.5 467.8 542.9 623.0 707.8
5 0.24 0.22 184.2 249.1 317.6 389.7 465.4 544.7 627.4 713.6 803.2 896.1
6 0.30 0.28 237.9 321.3 407.4 496.3 583.0 674.4 767.7 862.9 960.2 1059.3
7 0.36 0.34 285.4 386.7 487.6 589.6 692.5 796.5 901.4 1007.3 1114.3 1216.1
8 0.40 0.38 314.2 424.8 535.9 647.5 759.5 877.3 990.8 1104.8 1219.3 1334.3
9 0.44 0.42 341.0 461.4 581.9 702.4 822.9 943.5 1064.0 1184.7 1305.3 1426.0
10 0.10 0.06 27.8 64.5 121.8 198.6 293.5 405.7 534.0 677.6 835.6 1007.3
11 0.12 0.08 53.5 97.1 159.8 240.6 338.4 452.2 581.2 724.6 881.6 1051.5
12 0.16 0.12 101.1 157.8 231.0 319.7 423.1 540.6 671.4 814.8 970.3 1137.3
13 0.20 0.16 144.7 214.6 296.8 393.4 502.8 624.4 757.7 902.1 1057.2 1222.4
14 0.24 0.20 184.2 265.3 358.6 463.6 579.9 706.9 844.3 991.6 1148.5 1314.5
15 0.30 0.26 237.9 335.4 443.1 560.7 688.0 818.1 960.5 1111.1 1269.5 1435.4
16 0.36 0.32 285.4 399.1 519.3 647.0 782.0 924.2 1073.2 1229.0 1391.2 1559.8
17 0.40 0.36 314.2 436.2 565.0 700.4 842.1 995.4 1150.0 1310.5 1476.8 1648.7
18 0.44 0.40 341.0 471.9 608.7 751.3 899.4 1053.0 1212.0 1376.1 1545.3 1719.4
L
13.1
k0 kd 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0
1 0.08 0.06 494.2 591.7 697.1 810.2 930.6 1058.3 1193.0 1334.6 1482.9 1637.7 1798.8
2 0.10 0.08 537.5 649.7 752.6 862.5 979.1 1102.3 1232.0 1367.9 1510.0 1658.0 1811.9
3 0.14 0.12 671.0 764.3 863.3 967.9 1077.9 1193.3 1314.0 1439.8 1570.7 1706.5 1847.2
4 0.18 0.16 797.3 891.4 990.0 1093.1 1200.7 1312.5 1428.6 1548.9 1673.4 1801.8 1934.3
5 0.24 0.22 992.4 1092.0 1194.8 1300.8 1410.0 1522.3 1637.8 1756.3 1877.8 2002.3 2129.7
6 0.30 0.28 1160.4 1263.4 1368.4 1475.2 1583.8 1694.4 1806.8 1921.0 2037.0 2154.9 2274.5
7 0.36 0.34 1320.0 1441.0 1551.9 1663.7 1776.6 1890.4 2005.2 2120.9 2237.6 2355.3 2473.9
8 0.40 0.38 1449.8 1565.7 1682.1 1799.0 1916.3 2034.1 2152.4 2271.2 2390.5 2510.2 2630.3
9 0.44 0.42 1546.7 1667.4 1788.2 1909.0 2029.8 2150.6 2271.5 2392.4 2513.3 2634.2 2755.2
10 0.10 0.06 1191.8 1388.5 1596.8 1816.0 2045.5 2284.9 2533.7 2791.3 3057.4 3331.6 3613.4
11 0.12 0.08 1233.5 1427.2 1631.8 1846.9 2071.9 2306.4 2549.9 2801.9 3062.1 3330.1 3605.5
12 0.16 0.12 1315.2 1503.5 1701.8 1909.6 2126.4 2352.0 2585.8 2827.5 3076.8 3333.3 3596.8
13 0.20 0.16 1397.5 1581.9 1775.2 1977.2 2187.4 2405.4 2631.1 2864.1 3104.0 3350.7 3603.9
14 0.24 0.20 1489.3 1672.5 1863.9 2063.1 2269.8 2483.7 2704.6 2932.2 3166.3 3406.6 3653.0
15 0.30 0.26 1608.7 1789.0 1976.2 2169.9 2370.1 2576.4 2788.8 3006.9 3230.7 3459.9 3694.4
16 0.36 0.32 1734.5 1922.0 2108.6 2279.8 2491.2 2694.0 2902.0 3115.0 3332.9 3555.6 3782.8
17 0.40 0.36 1826.0 2008.5 2196.3 2389.1 2586.7 2789.2 2996.3 3207.9 3424.0 3644.3 3868.9
18 0.44 0.40 1898.3 2082.0 2270.2 2463.0 2660.1 2861.5 3067.1 3276.7 3490.4 3708.0 3929.4
249

–500
–1000
–1500
1
2
3
4 –2000
5
6
7 –2500
8
9
–3000
L

–500
–1000
–1500
–2000
–2500
10
–3000
11
12
13 –3500
14
15
16
17 –4000
18
–4500
L
13.1.2 Without Flow Separation

For NPV in this case, the following expression has been obtained (Brusov
and Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b)
(Table 13.3; Figs. 13.5 and 13.6):
13.1
L
k0 kd 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5
1 0.08 0.06 711.9 740.5 752.6 759.1 763.1 765.8 767.8 769.2 770.4 771.3
2 0.10 0.08 666.6 699.5 713.0 720.2 724.6 727.5 729.6 731.1 732.3 733.3
3 0.14 0.12 580.9 621.2 637.3 645.7 650.7 654.0 656.3 658.1 659.4 660.4
4 0.18 0.16 503.0 549.5 567.7 577.0 582.5 586.1 588.6 590.4 591.8 592.9
5 0.24 0.22 398.5 452.1 472.8 483.1 489.1 492.9 495.6 497.5 498.9 500.0
6 0.30 0.28 306.5 365.7 387.9 398.9 405.6 409.6 412.3 414.2 415.6 416.7
7 0.36 0.34 225.0 287.8 311.9 323.5 330.0 334.1 336.8 338.8 340.2 341.3
8 0.40 0.38 175.6 241.2 265.5 277.3 283.8 287.6 290.3 292.3 293.7 294.7
9 0.44 0.42 129.7 197.2 222.0 233.9 240.4 244.5 247.1 248.9 250.3 251.3
10 0.10 0.06 666.6 706.0 723.5 733.3 739.5 743.8 746.9 749.3 751.2 752.7
11 0.12 0.08 622.6 666.0 684.8 695.2 701.8 706.2 709.5 712.0 713.9 715.5
12 0.16 0.12 541.1 591.1 612.2 623.6 630.6 635.4 638.8 641.4 643.4 645.0
13 0.20 0.16 466.2 521.6 545.1 557.3 564.7 569.7 573.2 575.9 577.9 579.5
14 0.24 0.20 398.5 458.5 482.8 495.6 503.3 508.4 512.0 514.6 516.7 518.3
15 0.30 0.26 306.5 371.9 397.7 411.0 418.9 424.4 428.1 430.7 432.8 434.4
16 0.36 0.32 225.0 293.7 321.3 335.1 343.2 348.5 352.1 354.7 356.7 358.2
17 0.40 0.36 175.6 247.1 274.7 288.6 296.7 301.5 305.1 307.7 309.7 311.2
18 0.44 0.40 129.7 202.9 231.0 244.9 253.0 258.1 261.6 264.1 265.9 267.4
(continued)
251
252
L
k0 kd 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0
1 0.08 0.06 772.1 772.7 773.2 773.7 774.1 774.4 774.7 775.0 775.2 775.4 775.6
2 0.10 0.08 734.1 734.4 734.9 735.4 735.8 736.1 736.5 736.7 737.0 737.2 737.4
3 0.14 0.12 661.3 661.9 662.5 663.0 663.4 663.8 664.1 664.4 664.7 664.9 665.1
13
4 0.18 0.16 593.7 594.4 595.0 595.5 596.0 596.3 596.7 597.0 597.2 597.4 597.6
5 0.24 0.22 500.9 501.6 502.2 502.7 503.2 503.5 503.8 504.1 504.4 504.6 504.8
6 0.30 0.28 417.6 418.3 418.9 419.4 419.8 420.1 420.4 420.7 420.9 421.1 421.3
7 0.36 0.34 342.2 342.7 343.3 343.7 344.1 344.4 344.7 344.9 345.1 345.3 345.4
8 0.40 0.38 295.5 296.2 296.7 297.1 297.5 297.8 298.0 298.2 298.4 298.6 298.7
9 0.44 0.42 252.0 252.6 253.1 253.5 253.8 254.1 254.3 254.5 254.7 254.8 254.9
10 0.10 0.06 754.0 755.1 755.9 756.7 757.4 758.0 758.5 759.0 759.4 759.7 760.1
11 0.12 0.08 716.8 717.8 718.7 719.5 720.2 720.8 721.3 721.8 722.2 722.6 722.9
12 0.16 0.12 646.3 647.4 648.4 649.2 649.8 650.4 651.0 651.4 651.8 652.2 652.6
13 0.20 0.16 580.9 582.0 582.9 583.7 584.3 584.9 585.5 585.9 586.3 586.7 587.0
14 0.24 0.20 519.6 520.7 521.6 522.4 523.1 523.6 524.1 524.6 525.0 525.4 525.7
15 0.30 0.26 435.6 436.7 437.6 438.3 438.9 439.5 440.0 440.4 440.8 441.1 441.4
16 0.36 0.32 359.4 360.3 361.2 362.1 362.6 363.1 363.5 363.9 364.2 364.5 364.8
17 0.40 0.36 312.4 313.4 314.2 314.9 315.4 315.9 316.4 316.7 317.1 317.3 317.6
18 0.44 0.40 268.5 269.4 270.2 270.8 271.3 271.8 272.2 272.5 272.8 273.1 273.3

1
800
2
700
3
4 600
5 500
6
400
7
8 300
9
200
100
0
0 1 2 3 4 5 6 7 8 9 10 11
L

11
700
12
13 600
14
500
15
400
16
17
300
18
200
100
0
0 1 2 3 4 5 6 7 8 9 10 11
L

I k d ð1 t Þ 1 L
NPV ¼ 1þL 1 þ
1þL WACC ð1 þ WACCÞn ð1 þ WACCÞn
ð13:3Þ
NOIð1 t Þ 1
þ 1 :
WACC ð1 þ WACCÞn

leverage with output into saturation regime. The main increase in NPV occurs at
small values of leverage levels L 3. With growth of k0 (and kd), the сurves NPV
(L ) are lowered. Optimum in the dependence of NPV(L) is absent.
and different values of kd are started (at L ¼ 0) from one point, and the higher
values of kd (and, respectively, the lower values of Δk ¼ k0 kd) correspond to
lower-lying curves NPV(L ). Optimum in the dependence of NPV(L ) is absent.
With growth of NOI, all curves NPV(L ) are shifted practically parallel upward.
It is of interest the crossing of individual curves NPV(L) at certain leverage
levels. This means the equivalence of projects with different pairs of k0 and kd at
this leverage level [see, e.g., n ¼ 7; L ¼ 2.5; (k0 and kd) ¼ (18;14) and (24;10)].
3. At the constant values of kd, NPV shows a limited growth with leverage with
output into saturation regime. All curves NPV(L) at the constant values of k0 and
different values of kd are started (at L ¼ 0) from one point, and the higher values
of k0 (and, respectively, the higher values of Δk ¼ k0 kd) correspond to lower-
lying curves NPV(L ). Optimum in the dependence of NPV(L ) is absent. The
crossing of individual curves NPV(L ) at certain leverage levels (like point 2) was
not observed up to 10-year projects.
and Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b)
(Table 13.4; Figs. 13.7 and 13.8):

Lk d ð1 t Þ 1 L
NPV ¼ S 1 þ 1 n þ
WACC ð1 þ WACCÞ ð1 þ WACCÞn
ð13:4Þ
þ 1 :
WACC ð1 þ WACCÞn

credit rate value kd 12% turns out to be a boundary at all surveyed values of
leverage from descending of NPV with leverage) for 2-year projects. In other
words, with growth of kd, the transition from the growth of NPV with leverage to
its descending with leverage takes place, and at the credit rate kd 12 % , NPV
does not depend on the leverage level at all surveyed values of k0. For 5-year
projects, this boundary credit rate is equal to 16–18%, and for 7-year and 10-year
projects, it is equal to 12–15%.
Thus, we come to a conclusion that for arbitrary duration projects, NPV grows
with leverage at a credit rate kd < 12 18 % , and NPV decreases with leverage at
a credit rate kd > 12 18% (project remains effective up to leverage levels
L ¼ L0, NPV(L0) ¼ 0). Optimum in the dependence of NPV(L) is absent.
13.1
L
k0 kd 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5
1 0.08 0.06 1.4 32.9 62.7 90.6 117.5 143.9 170.0 195.9 221.6 247.1
2 0.10 0.08 27.8 2.5 16.9 33.8 49.6 64.6 79.2 93.5 107.6 121.5
3 0.14 0.12 77.8 69.8 70.1 73.7 79.1 85.4 92.4 99.8 107.4 115.3
4 0.18 0.16 123.2 131.6 150.2 173.0 198.0 224.2 251.2 278.8 306.7 335.0
5 0.24 0.22 184.2 215.3 259.2 308.4 360.4 413.9 468.4 523.6 579.3 635.3
6 0.30 0.28 237.9 289.8 356.6 429.7 505.9 584.2 663.6 743.8 824.6 905.8
7 0.36 0.34 285.4 356.7 444.0 538.7 637.0 737.6 839.5 942.3 1045.8 1150.1
8 0.40 0.38 314.2 396.9 497.4 605.4 717.3 831.3 946.9 1063.6 1180.9 1298.7
9 0.44 0.42 341.0 434.8 547.3 667.9 792.6 919.7 1048.4 1178.1 1308.6 1439.6
10 0.10 0.06 27.8 9.6 42.6 73.7 103.9 133.7 163.0 192.2 221.2 250.1
11 0.12 0.08 53.5 25.0 2.2 18.2 37.4 56.0 74.1 92.0 109.6 127.1
12 0.16 0.12 101.1 89.8 86.4 86.4 88.0 90.6 93.8 97.3 101.2 105.3
13 0.20 0.16 144.7 149.8 164.2 183.1 204.2 226.5 249.5 273.1 297.0 321.2
14 0.24 0.20 184.2 204.4 236.3 273.0 312.2 352.8 394.3 436.4 478.9 521.8
15 0.30 0.26 237.9 279.4 334.8 396.0 460.2 526.1 593.2 661.0 729.3 798.1
16 0.36 0.32 285.4 346.8 423.3 506.6 593.5 682.4 772.6 863.6 955.2 1047.3
17 0.40 0.36 314.2 387.3 477.3 574.4 675.2 778.0 882.2 987.5 1093.4 1199.7
18 0.44 0.40 341.0 425.5 527.9 637.9 751.8 868.1 985.8 1104.5 1223.9 1343.8
(continued)
255
256
L
k0 kd 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0
1 0.08 0.06 272.6 298.1 323.4 348.8 374.1 399.3 424.6 449.8 475.0 500.2 525.4
2 0.10 0.08 135.3 149.4 163.1 176.8 190.4 204.1 217.6 231.2 244.7 258.2 271.7
3 0.14 0.12 123.4 131.6 139.8 148.2 156.6 165.1 173.6 182.2 190.8 199.4 208.0
13
4 0.18 0.16 363.4 391.9 420.6 449.4 478.3 507.2 536.2 565.3 594.4 623.5 652.7
5 0.24 0.22 691.5 748.0 804.6 861.4 918.2 975.2 1032.2 1089.2 1146.3 1203.5 1260.7
6 0.30 0.28 987.4 1069.1 1151.1 1233.2 1315.5 1397.8 1480.2 1562.7 1645.3 1727.9 1810.6
7 0.36 0.34 1254.7 1358.6 1463.4 1568.4 1673.5 1778.7 1884.1 1989.5 2094.9 2200.5 2306.1
8 0.40 0.38 1417.0 1535.5 1654.3 1773.3 1892.5 2011.7 2131.1 2250.6 2370.1 2489.7 2609.4
9 0.44 0.42 1571.0 1702.7 1834.7 1966.9 2099.3 2231.8 2364.4 2497.1 2629.8 2762.7 2895.6
10 0.10 0.06 278.9 307.6 336.3 365.0 393.6 422.1 450.7 479.2 507.8 536.3 564.8
11 0.12 0.08 144.5 161.8 179.1 196.3 213.4 230.5 247.6 264.6 281.7 298.7 315.7
12 0.16 0.12 109.5 113.9 118.3 122.9 127.5 132.1 136.8 141.5 146.2 151.0 155.8
13 0.20 0.16 345.6 370.1 394.7 419.5 444.3 469.2 494.2 519.2 544.2 569.3 594.4
14 0.24 0.20 564.9 608.1 651.5 695.1 738.7 782.4 826.1 869.9 913.8 957.7 1001.6
15 0.30 0.26 867.1 936.3 1005.7 1075.3 1145.0 1214.7 1284.6 1354.5 1424.5 1494.5 1564.6
16 0.36 0.32 1139.8 1232.0 1324.9 1419.3 1511.6 1604.9 1698.3 1791.8 1885.3 1978.9 2072.5
17 0.40 0.36 1306.5 1413.5 1520.8 1628.3 1735.9 1843.6 1951.4 2059.3 2167.3 2275.3 2383.4
18 0.44 0.40 1464.2 1584.8 1705.6 1826.7 1947.9 2069.2 2190.7 2312.2 2433.8 2555.5 2677.2

1 500
2
0
0 1 2 3 4 5 6 7 8 9 10 3 11
–500
4
–1000
5
–1500
6
–2000
7
–2500
8
9
–3000
–3500
L

10
500
11
0
0 1 2 3 4 5 6 7 8 9 10 12 11
13
–500
14 –1000
15 –1500
16 –2000
17
–2500
18
–3000
L
2. At the constant values of kd, NPV shows two types of behavior: (a) an
unlimited growth with leverage and (b) NPV reaching maximum at relatively
low leverage level (L < 1) following then by an unlimited descend with
leverage.
NPV grows with leverage at a credit rate kd < 8 10 % , and NPV decreases
with leverage at a credit rate kd < 8 10% (project remains effective up to
leverage levels L ¼ L0, NPV(L0) ¼ 0). All curves NPV(L ) at the constant values
of k0 and different values of kd are started (at L ¼ 0) from one point, and the
higher values of k0 (and higher values of Δk ¼ k0 kd) correspond to more
low-lying curves NPV(L). Optimum in the dependence of NPV(L ) is absent. This
is observed for projects of all analyzed duration frames. The first type of depen-
dence of NPV(L) has a place mainly for pairs of values k0 and kd up to 16–18%,
while the second type has a place for higher pairs of values k0 and kd
irrespectively of the duration of the project.
Thus, for the projects of all analyzed durations, the second type of dependence
of NPV(L ) has a place for kd ¼ 16 % ; k0 ¼ 18 % 24 % ; kd ¼ 20 % ;
k0 ¼ 24 % 44 % ; kd ¼ 24 % ; k0 ¼ 30 % 44 % ; in the case of a 2-year
project, another pair (kd ¼ 12 % ; k0 ¼ 14%) is added.
3. At the constant values of k0, NPV as well as in case of constant values of Δk ¼ k0 kd
shows as an unlimited growth with leverage and unlimited descending with
leverage. An analysis of the data leads to the same conclusion that, in paragraph
(1), at an arbitrary duration of a project, NPV is growing with leverage at the credit
rate kd < 18 % , and NPV decreases with leverage at a credit rate kd < 18% (project
remains effective up to leverage levels L ¼ L0, NPV(L0) ¼ 0).
It should be noted that this pattern should be taken into account by the
regulator which should regulate normative base in such a way that credit rates,
which are associated with the Central Bank basic rate, do not exceed, say, 18%.
started (at L ¼ 0) from one point, and the higher values of kd (and lower values of
Δk ¼ k0 kd) correspond to more low-lying curves NPV(L ). Optimum in the


(Table 13.5; Figs. 13.9 and 13.10):

Lt 1 NOIð1 t Þ 1
NPV ¼ I 1 1 þ 1 : ð13:5Þ
1þL ð1 þ k d Þn ke ð1 þ k e Þn
13.2
L
k0 kd 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5
1 0.08 0.06 711.9 700.7 686.2 670.6 654.6 638.5 622.4 606.5 590.8 575.3
2 0.10 0.08 666.6 660.2 649.4 637.0 623.9 610.5 597.0 583.6 570.2 556.9
3 0.14 0.12 580.9 581.9 576.5 568.5 559.4 549.6 539.5 529.3 519.0 508.7
4 0.18 0.16 503.0 510.6 509.8 505.7 499.9 493.4 486.3 478.9 471.3 463.7
5 0.24 0.22 398.5 414.0 418.6 418.9 417.1 414.0 410.2 406.0 401.4 396.6
6 0.30 0.28 306.5 328.6 337.3 340.6 344.0 344.2 343.5 342.3 340.6 338.6
7 0.36 0.34 225.0 251.3 264.7 272.0 276.4 279.0 280.5 281.3 281.6 283.5
8 0.40 0.38 175.6 206.1 221.0 229.6 235.1 236.2 238.8 240.6 242.0 242.9
9 0.44 0.42 129.7 163.0 179.5 189.5 196.1 200.7 204.3 207.0 209.1 210.9
10 0.10 0.06 666.6 635.3 602.0 568.7 536.1 504.4 473.6 443.9 415.2 387.5
11 0.12 0.08 622.6 596.5 567.1 537.1 507.3 478.2 449.9 422.4 395.7 369.9
12 0.16 0.12 541.1 524.3 501.8 477.7 453.2 428.8 404.8 381.4 358.4 336.1
13 0.20 0.16 466.2 456.8 441.5 422.5 402.5 382.2 362.1 342.1 322.5 303.2
14 0.24 0.20 398.5 396.6 385.1 370.2 353.8 336.9 319.7 302.6 285.6 268.9
15 0.30 0.26 306.5 313.4 308.1 298.0 285.9 275.8 263.0 249.9 236.7 223.6
16 0.36 0.32 225.0 237.9 238.8 234.1 226.8 218.2 208.7 198.8 188.6 178.3
17 0.40 0.36 175.6 193.9 197.2 194.7 189.3 179.9 172.2 164.0 155.5 146.7
18 0.44 0.40 129.7 151.7 157.5 157.1 153.7 148.5 142.4 135.6 128.5 121.1
(continued)
259
260
L
k0 kd 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0
1 0.08 0.06 560.0 544.9 530.1 515.5 501.1 487.0 473.1 459.4 445.9 432.7 419.7
2 0.10 0.08 543.7 525.7 512.5 499.5 486.6 474.0 461.5 449.2 437.1 425.1 413.4
3 0.14 0.12 498.4 488.2 478.0 468.0 458.0 448.1 438.3 428.6 419.0 409.5 400.1
13
4 0.18 0.16 455.9 448.2 440.4 432.6 424.9 417.2 409.6 402.0 394.4 386.9 379.5
5 0.24 0.22 391.7 386.6 381.5 376.3 371.1 365.9 360.7 355.4 350.2 345.0 339.8
6 0.30 0.28 336.3 334.0 331.5 328.9 326.2 323.4 320.7 317.8 315.0 312.1 309.2
7 0.36 0.34 284.4 280.7 280.0 279.1 278.2 277.2 276.1 274.9 273.7 272.5 271.2
8 0.40 0.38 243.5 244.0 244.2 244.3 244.3 244.2 244.0 243.7 243.4 243.1 242.7
9 0.44 0.42 212.4 213.6 214.6 215.5 216.3 217.0 217.6 218.2 218.6 219.1 219.4
10 0.10 0.06 360.7 334.8 309.8 285.6 262.2 239.6 217.7 196.5 176.0 156.1 136.9
11 0.12 0.08 344.9 320.6 297.2 274.5 252.5 231.1 210.5 190.4 171.0 152.2 133.9
12 0.16 0.12 314.4 293.2 272.7 252.7 233.3 214.4 196.0 178.1 160.8 143.9 127.4
13 0.20 0.16 284.4 266.0 248.1 230.6 213.5 196.8 180.5 164.6 149.1 134.0 119.3
14 0.24 0.20 252.4 236.2 220.4 204.9 189.7 174.9 160.3 146.1 132.2 118.6 105.3
15 0.30 0.26 210.6 197.7 185.0 172.5 160.1 148.0 136.1 124.4 112.9 101.6 90.5
16 0.36 0.32 168.0 155.9 145.7 140.4 127.2 117.2 107.4 97.7 88.1 78.7 69.4
17 0.40 0.36 137.9 129.0 120.2 111.3 102.6 93.9 85.2 76.7 68.3 59.9 51.7
18 0.44 0.40 113.6 106.0 98.3 90.7 83.0 75.4 67.9 60.4 53.0 45.6 38.3

1
700
2
3 600
4 500
5 400
6 300
7
200
8
9
100
0
0 1 2 3 4 5 6 7 8 9 10 11
L

11
600
12
500
13
14 400
15 300
16
200
17
18
100
0
0 1 2 3 4 5 6 7 8 9 10 11
L
1. At the constant values of Δk ¼ k0 kd, NPV, as a rule, reaches an optimum at

relatively low leverage level (L < 1) and then decreases with leverage. All curves
NPV(L ) for the same values of k0 are started at the same point, but with growth of
Δk ¼ k0 kd (respectively, decreasing of kd), they are shifted into a region of
lower values of NPV, and descending speed decreases with leverage, and for not
too high values of k0 and kd, curves NPV(L) practically output into saturation
regime. For higher values of k0 and kd, saturation regime does not occur, and after
optimum (sometimes, but more seldom, without optimum), falling trend is still
present.
very rarely only (for individual values of k0 and kd) demonstrating the presence of
optimum at low leverage levels (L < 1) (it should be noted that, with the increase
of the duration of the project, the number of curves NPV(L ) having optimum is
growing while remaining to be not very large). All curves NPV(L ) at the constant
values of k0 and different values of kd are started (at L ¼ 0) from one point, and
the higher values of kd (and lower values of Δk ¼ k0 kd) correspond to higher-
lying curves NPV(L ). Descending speed decreases with leverage.
3. At the constant values of kd, NPV practically always decreases with leverage, and
the existence of optimum at low leverage levels (L < 1) is a rare exception. All
curves NPV(L ) at the constant values of k0 and different values of kd are started
(at L ¼ 0) from one point, and the higher values of k0 (and higher values of
Δk ¼ k0 kd) correspond to lower-lying curves NPV(L ). Descending speed
increases with leverage.
(Table 13.6; Figs. 13.11 and 13.12):

1
NPV ¼ S 1 þ L tL 1
ð1 þ kd Þn

þ 1 : ð13:6Þ
ke ð1 þ k e Þn
1. At the constant values of Δk ¼ k0 kd, NPV always decreases with leverage

[existence of an optimum at relatively low leverage level (L < 1)] and practically
has not been observed. All curves NPV(L ) for the same values of k0 are started at
the same point, but with growth of k0 (and, respectively, the growth of kd), they
are shifted into a region of lower values of NPV, and descending speed increases
with leverage.
The values of Δk ¼ k0 kd, equal to 2, 4, 6, and 10%, have been used.
With growth of Δk ¼ k0 kd, a narrowing of the NPV(L ) curve cluster takes
place (the width of the cluster is decreased), the difference between curves
becomes less and less, and at Δk ¼ 10 % , the curve cluster is practically
transformed into one wide line. The marked pattern has a place for projects of
all examined duration projects (2, 5, 7, 10 years).
2. At the constant values of k0, NPV always decreases with leverage. All curves NPV
(L) for the same values of k0 are started at the same point, but with growth of kd (and,
respectively, decrease of Δk ¼ k0 kd), they are shifted into a region of higher
values of NPV, and descending speed decreases with leverage. The width of the
NPV(L) curve cluster is decreased with the increase of the duration of the project.
13.2
L
k0 kd 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5
1 0.08 0.06 1.4 7.3 23.6 50.0 86.1 131.8 186.8 250.8 323.5 404.7
2 0.10 0.08 27.8 41.4 63.8 94.9 134.4 182.1 237.9 301.5 372.8 451.5
3 0.14 0.12 77.8 107.4 143.9 187.3 237.3 294.0 357.0 426.4 501.9 583.5
4 0.18 0.16 123.2 167.5 217.2 272.2 332.3 397.5 467.8 542.9 623.0 707.8
5 0.24 0.22 184.2 249.1 317.6 389.7 465.4 544.7 627.4 713.6 803.2 896.1
6 0.30 0.28 237.9 321.3 407.4 496.3 583.0 674.4 767.7 862.9 960.2 1059.3
7 0.36 0.34 285.4 386.7 487.6 589.6 692.5 796.5 901.4 1007.3 1114.3 1216.1
8 0.40 0.38 314.2 424.8 535.9 647.5 759.5 877.3 990.8 1104.8 1219.3 1334.3
9 0.44 0.42 341.0 461.4 581.9 702.4 822.9 943.5 1064.0 1184.7 1305.3 1426.0
10 0.10 0.06 27.8 64.5 121.8 198.6 293.5 405.7 534.0 677.6 835.6 1007.3
11 0.12 0.08 53.5 97.1 159.8 240.6 338.4 452.2 581.2 724.6 881.6 1051.5
12 0.16 0.12 101.1 157.8 231.0 319.7 423.1 540.6 671.4 814.8 970.3 1137.3
13 0.20 0.16 144.7 214.6 296.8 393.4 502.8 624.4 757.7 902.1 1057.2 1222.4
14 0.24 0.20 184.2 265.3 358.6 463.6 579.9 706.9 844.3 991.6 1148.5 1314.5
15 0.30 0.26 237.9 335.4 443.1 560.7 688.0 818.1 960.5 1111.1 1269.5 1435.4
16 0.36 0.32 285.4 399.1 519.3 647.0 782.0 924.2 1073.2 1229.0 1391.2 1559.8
17 0.40 0.36 314.2 436.2 565.0 700.4 842.1 995.4 1150.0 1310.5 1476.8 1648.7
18 0.44 0.40 341.0 471.9 608.7 751.3 899.4 1053.0 1212.0 1376.1 1545.3 1719.4
(continued)
263
264
L
k0 kd 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0
1 0.08 0.06 494.2 591.7 697.1 810.2 930.6 1058.3 1193.0 1334.6 1482.9 1637.7 1798.8
2 0.10 0.08 537.5 649.7 752.6 862.5 979.1 1102.3 1232.0 1367.9 1510.0 1658.0 1811.9
3 0.14 0.12 671.0 764.3 863.3 967.9 1077.9 1193.3 1314.0 1439.8 1570.7 1706.5 1847.2
13
4 0.18 0.16 797.3 891.4 990.0 1093.1 1200.7 1312.5 1428.6 1548.9 1673.4 1801.8 1934.3
5 0.24 0.22 992.4 1092.0 1194.8 1300.8 1410.0 1522.3 1637.8 1756.3 1877.8 2002.3 2129.7
6 0.30 0.28 1160.4 1263.4 1368.4 1475.2 1583.8 1694.4 1806.8 1921.0 2037.0 2154.9 2274.5
7 0.36 0.34 1320.0 1441.0 1551.9 1663.7 1776.6 1890.4 2005.2 2120.9 2237.6 2355.3 2473.9
8 0.40 0.38 1449.8 1565.7 1682.1 1799.0 1916.3 2034.1 2152.4 2271.2 2390.5 2510.2 2630.3
9 0.44 0.42 1546.7 1667.4 1788.2 1909.0 2029.8 2150.6 2271.5 2392.4 2513.3 2634.2 2755.2
10 0.10 0.06 1191.8 1388.5 1596.8 1816.0 2045.5 2284.9 2533.7 2791.3 3057.4 3331.6 3613.4
11 0.12 0.08 1233.5 1427.2 1631.8 1846.9 2071.9 2306.4 2549.9 2801.9 3062.1 3330.1 3605.5
12 0.16 0.12 1315.2 1503.5 1701.8 1909.6 2126.4 2352.0 2585.8 2827.5 3076.8 3333.3 3596.8
13 0.20 0.16 1397.5 1581.9 1775.2 1977.2 2187.4 2405.4 2631.1 2864.1 3104.0 3350.7 3603.9
14 0.24 0.20 1489.3 1672.5 1863.9 2063.1 2269.8 2483.7 2704.6 2932.2 3166.3 3406.6 3653.0
15 0.30 0.26 1608.7 1789.0 1976.2 2169.9 2370.1 2576.4 2788.8 3006.9 3230.7 3459.9 3694.4
16 0.36 0.32 1734.5 1922.0 2108.6 2279.8 2491.2 2694.0 2902.0 3115.0 3332.9 3555.6 3782.8
17 0.40 0.36 1826.0 2008.5 2196.3 2389.1 2586.7 2789.2 2996.3 3207.9 3424.0 3644.3 3868.9
18 0.44 0.40 1898.3 2082.0 2270.2 2463.0 2660.1 2861.5 3067.1 3276.7 3490.4 3708.0 3929.4

–500
–1000
–1500
1
2
3
4 –2000
5
6
7 –2500
8
9
–3000
L

–500
–1000
–1500
–2000
–2500
10 –3000
11
12
13 –3500
14
15
16
17 –4000
18
–4500
L
3. At the constant values of k0, NPV always decreases with leverage. All curves NPV
(L) for the same values of k0 are started at the same point, but with growth of k0
(and, respectively, increase of Δk ¼ k0 kd), they are shifted into a region of lower
values of NPV, and descending speed increases with leverage. The width of the
NPV(L) curve cluster is decreased with the increase of the duration of the project.
13.2.2 Without Flow Separation

For NPV in this case, the following expressions have been obtained (Brusov and
Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b) (Table 13.7;
Figs. 13.13 and 13.14):

NOIð1 t Þ þ k d Dt 1
NPV ¼ I þ 1
WACC ð1 þ WACCÞn
0 1
NOIð1 t Þ þ kd Dt B
n C
1
NPV ¼ I þ @1 A
k0 1 γ 1þL
L
1 þ k0 1 γ 1þL
L
2 0 13
L
6 kd t 7
NPV ¼ I 6 1 þ L B1 1
n C
41 @ A75
L 1 þ k0 1 γ 1þL
L
k0 1 γ t t
10þL 1 ð13:7Þ
NOIð1 t Þ B
n C
1
þ @1 A:
L þ γ L
k0 1 γ t 1 k 0 1 1þL t
1þL

leverage with output into saturation regime. The main increase in NPV occurs at
small values of leverage levels L 3 4. With growth of k0 (and kd), the сurves
NPV(L ) are lowered. Optimum in the dependence of NPV(L ) is absent.
with output into saturation regime. The main increase in NPV occurs at low
values of leverage levels L 4 5. All curves NPV(L ) at the constant values of
k0 and different values of kd are started (at L ¼ 0) from one point, and the higher
values of kd (and, respectively, the lower values of Δk ¼ k0 kd) correspond to
higher-lying curves NPV(L ). This is similar to the case of consideration from the
point of view of equity capital owners. Optimum in the dependence of NPV(L) is
absent, while in the case of consideration from the point of view of equity capital
owners optimum takes place at low leverage level L and at high values of k0 and
kd (of order 30–40%). With growth of project duration, the distance between
curves NPV(L ), corresponding to different pairs of values k0 and kd, increases.
3. At the constant values of kd, NPV demonstrates a limited growth with leverage
and different values of kd are started (at L ¼ 0) from one point, and the higher
values of k0 (and, respectively, the higher values of Δk ¼ k0 kd) correspond to
lower-lying curves NPV(L ). With growth of Δk ¼ k0 kd, the distance between
curves NPV(L ), corresponding to different pairs of values k0 and kd, decreases.
13.2
L
k0 kd 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5
1 0.08 0.06 711.9 731.8 741.8 747.8 751.9 754.8 757.0 758.6 760.0 761.1
2 0.10 0.08 666.6 692.1 705.0 712.9 718.1 721.9 724.7 726.9 728.7 730.2
3 0.14 0.12 580.9 615.9 633.9 644.7 652.0 657.3 661.2 664.3 666.7 668.8
4 0.18 0.16 503.0 546.2 568.4 581.9 590.9 597.5 602.4 606.2 609.3 611.8
5 0.24 0.22 398.5 451.5 478.8 495.5 506.8 514.9 521.0 525.7 529.5 532.7
6 0.30 0.28 306.5 367.3 398.7 417.7 431.7 441.1 448.3 453.9 458.4 462.0
7 0.36 0.34 225.0 291.2 326.7 348.5 363.2 373.8 381.8 388.1 393.1 397.6
8 0.40 0.38 175.6 246.0 283.0 305.8 321.2 331.5 340.0 346.7 352.1 356.6
9 0.44 0.42 129.7 203.1 241.7 265.6 281.7 293.4 302.3 309.2 314.8 319.4
10 0.10 0.06 666.6 686.0 695.8 701.8 705.7 708.6 710.7 712.4 713.7 714.8
11 0.12 0.08 622.6 647.4 660.0 667.6 672.7 676.3 679.1 681.2 682.9 684.3
12 0.16 0.12 541.1 575.2 592.7 603.2 610.3 615.4 619.3 622.3 624.7 626.6
13 0.20 0.16 466.2 507.9 530.4 543.6 552.4 558.8 563.6 567.3 570.3 572.8
14 0.24 0.20 398.5 447.3 472.4 487.7 498.0 505.5 511.1 515.4 518.9 521.8
15 0.30 0.26 306.5 363.6 393.1 411.0 423.0 432.8 439.5 444.7 448.9 452.3
16 0.36 0.32 225.0 287.9 321.6 342.3 356.3 366.3 373.9 379.9 384.6 388.5
17 0.40 0.36 175.6 243.0 278.3 300.1 314.8 324.5 332.7 339.1 344.2 348.4
18 0.44 0.40 129.7 200.3 237.4 260.2 275.8 287.0 295.5 302.1 307.4 311.8
(continued)
267
268
L
k0 kd 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0
1 0.08 0.06 762.0 762.8 763.5 764.1 764.6 765.1 765.5 765.8 766.1 766.4 766.7
2 0.10 0.08 731.4 731.4 732.3 733.0 733.7 734.3 734.8 735.3 735.7 736.0 736.4
3 0.14 0.12 670.5 671.9 673.1 674.2 675.1 675.9 676.7 677.3 677.9 678.4 678.9
13
4 0.18 0.16 613.9 615.7 617.2 618.6 619.7 620.7 621.7 622.5 623.2 623.9 624.5
5 0.24 0.22 535.3 537.5 539.4 541.1 542.5 543.8 544.9 546.0 546.9 547.7 548.5
6 0.30 0.28 465.1 467.7 470.0 471.9 473.6 475.1 476.5 477.7 478.7 479.7 480.6
7 0.36 0.34 401.3 403.6 406.1 408.3 410.2 411.8 413.3 414.7 415.9 417.0 418.0
8 0.40 0.38 360.2 363.4 366.1 368.4 370.5 372.3 373.9 375.3 376.6 377.8 378.9
9 0.44 0.42 323.2 326.4 329.2 331.7 333.8 335.7 337.4 338.9 340.2 341.4 342.6
10 0.10 0.06 715.7 716.5 717.2 717.7 718.2 718.7 719.1 719.4 719.8 720.0 720.3
11 0.12 0.08 685.5 686.5 687.3 688.1 688.7 689.3 689.8 690.2 690.7 691.0 691.4
12 0.16 0.12 628.3 629.7 630.9 631.9 632.8 633.6 634.3 634.9 635.5 636.0 636.5
13 0.20 0.16 574.8 576.6 578.1 579.4 580.5 581.5 582.4 583.2 583.9 584.6 585.2
14 0.24 0.20 524.2 526.2 528.0 529.5 530.8 532.0 533.0 533.9 534.8 535.5 536.2
15 0.30 0.26 455.2 457.6 459.7 461.6 463.2 464.6 465.8 466.9 467.9 468.9 469.7
16 0.36 0.32 391.8 394.1 396.6 399.7 400.8 402.4 403.8 405.1 406.3 407.3 408.2
17 0.40 0.36 351.9 354.9 357.5 359.7 361.7 363.4 364.9 366.3 367.5 368.7 369.7
18 0.44 0.40 315.5 318.6 321.3 323.6 325.7 327.5 329.1 330.5 331.8 333.0 334.0

800
1
2
3
700
4
600
5
6 500
7
8
400
9
300
200
100
0
0 1 2 3 4 5 6 7 8 9 10 11
L

10
11 700
12
13 600
14
500
15
16 400
17
18
300
200
100
0
0 1 2 3 4 5 6 7 8 9 10 11
L

2018a, b, c, d) (Table 13.8; Figs. 13.15 and 13.16):
270
L
k0 kd 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5
1 0.08 0.06 1.4 19.8 41.1 62.5 83.9 105.3 126.8 148.2 169.7 191.1
2 0.10 0.08 27.8 13.6 1.0 15.6 30.3 45.1 59.9 74.7 89.5 104.3
3 0.14 0.12 77.8 77.7 77.0 76.1 75.1 74.0 72.9 71.8 70.6 69.4
13
4 0.18 0.16 123.2 136.4 148.8 160.8 172.6 184.3 196.0 207.6 219.2 230.7
5 0.24 0.22 184.2 216.3 247.1 277.3 307.3 337.1 366.8 396.5 426.1 455.7
6 0.30 0.28 237.9 287.3 335.2 382.5 427.6 473.6 519.5 565.3 611.0 656.7
7 0.36 0.34 285.4 351.6 414.4 476.2 537.6 598.7 659.6 720.4 781.2 840.5
8 0.40 0.38 314.2 389.7 462.5 534.1 605.1 677.6 748.0 818.3 888.5 958.6
9 0.44 0.42 341.0 426.0 508.0 588.6 668.7 748.3 827.7 906.9 986.0 1065.1
10 0.10 0.06 27.8 20.4 12.7 5.1 2.7 10.4 18.2 26.0 33.7 41.5
11 0.12 0.08 53.5 52.8 51.9 50.9 49.9 48.8 47.6 46.5 45.4 44.2
12 0.16 0.12 101.1 113.6 125.5 137.3 148.9 160.5 172.0 183.5 195.0 206.5
13 0.20 0.16 144.7 170.2 193.6 217.4 241.0 264.6 288.1 311.5 334.9 358.3
14 0.24 0.20 184.2 221.2 257.1 292.6 327.8 362.9 397.9 432.9 467.8 502.7
15 0.30 0.26 237.9 291.7 344.2 396.1 447.8 496.9 547.6 598.2 648.7 699.2
16 0.36 0.32 285.4 355.6 422.6 488.7 554.4 619.8 685.1 750.3 815.5 880.5
17 0.40 0.36 314.2 393.4 470.1 545.7 620.8 697.6 772.2 846.6 920.9 995.2
18 0.44 0.40 341.0 429.5 515.1 599.6 683.5 767.0 850.3 933.4 1016.4 1099.3
L
13.2
k0 kd 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0
1 0.08 0.06 212.6 234.0 255.5 277.0 298.5 319.9 341.4 362.9 384.3 405.8 427.3
2 0.10 0.08 119.1 130.1 144.6 159.1 173.6 188.1 202.6 217.1 231.6 246.1 260.6
3 0.14 0.12 68.2 67.0 65.8 64.6 63.3 62.1 60.9 59.6 58.4 57.2 55.9
4 0.18 0.16 242.3 253.8 265.3 276.8 288.3 299.8 311.3 322.8 334.2 345.7 357.2
5 0.24 0.22 485.2 514.8 544.3 573.8 603.3 632.8 662.3 691.8 721.3 750.7 780.2
6 0.30 0.28 702.3 747.9 793.5 839.0 884.6 930.1 975.6 1021.1 1066.6 1112.1 1157.6
7 0.36 0.34 900.1 963.2 1023.8 1084.3 1144.9 1205.5 1266.0 1326.5 1387.0 1447.5 1508.1
8 0.40 0.38 1028.7 1098.7 1168.7 1238.6 1308.6 1378.5 1448.4 1518.3 1588.2 1658.1 1727.9
9 0.44 0.42 1144.0 1222.9 1301.8 1380.6 1459.4 1538.2 1617.0 1695.7 1774.4 1853.2 1931.9
10 0.10 0.06 49.3 57.1 64.9 72.7 80.5 88.2 96.0 103.8 111.6 119.4 127.2
11 0.12 0.08 43.1 41.9 40.7 39.6 38.4 37.2 36.1 34.9 33.7 32.6 31.4
12 0.16 0.12 218.0 229.4 240.9 252.3 263.8 275.2 286.6 298.1 309.5 320.9 332.4
13 0.20 0.16 381.6 405.0 428.3 451.7 475.0 498.3 521.6 544.9 568.3 591.6 614.9
14 0.24 0.20 537.5 572.4 607.2 642.0 676.8 711.6 746.5 781.2 816.0 850.8 885.6
15 0.30 0.26 749.6 800.1 850.5 900.9 951.3 1001.6 1052.0 1102.3 1152.7 1203.0 1253.4
16 0.36 0.32 945.6 1012.2 1077.2 1137.5 1205.5 1270.4 1335.4 1400.3 1465.2 1530.1 1595.0
17 0.40 0.36 1069.4 1143.6 1217.8 1291.9 1366.0 1440.1 1514.2 1588.3 1662.4 1736.4 1810.5
18 0.44 0.40 1182.2 1265.0 1347.8 1430.6 1513.3 1596.0 1678.7 1761.4 1844.1 1926.7 2009.4
271

1 500
2
3 0
0 1 2 3 4 5 6 7 8 9 10 11
4
–500
5
–1000
6
7 –1500
8
9
–2000
–2500
L

10
11 0
0 1 2 3 4 5 6 7 8 9 10 11
12
–500
13
14
–1000
15
–1500
16
17
18 –2000
–2500
L

k d Lt 1
NPV ¼ S 1 þ L 1 n
WACC ð1 þ WACC
Þ ð13:8Þ
þ 1 :
WACC ð1 þ WACCÞn

leverage and unlimited descending with leverage. There is a boundary credit rate
13.3 The Elaboration of Recommendations on the Capital Structure of. . . 273
value, which separates the growth of NPV with leverage from descending of NPV
with leverage. This rate depends on the values Δk ¼ k0 kd, equal to 2, 4, 6, and
10%, weakly depends on project duration, and is within region 8–20%. Thus, we
come to a conclusion that for arbitrary duration projects, NPV grows with
leverage at a credit rate kd < 8 20 % , and NPV decreases with leverage at a
credit rate kd > 8 20% (project remains effective up to leverage levels L ¼ L0,
NPV(L0) ¼ 0). Optimum in the dependence of NPV(L ) is absent.
2. At the constant values of k0 (similar to the case of Δk ¼ k0 kd), NPV shows as
an unlimited growth with leverage and unlimited descending with leverage.
started (at L ¼ 0) from one point, and the higher values of kd (and lower values of
Δk ¼ k0 kd) correspond to higher-lying curves NPV(L ). Optimum in the
3. At the constant values of kd, NPV as well as in the case of constant values of
Δk ¼ k0 kd shows as an unlimited growth with leverage and unlimited
descending with leverage. There is a boundary credit rate value, which separates
the growth of NPV with leverage from descending of NPV with leverage. This
rate depends on the values Δk ¼ k0 kd, equal to 2, 4, 6, and 10%; weakly
depends on project duration; and is within region 8–20%. Thus, we come to a
conclusion that for arbitrary duration projects NPV grows with leverage at a
credit rate kd < 8 20 % , and NPV decreases with leverage at a credit rate
kd > 8 20% (project remains effective up to leverage levels L ¼ L0, NPV
13.3 The Elaboration of Recommendations on the Capital

Structure of Investment of Enterprises, Companies,
Taking into Account All the Key Financial Parameters
of Investment Project
13.3.1 General Conclusions and Recommendations
on the Definition of Capital Structure of Investment
of Enterprises
As the dependence NPV(L ) at different I, NOI, S, and β indicates, the changing of

the first two parameters, as a rule, leads to the shift of curves NPV(L ) in the vertical
direction only (parallel offset), without changing of characteristic points of these
curves, and of type L* [value of L, where NPV(L ) reaches optimum (if available)].
Only the maximum permissible leverage level L0 is changed (in case of monotonic
descending of NPV with leverage).
This opens the way for tabulation of the results obtained in the case of constant
value of investment. In other words this fact is the basis for the use of our tables and
graphs to estimate the optimal debt level for the investor. Thus, obtained by us,
tables and graphs allow to determine value of L*, knowing only k0 and kd for
investment project. kd is the credit rate, which is determined by the creditor, but
determination of parameter k0 is always a complicated problem. This has been noted
by several researchers, and we can also add that the parameter k0 is one of the most
important parameters in both used theories: Modigliani–Miller (Мodigliani and
Мiller 1958, 1963, 1966) and Brusov–Filatova–Orekhova (Brusov and Filatova
2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b; Filatova et al. 2008).
In contrast to the parameters I and NOI, a change of parameters S and β, both
individually and simultaneously, can significantly change the nature of the curves
NPV(L ), i.e., the dependence of NPV on the leverage level. Thus, with change of β,
NPV(L ) can be changed from decreasing function to function, having an optimum.
Such studies have been conducted on the example of “Nastcom Plus” company. This
means the inability of tabulation of the results obtained in the case of constant value
of equity capital S: in this case, one will need to use the formulas; we have received
to determine the NPV at the existing level leverage, as well as to optimize the
existing investment structure.
In the case of a constant invested capital I with the division of flows (with using
two discount rates) in the case of finite-duration projects, the descending of NPV
with leverage is possible, as well as the existence of optimum. Without flow
separation a moderate growth of NPV(L )—output to saturation—has been observed.
This demonstrates the limitation of approach, associated with the use of one discount
rate, veiling various options of dependence of NPV(L ) at different equity and
debt cost.
At constant equity value S with the use of one discount rate (in WACC approx-
imation), one has either growth or decrease of NPV, depending on credit rate kd. We
have found the boundary rates kd, determining transition from growth to decrease of
NPV. Because application of two discount rates (at flow separation) demonstrates
the existence of optimum in this case, WACC approximation changes the type of
dependence of NPV(L ).
Thus, one can make the following general recommendations:
1. It is necessary to use an assessment of the efficiency of investment projects with
flow separation.
2. In the case of a constant value of investment I, a tabulation of the obtained results
is possible, i.e., one can use obtained by us tables and graphs to estimate the
optimal for the investor level of borrowing. Thus, obtained by us, tables and
graphs allow to determine value of L*, knowing only k0 and kd for investment
project.
3. At a constant equity value S as well as to determine the NPV at the existing level
leverage and to estimate the optimal for the investor level of borrowing, received
by us, analytical expressions (formulas) should be used because the behavior of
NPV(L ) in this case depends strongly on S and β.
References 275
References
(11):815–824
org/10.1080/23322039.2014.946150
7:37–62
Econ Rev 53:147–175
1954–1957. Am Econ Rev 56:333–391
Chapter 14
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 ade-
quately 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 (Brusov and Filatova 2011;
Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b, 2015, 2018a, b, c, d; Filatova
et al. 2008; Brusova 2011) as well as on perpetuity limit (Мodigliani and Мiller
1958, 1963, 1966).
14.1 Investment Models with Uniform Debt Repayment
As in the case of debt repayment at the end of the project, the effectiveness of the
investment project is considered from two perspectives: the owners of equity and
debt and the equity holders only. In the first case, the interest and duty paid by
owners of equity (negative flows) returned to the project because they are exactly
equal to the flow (positive), obtained by owners of debt capital. The only effect of
leverage in this case is the effect of tax shield, generated from the tax relief: interest
on the loan is entirely included into the net cost and, thus, reduces the tax base. For
each of these cases, NPV is calculated in two ways: with the division of credit and
investment flows (and thus discounting the payments, using two different rates) and
without such a division (in this case, both flows are discounted at the same rate as
which, obviously, WACC can be chosen). For each of the four situations, two cases
are considered: (1) a constant value of equity S and (2) a constant value of the total
invested capital I ¼ S þ D (D is value of debt funds).

https://doi.org/10.1007/978-3-319-99686-8_14
278 14 Investment Models with Uniform Debt Repayment and Their Application
The main debt repayment occurs evenly (by equal parts) at the end of each period,
and the remaining debt at the end of the each period is an arithmetic progression with
the difference D/n

D 2D D n1 n2 D
D; D ; D ;...; ¼ D; D ;D ;...; ð14:1Þ
n n n n n n
Interest constitutes a sequence:

n1 n2 D
k d D; kd D ; kd D ; . . . ; kd : ð14:2Þ
n n n
In the case of consideration from the point of view of equity owners and debt
owners, the after-tax flow of capital for each period is equal to
NOIð1 t Þ þ k d Di t, ð14:3Þ
where
n ð i 1Þ
Di ¼ D , ð14:4Þ
n
and investments at time moment T ¼ 0 are equal to I ¼ S D. Here NOI stands

for net operating income (before tax).
In the second case (from the point of view of equity owners only), investments at
the initial moment T ¼ 0 are equal to S, and the flow of capital for the ith period
(apart from tax shields kdDt, it includes payment of interest on the loan kdDi) is
equal to
Di
ðNOI kd Di Þð1 t Þ : ð14:5Þ
n
We suppose that the interest on the loan and the loans itself are paid in tranches
kdDi and D ni
n consequently during the all ith periods. We cite in Table 14.1 the
sequence of debt and interest values and credit values.
As in the case of debt repayment at the end of the project, we will consider two
different ways of discounting:
Table 14.1 The sequence of Period number 1 2 3 ... n

debt and interest values and
Debt D D n1 D n2 ... D 1n
credit values n n
Interest kdD k d D n1
n k d D n2
n
... k d D 1n
1. Operating and financial flows are not separated, and both are discounted, using
the general rate (as which, obviously, the weighted average cost of capital
(WACC) can be selected). For perpetuity projects, the Modigliani–Miller for-
mula (Мodigliani and Мiller 1963) for WACC will be used and for projects of
finite duration Brusov–Filatova–Orekhova formula for WACC (Brusov and
Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b; Filatova
et al. 2008).
2. Operating and financial flows are separated and are discounted at different rates:
the operating flow at the rate equal to the equity cost ke, depending on leverage,
and credit flow, at the rate equal to the debt cost kd, which until fairly large values
of leverage remain constant and start to grow only at high values of leverage L,
when there is a danger of bankruptcy.
Note once again that loan capital is the least risky, because interest on credit is
paid after tax in the first place. Therefore, the cost of credit will always be less than
the equity cost, whether of ordinary or of preference shares ke > kd; kp > kd. Here ke;
kp is equity cost of ordinary or of preference shares consequently.
One can show that the present value of interest can be calculated by using the
following formula, which we have been able to derive:
1 2 3 n að1 an Þ n
þ 2 þ 3 þ þ n ¼ : ð14:6Þ
a a a a ð a 1Þ 2 ð a 1Þan
Here a ¼ 1 þ i.
We will use this formula in the further calculations.

To obtain an expression for NPV, the discounted flow values for one period, given
by formulas (Eq. 14.3) and (Eq. 14.5), must be summed, using our obtained formula
(Eq. 14.6), in which a ¼ 1 þ i, where i is the discount rate. Its accurate assessment is
one of the most important advantages of BFO (Brusov–Filatova–Orekhova) theory
Filatova et al. 2008) over its perpetuity limit—Modigliani–Miller theory (Мodigliani
and Мiller 1958, 1963, 1966).
In this case, the expression for NPV has a view:
nþ1i D
X n k d D
X ð1 t Þ
n
NOIð1 t Þ n n
NPV ¼ S þ þ
i¼1 ð1 þ k e Þi i¼1 ð1 þ k d Þi
NOIð1 t Þð1 ð1 þ k e Þn Þ

¼ S þ
ke

D nþ1 1 ð1 þ kd Þn
þ kd D ð1 t Þ
n n kd

D ð1 þ kd Þ½1 ð1 þ kd Þn n
þ k d ð1 t Þ ð14:7Þ
n k 2d k d ð1 þ k d Þn
In perpetuity limit (let us call it Modigliani–Miller limit), one has
NOIð1 t Þ
ke
In this case, operating and financial flows are not separated and are discounted, using
The main debt repayment, which occurs evenly (by equal parts) at the end of each
period, can be discounted either at the same rate WACC or at the debt cost rate kd.
Now we choose a uniform rate and the first option.
We still consider the effectiveness of the investment project from the perspective
of the equity holders only.
nþ1i D
n NOIð1 t Þ k d D
X ð1 t Þ
NPV ¼ S þ n n
i¼1 ð1 þ WACCÞi
D nþ1
NOIð1 t Þ kd D ð1 t Þ 1

¼ S þ n n 1
WACC ð1 þ WACCÞn

kd D ð1 þ WACCÞ½1 ð1 þ WACCÞn
þ ð1 t Þ
n WACC2

n
ð14:9Þ
WACCð1 þ WACCÞn

NPV ¼ S þ : ð14:10Þ
WACC
Note that the formula (14.10) as well as other formulas for perpetuity limit (14.12
and 14.14) could be applied to analyze the effectiveness of the long-term investment
projects.

Projects of Arbitrary (Finite) Duration

In the case of consideration from the perspective of the owners of equity and debt
nþ1i
X
n
NOIð1 t Þ X
n kd D t
NPV ¼ I þ þ n
i¼1 ð1 þ k e Þi i¼1 ð1 þ k d Þ i
NOIð1 t Þð1 ð1 þ ke Þn Þ

¼ I þ
ke
nþ1
þD t ½1 ð1 þ kd Þn
n

D ð1 þ k d Þ½1 ð1 þ kd Þn n
kd t ð14:11Þ
n k2d k d ð1 þ k d Þn

NOIð1 t Þ
NOI ¼ I þ þ Dt: ð14:12Þ
ke
We still consider the effectiveness of the investment project from the perspective of
the owners of equity and debt.
nþ1i
n NOIð1 t Þ þ k d D
X t
NPV ¼ I þ n
i¼1 ð1 þ WACCÞi
nþ1
NOIð1 t Þ þ kd D t 1
¼ I þ n 1
WACC ð1 þ WACCÞn

kd D ð1 þ WACCÞ½1 ð1 þ WACCÞn
t
n WACC2

n
ð14:13Þ
WACCð1 þ WACCÞn

NPV ¼ I þ : ð14:14Þ
WACC
14.4 Example of the Application of the Derived Formulas
As an example of application of the obtained formulas, let’s take a look at the

dependence of the NPV of project on the leverage level at three values of the tax on
profit rates in the case of consideration from the perspective of the equity holders
only without flows separation on operating and finance ones.
We use formula (Eq. 14.10) and the next parameters values
NOI ¼ 800; S ¼ 500; k0 ¼ 22%; kd ¼ 19%; T ¼ 15%; 20%; 25%:
Making the calculations in Excel, we get the data, which are shown in Fig. 14.1.
From the calculations and Fig. 14.1, one can make the following conclusions:
1. With growth of the tax on profit rate, the NPV of the project decreases, and our
model makes it possible to assess for how many percent, with growth of tax on
profit rate, for example, by 1%.
It should be noted that the possibility of such evaluations is unique.
2. The effect of taxation on the NPV significantly depends on the leverage level:
With its increase, the impact of changing of tax on profit rate is greatly
reduced. This is valid for increasing of the tax on profit rate and for its reduction.
3. At tax on profit rates 20% (as in Russia) and 25%, there is an optimum in NPV
dependence on leverage. Investors should take into account the invested capital
structure: in this case, they may, without special effort (only changing this
structure), obtain (sometimes very substantial) gains in NPV. Note that at tax
on profit rate 15%, there is no optimum in NPV dependence on leverage: NPV
descends monotonically with leverage.
14.5 Conclusions 283

NPV of the project on the
leverage level at three values
of the tax on profit rates
NOI ¼ 800; S ¼ 500;
k0 ¼ 22 % ; kd ¼ 19 % ;
T ¼ 15 % ; 20 % ; 25 %
14.5 Conclusions
New investment models with uniform debt repayment during the duration of the
project, quite adequately describing real investment projects, are described. Within
these models, it is possible, in particular, to analyze the dependence of effectiveness
of investment projects on debt financing and taxation. We work on the modern
theory of capital cost and capital structure developed by Brusov–Filatova–Orekhova
as well as on perpetuity limit–MM theory.
As in the case of debt repayment at the end of the project, the effectiveness of the
investment project is considered from two perspectives: the owners of equity and
debt and the equity holders only. For each of these cases, NPV is calculated in two
ways: with the division of credit and investment flows (and thus discounting the
payments, using two different rates) and without such a division (in this case, both
flows are discounted at the same rate as which, obviously, WACC can be chosen).
For each of the four situations, two cases are considered: (1) a constant value of
equity S and (2) a constant value of the total invested capital I ¼ S þ D (D is value
of debt funds).
As an example of application of the obtained formulas, the dependence of the
NPV of project on the leverage level at three values of the tax on profit rate has been
investigated in the case of consideration from the perspective of the equity holders
only and without flows separation on operating and financial ones. It has been shown
that effect of taxation on the NPV significantly depends on the leverage level: with
its increase, the impact of changing of tax on profit rates is greatly reduced. This is
valid for increasing of the tax on profit rate and for its reduction. The model allows
investigating the dependence of effectiveness of the investment project on leverage
level, on the tax on profit rate, on credit rate, on equity cost, etc.
References
(11):815–824
org/10.1080/23322039.2014.946150
7:37–62
Econ Rev 53:147–175
1954–1957. Am Econ Rev 56:333–391
Part III
Taxation
Chapter 15
Is It Possible to Increase Taxing
and Conserve a Good Investment Climate
in the Country?
Within investment models, developed by Brusov, Filatova, and Orekhova earlier

(Brusov and Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b,
2015, 2018a, b, c, d; Filatova et al. 2008; Brusova 2011), the influence of tax on
profit rate on effectiveness of long-term investment projects at different debt levels is
investigated. It is shown that increase of tax on profit rate from one side leads to
decrease of project NPV, but from other side, it leads to decrease of sensitivity of
NPV with respect to leverage level. At high leverage level L, the influence of tax on
profit rate increase on effectiveness of investment projects becomes significantly
less. We come to a conclusion that taxing could be differentiated depending on debt
level of investment projects of the company: for projects with high debt level L, it is
possible, in principle, to apply a higher tax on profit rate.
15.1 Influence of Tax on Profit Rates on the Efficiency

of the Investment Projects
The bases of the modern tax systems are the following taxes: tax on profit of
organizations, income tax (tax on the income of individuals), social tax (contribu-
tions into state extra budgetary funds), sales tax (the value-added tax), and tax on
property of the organization. In this chapter, we investigate the influence of tax on
profit rate on the efficiency of the investment projects.
The problems and those questions, which we are currently investigating and
analyzing now in all of their complexity and diversity and to which we give answers,
not be tractable by analysis and assessment previously, for which one was not able to
give an answer, they even are not raised in such a setting. What should be the tax
scale—flat, progressive, or otherwise differentiated—and what impact tax rate has
on the cost of company’s capital? What is the cumulative effect of increase of taxes
(whether the system “state-entrepreneur” will win or will lose as a whole from the

https://doi.org/10.1007/978-3-319-99686-8_15
288 15 Is It Possible to Increase Taxing and Conserve a Good Investment. . .
tax growth, and if it will lose, then how much—or whether the redistribution of
income in favor of the state does not destroy the spirit of enterprise, its driving
force)? If tax on profit rate will increase by 1%, how much will the cost of attractive
capital of company increase and how much will its capitalization decrease? If by
3–6%, it should be serious reasons for such increase, but if by 0.5–1.5%, it is
possible to discuss such tax on profit rate increase.
How does taxation affect the efficiency of investment? By how much will the
NPV of the investment project decrease, if tax on profit rate will increase by 1%? If
on 5–10%, it has a strong negative impact on investment, if on 1%, or 0.5%, or
0.25%, Regulator can accept this: this will help the state and does not exert much to
investment programs of companies.
One of the main reasons, for which it has become possible to carry out such
studies, has been a progress in corporate finance, made recently. It relates primarily
to the establishment of a modern theory of capital cost and capital structure by
Brusov, Filatova, and Orekhova (BFO theory) (Brusov and Filatova 2011; Brusov
2008; Brusova 2011) and to their creation of the framework of this theory of modern
investment models. The BFO theory allows to make correct assessment of the
financial performance of companies with arbitrary lifetime (arbitrary age) and of
efficiency of investment projects of arbitrary duration. This distinguishes BFO
theory from Мodigliani–Мiller theory (Мodigliani and Мiller 1958, 1963, 1966),
which is a perpetuity limit of BFO theory. Archived, after the appearance of BFO
theory, the Мodigliani–Miller theory, still heavily used in the West, despite of its
obvious limitations, may, in principle, be applied to long-living stable companies
and long-term investment projects. In its framework in this chapter, effects of
taxation on the effectiveness of long-term investment will be investigated.
So, at present, there are two main theories that allow to explore the effects of
taxation on the efficiency of investments: perpetuity Modigliani–Miller theory
(Мodigliani and Мiller 1958, 1963, 1966) and the modern theory of capital cost
and capital structure developed by Brusov, Filatova, and Orekhova (Brusov and
Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b, 2015, 2018a,
b, c, d; Filatova et al. 2008; Brusova 2011). In this chapter, we describe the first real
results obtained by us within investment models in perpetuity limit, which can be
applied to long-term projects.
The effectiveness of the investment project is considered from the perspectives of
the equity holders. For this case, NPV is calculated in two ways: with the division of
credit and investment flows (and thus discounting the payments, used two different
rates) and without such a division (in this case, both flows are discounted at the same
rate, as which, obviously, WACC can be chosen). For each of the four situations, two
cases are considered: (1) a constant value of equity S and (2) a constant value of the
total invested capital I ¼ S + D (D is value of debt funds).
We start first from the case with the division of credit and investment flows and
then consider the case without the division of flows.
15.2 Investment Models 289
Let us remind shortly the main points of the investment models with debt repayment
at the end of the project, well-proven in the analysis of real investment projects.
Investments at the initial time moment T ¼ 0 are equal to S and the flow of
capital for the period (in addition to the tax shields kd Dt, it includes a payment of
interest on a loan kdD).
shares kdD during all periods. Note that principal repayment is made at the end of last
period.
Here NOI is net operating income (before taxes), kd is debt cost, and t is tax on
profit rate.
Let us first consider the case with the division of credit and investment flows. In
this case in perpetuity limit (Modigliani–Miller approximation), expression for NPV
takes the following form (Brusov and Filatova 2011; Brusov et al. 2011a, b, c,
2012a, b, 2013a, b, 2014a, b; Filatova et al. 2008):
NOIð1 t Þ
ke
We will consider two cases:

1. A constant value of the total invested capital I ¼ S + D (D is value of debt funds)
2. A constant value of equity S
At a constant value of the total invested capital (I ¼ const), accounting D ¼ IL/
(1 + L ) and S ¼ I/(1 + L ), one gets
I NOIð1 t Þ
1þL ke
I NOIð1 t Þ
NPV ¼ ð1 þ Lð1 t ÞÞ þ , ð15:4Þ
where L ¼ D/S is leverage level, ke is equity cost of leverage company (which uses
the debt financing), and k0 is equity cost of non-leverage company (which does not
use the debt financing).
Under the transition from Eq. (15.3) to Eq. (15.4), we have used the dependence
of equity capital on leverage, received by Мodigliani and Мiller (1958, 1963, 1966):
So we explore Eq. (15.4). A number of conclusions can be drawn from the study
of dependence of NPV of the project on leverage level at different values of tax on
profit rate t (Fig. 15.1). It is clear that the increase of tax on profit rate leads not only
to reduce of NPV of the project but also to decrease of the sensitivity of effectiveness
of investment project NPV to the leverage level L. At high leverage levels, the
influence of growth of tax on profit rate on the effectiveness of investment projects is
significantly reduced.
Hence, in particular, it should be noted that taxation can be differentiated
depending on the debt financing level in the company investment projects: for
projects with a high leverage level L, the higher tax on profit rates t can be used.
The foregoing is illustrated also in Fig. 15.2, where it is clear that the change of NPV
(ΔNPV) with leverage level decreases when the tax on profit rate t grows and when
leverage level increases.
NPV(L)
3000.00
1
2500.00 2
2000.00 3
NPV
1500.00
1000.00
500.00
0.00
0 2 4 6 8 10 12
L
Fig. 15.1 Dependence of NPV on leverage level L at three values of tax on profit rate (1, t ¼ 0.15;
2, t ¼ 0.20; 3, t ¼ 0.25), NOI ¼ 800
ΔNPV(L)
0.00
0 2 4 6 8 10
–100.00
–200.00
ΔNPV
–300.00 1
–400.00
2
–500.00 3
–600.00
L
Fig. 15.2 Dependence of ΔNPV on leverage level L at three values of tax on profit rate (1, t ¼ 0.25;
2, t ¼ 0.20; 3, t ¼ 0.15), NOI ¼ 800, I ¼ 1000
Let us increase our return on investment by 1.5 times (NOI ¼ 1200 instead of
800) (Fig. 15.3). Still, the impact of the tax on profit rate on the NPV value
significantly depends on the level of debt financing. So the increase in tax on profit
rate by 1% from the existing (in Russia t ¼ 20%) leads to a reduction in the NPV by
44.5 units at L ¼ 0, by 27.7 units at L ¼ 1, by 12.2 units at L ¼ 3, and by 5 units at
L ¼ 5.
That is, for companies with a high level of debt financing (e.g., companies in the
telecommunication sector and others), an increase in tax on profit rate will have less
impact on the effectiveness of their investment projects and will be less painful than
for companies with low leverage level in investment. It should be noted that the
increase of NOI by 1.5 times increases NPV by 1.7 times (from 2555 up to 4333) and
increases ΔNPV(L ) by 1.62 at L ¼ 0 and by 1.5 times at L ¼ 9 (Fig. 15.4).
NPV(L)
5000.00 1
4500.00
4000.00 2
3500.00 3
3000.00
NPV
2500.00
2000.00
1500.00
1000.00
500.00
0.00
0 1 2 3 4 5
L
Fig. 15.3 Dependence of NPV on leverage level L at three values of tax on profit rate (1, t ¼ 0.15;
2, t ¼ 0.20; 3, t ¼ 0.25), NOI ¼ 1200, I ¼ 1000
ΔNPV(L)
0.00
–100.00 0 2 4 6 8 10
–200.00
–300.00
ΔNPV
–400.00
–500.00 1
–600.00
–700.00 2
–800.00
–900.00 3
L
Fig. 15.4 Dependence of ΔNPV on the leverage level L at three values of tax on profit rate
(1, t ¼ 0.25; 2, t ¼ 0.20; 3, t ¼ 0.15), NOI ¼ 1200, I ¼ 1000
It is clear also that with the increase of the leverage level L, curves, describing the
dependence ΔNPV(L ), virtually converge, which demonstrates once again the
reduction of impact of the change of the tax on profit rate t on the efficiency of
investment projects with the increase of the leverage level L.
15.3 Borrowings Abroad
Until recently, Russian companies have preferred to borrow abroad, because over-
seas credits are much cheaper than domestic ones. Although the relevance of the
studies using such loans is not so high now in connection with the West sanctions, all
same, realizing that in the not-too-distant future, all will return to its circles; here’s a
comparison of NPV dependencies on leverage at typical values of rates on credit,
with borrowings abroad (k0 ¼ 0.1; kd ¼ 0.07) and with borrowings at domestic
(Russian) credit market (k0 ¼ 0.18; kd ¼ 0.14). Here k0 is equity cost of financially
independent company (Fig. 15.5). The growth of effectiveness of investments when
using cheaper foreign credit is obvious. In case of the stabilization of the situation at
the external credit market, a detailed analysis of this case as well as of the case of the
use of domestic and overseas credits simultaneously can be done.
We analyze now the impact of the tax on profit rate on dependence of NPV on
leverage level at typical values of credit rates with borrowings abroad and with
borrowings at domestic (Russian) credit market (Fig. 15.6).
It is clear that at low leverage levels, the influence of tax on profit rate is very
significant: at zero leverage, the NPV drops by 80 units at increase of tax on profit
rate of 1% when one borrows abroad and by 44 units when one borrows at domestic
(Russian) credit market. It would seem that this could be one of the signals for
borrowing within the country; however, taking into account the different values of
NPV at two considering cases (ratio is 2.1), we come to the conclusion that the
impact of tax on profit rate is in close proportions (ratio is 80/44 ¼ 1.8). So it seems
that after the West sanctions will be over, to borrow at the West will be more
advantageous for a long time.
NPV(L)
8000.00
1
6000.00
NPV
4000.00
2000.00
2
0.00
0 2 4 6 8 10 12
L
Fig. 15.5 Comparison of dependences of NPV on the leverage level L at typical values of credit
rates with borrowings abroad (1, k0 ¼ 0.1; kd ¼ 0.07) and with borrowings at domestic (Russian)
credit market (2, k0 ¼ 0.18; kd ¼ 0.14), NOI ¼ 800, I ¼ 1000, t ¼ 15%
15.4 Dependence of NPV on Tax on Profit Rate at Different Leverage Levels 293
NPV(L)
7000.00
6000.00
1
5000.00 2
3
4000.00
NPV
3000.00 4
5
2000.00 6
1000.00
0.00
0 2 4 6 8 10 12
L
Fig. 15.6 Influence of tax on profit rate on dependence of NPV on the leverage level at typical
values of credit rates with borrowings abroad (lines 1–2–3) and with borrowings at domestic
(Russian) credit market (lines 4–5–6) 1, k0 ¼ 0.1, kd ¼ 0.07, t ¼ 0.15; 2, k0 ¼ 0.1, kd ¼ 0.07,
t ¼ 0.2; 3, k0 ¼ 0.1, kd ¼ 0.07, t ¼ 0.25; 4, k0 ¼ 0.18, kd ¼ 0.14, t ¼ 0.15; 5, k0 ¼ 0.18, kd ¼ 0.14,
t ¼ 0.2; 6, k0 ¼ 0.18, kd ¼ 0.14, t ¼ 0.25
Fig. 15.7 Dependence of NPV(t)

NPV on tax on profit rate at 4000.00
1
different leverage levels
L (1, L ¼ 0; 2, L ¼ 1; 3000.00
3, L ¼ 3; 4, L ¼ 5), 2
NOI ¼ 800, I ¼ 1000
2000.00 3
NPV
1000.00
4
0.00
0 0.2 0.4 0.6 0.8 1 1.2
–1000.00
–2000.00
t
15.4 Dependence of NPV on Tax on Profit Rate at Different

Leverage Levels
From Fig. 15.7, it is seen that dependence of NPV on tax on profit rate significantly
depends on the leverage level L.
When there is no borrowing (L ¼ 0), NPV linearly decreases with t with a
factor 43.44 units at 1%. When L ¼ 1, this factor (at t ¼ 20%) is equal to
27.7 units at 1%; when L ¼ 3, this factor (when t ¼ 20%) is equal to
12.3 units at 1%; and when L ¼ 5, this factor (at t ¼ 20%) is equal to 5.8 units
at 1%. It can be seen that the influence of tax on profit rate on efficiency of
investment projects drops significantly with increase of the leverage level L, used
in investments.
1 ΔNPV (t)
0.00
0 0.2 0.4 0.6 0.8 1 1.2
–100.002
ΔNPV –200.00
3
–300.00
–400.00
–500.00
4 t
Fig. 15.8 Dependence of ΔNPV on tax on profit rate at different leverage levels L (1, L ¼ 5;
2, L ¼ 3; 3, L ¼ 1; 4, L ¼ 0), NOI ¼ 800, I ¼ 1000
This is particularly seen in Fig. 15.8 in the dependence of ΔNPV on tax on profit
rate at different leverage levels L (here ΔNPV is increment of NPV under change of
t for 10%). When there is no borrowing (L ¼ 0), ΔNPV ¼ 450 and does not depend
on tax on profit rate. At t ¼ 20% at L ¼ 1, ΔNPV ¼ 276.6; L ¼ 3, ΔNPV ¼ 122.6;
and L ¼ 5, ΔNPV ¼ 49. It is clear that the change of tax on profit rate affects
mostly the effectiveness of the projects, funded by equity capital only, and if you use
debt financing to finance the projects, the impact of the change of tax on profit rate
drops very substantially (up to ten times).
15.5 At a Constant Value of Equity Capital (S ¼ Const)
At a constant value of equity capital (S ¼ const), when investment growth is

associated with the increased borrowing only, the dependence of NPV on the
leverage level is qualitatively different in nature, rather than in the case of a constant
value of invested capital I. Now, depending on the values of the coefficient β ¼ NOI/
I, NPV can grow with leverage level. It should be noted that in this case (at large
values of the coefficient β) the optimal structure of invested capital, in which NPV is
maximized, could take place. NPV in this case is described by the following
expression:
k0 þ ðk0 kd ÞLðt 1Þ
It is seen from Fig. 15.9 that with the increase of the coefficient β value, NPV and
its optimal (maximum) values grow.
It follows from Fig. 15.10 that with the increase of the leverage level, ΔNPV
drops and either goes to the saturation (ΔNPV ¼ 0) or becomes negative
(ΔNPV < 0), and this means that there is an optimum (after ΔNPV > 0 at small
leverage level L).
15.5 At a Constant Value of Equity Capital (S ¼ Const) 295
Fig. 15.9 Dependence of NPV(L)

NPV on the leverage level 10000.00
1
L at three values of β- 9000.00
coefficient (1, β ¼ 1.5; 8000.00
2, β ¼ 1.2; 3, β ¼ 0.8), 7000.00
S ¼ 500 6000.00
2
NPV
5000.00
4000.00
3000.00
2000.00
1000.00
0.00
0 2 4 6 8 10 12
L
Fig. 15.10 Dependence of ΔNPV(L)

ΔNPV on the leverage level 2500.00
L at three values of β-
coefficient (1, β ¼ 1.5; 2000.00
1
2, β ¼ 1.2; 3, β ¼ 0.8), 1500.00
S ¼ 500
ΔNPV
2
1000.00
500.00
0.00
0 2 4 6 8 10 12
–500.00
L

different leverage levels 3500.00
1
L (1, L ¼ 5; 2, L ¼ 3; 3000.00
3, L ¼ 1; 4, L ¼ 0), S ¼ 500, 2500.00
β ¼ 0.8 2
2000.00
NPV
1500.00
1000.00
3
500.00
0.00 4
–500.00 0 0.2 0.4 0.6 0.8 1 1.2
–1000.00
t
In Figs. 15.11 and 15.12, the dependencies of ΔNPV and NPV on tax on profit
rate at different leverage levels and at S ¼ 500 and β ¼ 0.8 are shown.
From Fig. 15.11, as well as from Fig. 15.9, it is seen that at fixed tax on profit rate,
NPV grows with leverage level. With the increase of tax on profit rate, NPV drops,
and curves, corresponding to the different leverage level, converge in one point at
t ¼ 100% and NPV ¼ S in accordance to Eq. (15.6). Change of ΔNPV with
increase of t also depends on the leverage level: with the growth of the leverage
Fig. 15.12 Dependence of ΔNPV(t)

ΔNPV on tax on profit rate 0.00
at different leverage levels 0 0.2 0.4 0.6 0.8 1 1.2
L (1, L ¼ 0; 2, L ¼ 1; –200.00 1
3, L ¼ 3; 4, L ¼ 5), S ¼ 500,
β ¼ 0.8 –400.00
ΔNPV
2
–600.00
3
–800.00
–1000.00
t
level, it changes from constant (at L ¼ 0) and increasingly grows at t > 30–40% and
at L ¼ 1, 3, and 5.
15.6 Without Flow Separation
Let us consider the case without the division of credit and investment flows. In this
case, both flows are discounted at the same rate, as which, obviously, WACC can be
chosen. In perpetuity limit (n ! 1), one has
NPV ¼ S þ : ð15:7Þ
WACC
Note, that formula (15.7) as well as other formulas for perpetuity limit could be
applied for analyzing the effectiveness of the long-term investment projects.
15.6.1 At a Constant Value of the Total Invested Capital

(I ¼ Const)
In case of a constant value of the total invested capital (I ¼ const), accounting

D ¼ IL/(1 + L ) and S ¼ I/(1 + L ), we get (Fig. 15.13)

1 Lk d ð1 t Þ NOIð1 t Þ
NPV ¼ I 1þ þ : ð15:8Þ
1þL k0 ð1 Lt=ð1 þ LÞÞ k0 ð1 Lt=ð1 þ LÞÞ
It should be noted that in contrast to the case with the division of flows, described
above, in a situation without the division of flows, NPV is growing with leverage
level. It is seen that while NOI increases by 1.5 times, NPV increases by 1.68 times
(Fig. 15.14).
15.6 Without Flow Separation 297

1
L at two values of NOI 6000.00
(1, NOI ¼ 1200; 5000.00
2, NOI ¼ 800), I ¼ 1000 4000.00
NPV
3000.00
2000.00
1000.00
0.00
0 2 4 6 8 10 12
L

L at two values of NOI 600.00
(1, NOI ¼ 1200; 500.00
2, NOI ¼ 800), I ¼ 1000
ΔNPV
400.00
300.00
200.00
100.00 2
0.00
0 2 4 6 8 10 12
L

L (1, L ¼ 5; 2, L ¼ 3; 3000.00 1
3, L ¼ 1; 4, L ¼ 0), 2000.00 2
NOI ¼ 800, I ¼ 1000 3
NPV
1000.00
0.00 4
0 0.2 0.4 0.6 0.8 1 1.2
–1000.00
–2000.00
t
NPV rather quickly goes to the saturation; at L > 4, it varies weakly, and the
leverage level, at which the saturation of NPV(L ) takes place, practically does not
depend on NOI value (Fig. 15.15).
NPV falls down with growth of tax on profit rate at different leverage levels:
At L ¼ 0 at change of tax on profit rate of 1%, NPV falls down on 1.74%.
It is seen that with the rise of the tax on profit rate by 1%, NPV drops the less at
the higher leverage level. This confirms the conclusion, made in the previous
Fig. 15.16 Dependence of ΔNPV(t)

ΔNPV on tax on profit rate 0.00
at different leverage levels –200.00 0 0.2 0.4 0.6 0.8 1
L (1, L ¼ 5; 2, L ¼ 3; –400.00
3, L ¼ 1; 4, L ¼ 0), 4
–600.00
NOI ¼ 800, I ¼ 1000
ΔNPV
–800.00 3
–1000.00
–1200.00 2
–1400.00
1
–1600.00
t

L at three values of β- 1
40000.00
coefficient (1, β ¼ 1.5;
2, β ¼ 1.2; 3, β ¼ 0.8), 30000.00 2
NPV
S ¼ 500
20000.00
10000.00
0.00
0 2 4 6 8 10 12
L
section, that with the increase of the leverage level, a negative impact of the growth
of the tax on profit rate declines in a few times, allowing the regulator to establish the
differentiated tax on profit rates (as can be seen from Fig. 15.16, the founded
conclusions are true up to tax on profit rate values of 70–80%).
15.6.2 At a Constant Value of Equity Capital (S ¼ Const)
NPV ¼ S þ : ð15:9Þ
WACC
Substituting D ¼ LS, one gets

NPV ¼ S 1 þ þ : ð15:10Þ
From Fig. 15.17, it follows that NPV grows linearly with leverage level and its
growth rate increases with growth of coefficient β.
From Fig. 15.18, it follows that ΔNPV practically does not depend on leverage
level L; at decrease of β-coefficient by 1.25 times (the transition from line 1 to line
15.6 Without Flow Separation 299

L at three values of β- 1
3500.00
coefficient (1, β ¼ 1.5; 3000.00
2, β ¼ 1.2; 3, β ¼ 0.8), 2
2500.00
ΔNPV
S ¼ 500 2000.00
3
1500.00
1000.00
500.00
0.00
0 2 4 6 8 10 12
L

NPV on tax on profit rate t at 12000.00 1
10000.00
L (1, L ¼ 5; 2, L ¼ 3;
3, L ¼ 1; 4, L ¼ 0), S ¼ 500 8000.00 2
6000.00
NPV
4000.00
3
2000.00
4
0.00
0 0.2 0.4 0.6 0.8 1 1.2
–2000.00
t
2), ΔNPV is decreased by 1.28 times (practically so); and at decrease of β-coefficient
by 1.5 times (the transition from line 2 to line 3), ΔNPV is decreased by 1.59 times
(practically so).
As in the case of constant value of investments (I ¼ const), at constant equity
capital value (S ¼ const), NPV falls down with growth of tax on profit rate t at
different leverage levels L.
Let us take a look at the region of changes of tax on profit rates from 0% up to
60%. In this region:
And so, with the increase of the tax on profit rates at 1%, NPV drops the less for
the higher leverage level. This correlates with the conclusion, made above and in the
previous section, that with the increase of the leverage level, a negative impact of the
growth of the tax on profit rate declines in a few times, allowing the regulator to
introduce differentiated tax on profit rate (as it can be seen from Figs. 15.19 and
15.20, the findings are true up to values of tax on profit rates 60%). At higher rates
(which, however, is a purely theoretical interest), the situation will be different.
ΔNPV(t)
0.00 1
0 0.2 0.4 0.6 0.8 1 1.2
–1000.00
2
ΔNPV –2000.00
3
–3000.00
–4000.00
–5000.00
t
Fig. 15.20 Dependence of ΔNPV on tax on profit rate t at different leverage levels L (1, L ¼ 0;
2, L ¼ 1; 3, L ¼ 3; 4, L ¼ 5), S ¼ 500
15.7 Conclusions
Within investment models, developed by Brusov, Filatova, and Orekhova earlier

Filatova et al. 2008), the influence of tax on profit rate on effectiveness of long-term
investment projects at different debt levels is investigated. The ability to obtain
quantitative estimates of such impact on the projects with various costs of equity and
debt capital at an arbitrary structure of invested capital has been demonstrated. It is
shown that increase of tax on profit rate from one side leads to decrease of project
NPV, but from other side, it leads to decrease of sensitivity of NPV with respect to
leverage level. At high leverage level L, the influence of tax on profit rate increase on
effectiveness of investment projects becomes significantly less. We come to conclu-
sion that taxing could be differentiated depending on debt level of investment
projects of the company: for projects with high debt level L, it is possible to apply
a higher tax on profit rate.
These recommendations, in particular, may be addressed to the regulator. Effects
of taxation on the effectiveness of investment projects depend on the level of
leverage, on the project duration, on the equity cost, as well as on the level of returns
on investment (NOI) and on methods of forming of invested capital. The study of all
these problems, as the results of this chapter show, may be successfully carried out
within investment models developed by Brusov, Filatova, Orekhova, using discount
rates, derived from the Brusov–Filatova–Orekhova (BFO) theory.
References
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References 301
org/10.1080/23322039.2014.946150
7:37–62
Modigliani–Miller, modified for a finite lifetime company. Bull FU 48:68–77
Econ Rev 53:147–175
1954–1957. Am Econ Rev 56:333–391
Chapter 16
Is It Possible to Increase the Investment
Efficiency by Increasing Tax on Profit Rate?
An Abnormal Influence of the Growth
of Tax on Profit Rate on the Efficiency
of the Investment
Within the modern theory of capital cost and capital structure by Brusov–Filatova–
Orekhova (BFO theory) (Brusov and Filatova 2011; Brusov et al. 2011a, b, c, 2012a,
b, 2013a, b, 2014a, b, 2015, 2018a, b, c, d; Filatova et al. 2008; Brusova 2011) and
modern investment models created within this theory, the influence of the growth of
tax on profit rate on the efficiency of the investment is investigated. It has been shown
that for long-term investment projects, as well as for arbitrary duration projects, the
growth of tax on profit rate changes the nature of the NPV dependence on leverage at
some value t*: there is a transition from the diminishing function NPV(L), when
t < t*, to the growing function NPV(L). The t* value depends on the duration of the
project, cost of capital (equity and debt) values, and other parameters of the project.
At high leverage levels, this leads to a qualitatively new effect in investments:
growth of the efficiency of the investments with the growth of tax on profit rate.
Discovered effects take place under consideration from the point of view of owners
of equity capital as well as from the point of view of owners of equity and debt
capital.
16.1 Dependence of NPV on Leverage Level L at Fixed

Levels of Tax on Profit Rate t
16.1.1 The Effectiveness of the Investment Project from

Investigations will be done with the division of credit and investment flows; oper-
ating and finance flows are divided and discounted using different rates: operating
flows, by the rate equal to equity cost ke, depending on leverage, and credit ones, by
the rate equal to debt cost kd, which, until sufficiently large values of leverage levels,
remains constant and starts to grow only at sufficiently high leverage values L, when

https://doi.org/10.1007/978-3-319-99686-8_16
304 16 Is It Possible to Increase the Investment Efficiency by Increasing. . .
a risk of bankruptcy will appear. The consideration has been done upon constant
value of investment capital I.
In this case, NPV is described by the following formula (Brusov and Filatova
Filatova et al. 2008; Brusova 2011):

I 1 1
NPV ¼ 1 þ L ð1 t Þ 1 þ
1þL ð1 þ kd Þn ð1 þ k d Þn
ð16:1Þ
NOIð1 t Þ 1
þ 1 :
ke ð1 þ k e Þn
Using it, we calculate NPV and ΔNPV at fixed levels of tax on profit rate t.
Five-Year Project
For 5-year projects, we get the following results (Tables 16.1, 16.2, 16.3, 16.4, 16.5,
16.6, and 16.7; Figs. 16.1 and 16.2).
Table 16.1 Dependence of NPV and ΔNPV on leverage level L at fixed levels of tax on profit rate
t for a 5-year project at t ¼ 0.3
L k0 kd wd t n NOI ke NPV ΔNPV
0 0.18 0.14 0 0.3 5 800 0.18 751.22 4.922709
1 0.18 0.14 0.5 0.3 5 800 0.197488 756.14 36.8599
2 0.18 0.14 0.66667 0.3 5 800 0.214367 719.28 44.7663
3 0.18 0.14 0.75 0.3 5 800 0.231082 674.51 46.126
4 0.18 0.14 0.8 0.3 5 800 0.24773 628.39 45.4549
5 0.18 0.14 0.83333 0.3 5 800 0.264343 582.93 44.027
6 0.18 0.14 0.85714 0.3 5 800 0.280937 538.90 42.3084
7 0.18 0.14 0.875 0.3 5 800 0.297518 496.60 40.4978
8 0.18 0.14 0.88889 0.3 5 800 0.314091 456.10 38.6879
9 0.18 0.14 0.9 0.3 5 800 0.330658 417.41 36.9239
10 0.18 0.14 0.90909 0.3 5 800 0.34722 380.49
0 0.18 0.14 0 0.4 5 800 0.18 501.04 64.13345
1 0.18 0.14 0.5 0.4 5 800 0.189578 565.18 4.73089
2 0.18 0.14 0.66667 0.4 5 800 0.19803 569.91 9.5017
3 0.18 0.14 0.75 0.4 5 800 0.206172 560.40 14.7815
4 0.18 0.14 0.8 0.4 5 800 0.214184 545.62 17.1025
5 0.18 0.14 0.83333 0.4 5 800 0.22213 528.52 18.1709
6 0.18 0.14 0.85714 0.4 5 800 0.230037 510.35 18.6246
7 0.18 0.14 0.875 0.4 5 800 0.23792 491.73 18.7461
8 0.18 0.14 0.88889 0.4 5 800 0.245786 472.98 18.6762
9 0.18 0.14 0.9 0.4 5 800 0.253642 454.30 18.4911
10 0.18 0.14 0.90909 0.4 5 800 0.261488 435.81
16.1 Dependence of NPV on Leverage Level L at Fixed Levels of Tax on Profit Rate t 305
0 0.18 0.14 0 0.5 5 800 0.18 250.87 116.0669
1 0.18 0.14 0.5 0.5 5 800 0.181448 366.94 41.1323
2 0.18 0.14 0.66667 0.5 5 800 0.181065 408.07 22.57738
3 0.18 0.14 0.75 0.5 5 800 0.180162 430.65 15.19888
4 0.18 0.14 0.8 0.5 5 800 0.179041 445.84 11.52994
5 0.18 0.14 0.83333 0.5 5 800 0.177806 457.37 9.446706
6 0.18 0.14 0.85714 0.5 5 800 0.176505 466.82 8.154973
7 0.18 0.14 0.875 0.5 5 800 0.175162 474.98 7.302458
8 0.18 0.14 0.88889 0.5 5 800 0.173792 482.28 6.713275
9 0.18 0.14 0.9 0.5 5 800 0.172401 488.99 6.291579
10 0.18 0.14 0.90909 0.5 5 800 0.170996 495.28
0 0.18 0.14 0 0.6 5 800 0.18 0.69 160.0655
1 0.18 0.14 0.5 0.6 5 800 0.173086 160.76 70.95083
2 0.18 0.14 0.66667 0.6 5 800 0.163424 231.71 49.78654
3 0.18 0.14 0.75 0.6 5 800 0.15296 281.50 42.12961
4 0.18 0.14 0.8 0.6 5 800 0.142153 323.63 39.00243
5 0.18 0.14 0.83333 0.6 5 800 0.131168 362.63 37.85743
6 0.18 0.14 0.85714 0.6 5 800 0.120078 400.49 37.74625
7 0.18 0.14 0.875 0.6 5 800 0.108922 438.23 38.25211
8 0.18 0.14 0.88889 0.6 5 800 0.097721 476.49 39.17065
9 0.18 0.14 0.9 0.6 5 800 0.086488 515.66 40.39427
10 0.18 0.14 0.90909 0.6 5 800 0.075231 556.05
0 0.18 0.14 0 0.7 5 800 0.18 249.48 195.3877
1 0.18 0.14 0.5 0.7 5 800 0.16448 54.09 92.40829
2 0.18 0.14 0.66667 0.7 5 800 0.145057 38.32 69.68464
3 0.18 0.14 0.75 0.7 5 800 0.124461 108.00 63.19622
4 0.18 0.14 0.8 0.7 5 800 0.103355 171.20 62.43475
5 0.18 0.14 0.83333 0.7 5 800 0.081982 233.63 64.46977
6 0.18 0.14 0.85714 0.7 5 800 0.060453 298.10 68.26526
7 0.18 0.14 0.875 0.7 5 800 0.038822 366.37 73.42597
8 0.18 0.14 0.88889 0.7 5 800 0.017124 439.79 79.82524
9 0.18 0.14 0.9 0.7 5 800 0.00462 519.62 87.47314
10 0.18 0.14 0.90909 0.7 5 800 0.0264 607.09
0 0.18 0.14 0 0.8 5 800 0.18 499.65 221.1945
1 0.18 0.14 0.5 0.8 5 800 0.155616 278.46 103.2179
2 0.18 0.14 0.66667 0.8 5 800 0.125907 175.24 78.69376
3 0.18 0.14 0.75 0.8 5 800 0.094544 96.55 73.65304
4 0.18 0.14 0.8 0.8 5 800 0.062454 22.89 76.11182
5 0.18 0.14 0.83333 0.8 5 800 0.029979 53.22 82.93806
6 0.18 0.14 0.85714 0.8 5 800 0.00272 136.16 93.28915
7 0.18 0.14 0.875 0.8 5 800 0.03557 229.45 107.1925
8 0.18 0.14 0.88889 0.8 5 800 0.06852 336.64 125.1636
9 0.18 0.14 0.9 0.8 5 800 0.10154 461.80 148.1245
10 0.18 0.14 0.90909 0.8 5 800 0.13462 609.93
0 0.18 0.14 0 0.9 5 800 0.18 749.83 236.5329
1 0.18 0.14 0.5 0.9 5 800 0.14648 513.29 100.4127
2 0.18 0.14 0.66667 0.9 5 800 0.105908 412.88 71.49601
3 0.18 0.14 0.75 0.9 5 800 0.063074 341.38 65.36206
4 0.18 0.14 0.8 0.9 5 800 0.019228 276.02 68.55205
5 0.18 0.14 0.83333 0.9 5 800 0.02516 207.47 77.93497
6 0.18 0.14 0.85714 0.9 5 800 0.06987 129.54 93.29474
7 0.18 0.14 0.875 0.9 5 800 0.11479 36.24 115.8841
8 0.18 0.14 0.88889 0.9 5 800 0.15985 79.64 148.3017
9 0.18 0.14 0.9 0.9 5 800 0.20501 227.94 194.9563
10 0.18 0.14 0.90909 0.9 5 800 0.25024 422.90
Fig. 16.1 Dependence of NPV on leverage level L at fixed levels of tax on profit rate t for a 5-year
project
Fig. 16.2 Dependence of ΔNPV on leverage level L at fixed levels of tax on profit rate t for a 5-year
project
One can see from Fig. 16.1 that the nature of the NPV dependence on leverage at
t* ¼ 0.5 is changed: there is a transition from the diminishing function NPV(L )
when t < t* to the growing function NPV(L) at t > t*.
Ten-Year Project
For 10-year projects, we get the following results (Tables 16.8, 16.9, 16.10, 16.11,
16.12, 16.13, and 16.14; Figs. 16.3 and 16.4).
Perpetuity Limit
In perpetuity limit n ! 1 [Мodigliani and Мiller limit (Мodigliani and Мiller 1958,
1963, 1966)], the formula for NPV is as the following (Brusov and Filatova 2011;
0 0.18 0.14 0 0.3 10 800 0.18 1516.69 51.935
1 0.18 0.14 0.5 0.3 10 800 0.19907 1464.75 101.47
2 0.18 0.14 0.66667 0.3 10 800 0.217182 1363.28 104.843
3 0.18 0.14 0.75 0.3 10 800 0.235022 1258.44 100.263
4 0.18 0.14 0.8 0.3 10 800 0.252747 1158.18 93.8156
5 0.18 0.14 0.83333 0.3 10 800 0.270413 1064.36 87.1129
6 0.18 0.14 0.85714 0.3 10 800 0.288045 977.25 80.6768
7 0.18 0.14 0.875 0.3 10 800 0.305654 896.57 74.6812
8 0.18 0.14 0.88889 0.3 10 800 0.323249 821.89 69.1705
9 0.18 0.14 0.9 0.3 10 800 0.340834 752.72 64.1369
10 0.18 0.14 0.90909 0.3 10 800 0.358411 688.58
0 0.18 0.14 0 0.4 10 800 0.18 1157.16 61.10029
1 0.18 0.14 0.5 0.4 10 800 0.191455 1218.26 18.517
2 0.18 0.14 0.66667 0.4 10 800 0.201083 1199.74 35.7995
3 0.18 0.14 0.75 0.4 10 800 0.210169 1163.95 41.1321
4 0.18 0.14 0.8 0.4 10 800 0.21902 1122.81 42.6427
5 0.18 0.14 0.83333 0.4 10 800 0.22775 1080.17 42.6081
6 0.18 0.14 0.85714 0.4 10 800 0.236408 1037.56 41.8669
7 0.18 0.14 0.875 0.4 10 800 0.24502 995.70 40.7844
8 0.18 0.14 0.88889 0.4 10 800 0.253602 954.91 39.5386
9 0.18 0.14 0.9 0.4 10 800 0.262161 915.37 38.2228
10 0.18 0.14 0.90909 0.4 10 800 0.270705 877.15
0 0.18 0.14 0 0.5 10 800 0.18 797.63 44.2013
1 0.18 0.14 0.5 0.5 10 800 0.219687 753.43 104.707
2 0.18 0.14 0.66667 0.5 10 800 0.255351 648.73 103.671
3 0.18 0.14 0.75 0.5 10 800 0.290005 545.06 93.6005
4 0.18 0.14 0.8 0.5 10 800 0.32421 451.45 82.6797
5 0.18 0.14 0.83333 0.5 10 800 0.358168 368.78 72.7174
6 0.18 0.14 0.85714 0.5 10 800 0.391982 296.06 64.0269
7 0.18 0.14 0.875 0.5 10 800 0.425702 232.03 56.5734
8 0.18 0.14 0.88889 0.5 10 800 0.459362 175.46 50.1953
9 0.18 0.14 0.9 0.5 10 800 0.492979 125.26 44.7383
10 0.18 0.14 0.90909 0.5 10 800 0.526564 80.52
0 0.18 0.14 0 0.6 10 800 0.18 438.11 244.5668
1 0.18 0.14 0.5 0.6 10 800 0.175084 682.67 125.4304
2 0.18 0.14 0.66667 0.6 10 800 0.165407 808.10 101.3662
3 0.18 0.14 0.75 0.6 10 800 0.154162 909.47 95.93652
4 0.18 0.14 0.8 0.6 10 800 0.142206 1005.41 97.02629
5 0.18 0.14 0.83333 0.6 10 800 0.129869 1102.43 101.3309
6 0.18 0.14 0.85714 0.6 10 800 0.117304 1203.76 107.7015
7 0.18 0.14 0.875 0.6 10 800 0.10459 1311.47 115.7055
8 0.18 0.14 0.88889 0.6 10 800 0.091775 1427.17 125.2046
9 0.18 0.14 0.9 0.6 10 800 0.078888 1552.38 136.2059
10 0.18 0.14 0.90909 0.6 10 800 0.065947 1688.58
0 0.18 0.14 0 0.7 10 800 0.18 78.58 310.4744
1 0.18 0.14 0.5 0.7 10 800 0.166255 389.06 177.1979
2 0.18 0.14 0.66667 0.7 10 800 0.145497 566.25 160.5402
3 0.18 0.14 0.75 0.7 10 800 0.122295 726.79 169.9063
4 0.18 0.14 0.8 0.7 10 800 0.097953 896.70 191.9196
5 0.18 0.14 0.83333 0.7 10 800 0.072986 1088.62 224.1724
6 0.18 0.14 0.85714 0.7 10 800 0.04764 1312.79 267.4019
7 0.18 0.14 0.875 0.7 10 800 0.022047 1580.19 323.9861
8 0.18 0.14 0.88889 0.7 10 800 0.00372 1904.18 397.7601
9 0.18 0.14 0.9 0.7 10 800 0.0296 2301.94 494.3094
10 0.18 0.14 0.90909 0.7 10 800 0.05558 2796.25
0 0.18 0.14 0 0.8 10 800 0.18 280.95 355.2633
1 0.18 0.14 0.5 0.8 10 800 0.156938 74.32 204.8466
2 0.18 0.14 0.66667 0.8 10 800 0.123925 279.16 198.4863
3 0.18 0.14 0.75 0.8 10 800 0.087223 477.65 232.7806
4 0.18 0.14 0.8 0.8 10 800 0.048741 710.43 297.8303
5 0.18 0.14 0.83333 0.8 10 800 0.009262 1008.26 400.9259
6 0.18 0.14 0.85714 0.8 10 800 0.03083 1409.19 560.3743
7 0.18 0.14 0.875 0.8 10 800 0.07133 1969.56 809.4944
8 0.18 0.14 0.88889 0.8 10 800 0.11211 2779.06 1207.425
9 0.18 0.14 0.9 0.8 10 800 0.1531 3986.48 1861.112
10 0.18 0.14 0.90909 0.8 10 800 0.19424 5847.59
0 0.18 0.14 0 0.9 10 800 0.18 640.47 375.0978
1 0.18 0.14 0.5 0.9 10 800 0.147081 265.38 194.2145
2 0.18 0.14 0.66667 0.9 10 800 0.100417 71.16 186.9461
3 0.18 0.14 0.75 0.9 10 800 0.048303 115.79 239.586
4 0.18 0.14 0.8 0.9 10 800 0.00655 355.37 356.4744
5 0.18 0.14 0.83333 0.9 10 800 0.06297 711.85 583.6021
6 0.18 0.14 0.85714 0.9 10 800 0.12039 1295.45 1032.383
7 0.18 0.14 0.875 0.9 10 800 0.17847 2327.83 1967.211
8 0.18 0.14 0.88889 0.9 10 800 0.23701 4295.04 4054.338
9 0.18 0.14 0.9 0.9 10 800 0.2959 8349.38 9115.336
10 0.18 0.14 0.90909 0.9 10 800 0.35504 17,464.72
project
Fig. 16.4 Dependence of ΔNPV on leverage level L at fixed levels of tax on profit rate t for a
10-year project
NOIð1 t Þ
ke
At constant value of investment capital (I ¼ const), accounting D ¼ IL/(1 + L )

and S ¼ I/(1 + L ), one gets
I NOIð1 t Þ
1þL ke
I NOIð1 t Þ
NPV ¼ ð1 þ Lð1 t ÞÞ þ , ð16:4Þ
where L ¼ D/S is the leverage level, ke is the equity cost of a leverage company
(which uses the debt capital), and k0 is the equity cost of a financially independent
company.
In the transition from the Eq. (16.3) to Eq. (16.4), we have used the formula for
equity capital cost, received by Мodigliani and Мiller (1958, 1963, 1966):
For perpetuity (long-term) projects, we get the following results (Tables 16.15,
16.16, 16.17, 16.18, 16.19, 16.20, and 16.21; Figs. 16.5 and 16.6).
t for a perpetuity (long-term) project at t ¼ 0.3
L t k0 kd I NOI NPV ΔNPV
0 0.3 0.18 0.14 1000 800 2111.111 268.803
1 0.3 0.18 0.14 1000 800 1842.308 269.426
2 0.3 0.18 0.14 1000 800 1572.881 226.669
3 0.3 0.18 0.14 1000 800 1346.212 188.404
4 0.3 0.18 0.14 1000 800 1157.808 157.808
5 0.3 0.18 0.14 1000 800 1000 133.662
6 0.3 0.18 0.14 1000 800 866.3383 114.477
7 0.3 0.18 0.14 1000 800 751.8617 99.0564
8 0.3 0.18 0.14 1000 800 652.8053 86.509
9 0.3 0.18 0.14 1000 800 566.2963 76.1777
10 0.3 0.18 0.14 1000 800 490.1186
0 0.4 0.18 0.14 1000 800 1666.667 113.725
1 0.4 0.18 0.14 1000 800 1552.941 181.011
2 0.4 0.18 0.14 1000 800 1371.93 167.168
3 0.4 0.18 0.14 1000 800 1204.762 145.631
4 0.4 0.18 0.14 1000 800 1059.13 125.797
5 0.4 0.18 0.14 1000 800 933.3333 108.995
6 0.4 0.18 0.14 1000 800 824.3386 95.0283
7 0.4 0.18 0.14 1000 800 729.3103 83.4322
8 0.4 0.18 0.14 1000 800 645.8781 73.7569
9 0.4 0.18 0.14 1000 800 572.1212 65.6277
10 0.4 0.18 0.14 1000 800 506.4935
0 0.5 0.18 0.14 1000 800 1222.222 27.77778
1 0.5 0.18 0.14 1000 800 1250 98.4848
2 0.5 0.18 0.14 1000 800 1151.515 109.848
3 0.5 0.18 0.14 1000 800 1041.667 103.205
4 0.5 0.18 0.14 1000 800 938.4615 93.2234
5 0.5 0.18 0.14 1000 800 845.2381 83.3333
6 0.5 0.18 0.14 1000 800 761.9048 74.4048
7 0.5 0.18 0.14 1000 800 687.5 66.585
8 0.5 0.18 0.14 1000 800 620.915 59.8039
9 0.5 0.18 0.14 1000 800 561.1111 53.9341
10 0.5 0.18 0.14 1000 800 507.177
0 0.6 0.18 0.14 1000 800 777.7778 154.8753
1 0.6 0.18 0.14 1000 800 932.6531 23.2191
2 0.6 0.18 0.14 1000 800 909.434 55.9252
3 0.6 0.18 0.14 1000 800 853.5088 62.0334
4 0.6 0.18 0.14 1000 800 791.4754 60.7062
5 0.6 0.18 0.14 1000 800 730.7692 57.0632
6 0.6 0.18 0.14 1000 800 673.706 52.8156
7 0.6 0.18 0.14 1000 800 620.8904 48.596
8 0.6 0.18 0.14 1000 800 572.2944 44.6401
9 0.6 0.18 0.14 1000 800 527.6543 41.0233
10 0.6 0.18 0.14 1000 800 486.631
t k0 kd I NOI NPV ΔNPV
0 0.7 0.18 0.14 1000 800 333.3333 266.6667
1 0.7 0.18 0.14 1000 800 600 43.13725
2 0.7 0.18 0.14 1000 800 643.1373 7.02614
3 0.7 0.18 0.14 1000 800 636.1111 23.4795
4 0.7 0.18 0.14 1000 800 612.6316 29.2982
5 0.7 0.18 0.14 1000 800 583.3333 30.9524
6 0.7 0.18 0.14 1000 800 552.381 30.79
7 0.7 0.18 0.14 1000 800 521.5909 29.8035
8 0.7 0.18 0.14 1000 800 491.7874 28.4541
9 0.7 0.18 0.14 1000 800 463.3333 26.9697
10 0.7 0.18 0.14 1000 800 436.3636
0 0.8 0.18 0.14 1000 800 111.111 362.1749
1 0.8 0.18 0.14 1000 800 251.0638 98.59603
2 0.8 0.18 0.14 1000 800 349.6599 34.65386
3 0.8 0.18 0.14 1000 800 384.3137 10.40326
4 0.8 0.18 0.14 1000 800 394.717 0.77759
5 0.8 0.18 0.14 1000 800 393.9394 6.47072
6 0.8 0.18 0.14 1000 800 387.4687 9.50257
7 0.8 0.18 0.14 1000 800 377.9661 11.1173
8 0.8 0.18 0.14 1000 800 366.8488 11.9282
9 0.8 0.18 0.14 1000 800 354.9206 12.2633
10 0.8 0.18 0.14 1000 800 342.6573
0 0.9 0.18 0.14 1000 800 555.556 440.3382
1 0.9 0.18 0.14 1000 800 115.217 140.7493
2 0.9 0.18 0.14 1000 800 25.53191 66.13475
3 0.9 0.18 0.14 1000 800 91.66667 36.4966
4 0.9 0.18 0.14 1000 800 128.1633 21.83673
5 0.9 0.18 0.14 1000 800 150 13.58543
6 0.9 0.18 0.14 1000 800 163.5854 8.52995
7 0.9 0.18 0.14 1000 800 172.1154 5.243106
8 0.9 0.18 0.14 1000 800 177.3585 3.01188
9 0.9 0.18 0.14 1000 800 180.3704 1.447811
10 0.9 0.18 0.14 1000 800 181.8182
Fig. 16.5 Dependence of NPV on leverage level L at fixed levels of tax on profit rate t for a
perpetuity (long-term) project
perpetuity (long-term) project

the Perspective of the Equity and Debt Holders
In this case, we use the following expression for NPV (Brusov and Filatova 2011;

Lt 1 NOIð1 t Þ 1
NPV ¼ I 1 1 þ 1 ð16:6Þ
1þL ð1 þ kd Þn ke ð1 þ k e Þn
Using it, we calculate the dependence of NPV and ΔNPV on leverage level L at
fixed levels of tax on profit rate t.
Five-Year Project
16.26, 16.27, and 16.28; Figs. 16.7 and 16.8).
I L WACC k0 kd wd t n NOI ke NPV ΔNPV
1000 0 0.18 0.18 0.14 0 0.3 5 800 0.18 751.2158 4.922709
1000 1 0.14774 0.18 0.14 0.5 0.3 5 800 0.197488 756.1385 36.8599
1000 2 0.13679 0.18 0.14 0.66667 0.3 5 800 0.214367 719.2786 44.7663
1000 3 0.13127 0.18 0.14 0.75 0.3 5 800 0.231082 674.5122 46.126
1000 4 0.12795 0.18 0.14 0.8 0.3 5 800 0.24773 628.3863 45.4549
1000 5 0.12572 0.18 0.14 0.83333 0.3 5 800 0.264343 582.9313 44.027
1000 6 0.12413 0.18 0.14 0.85714 0.3 5 800 0.280937 538.9044 42.3084
1000 7 0.12294 0.18 0.14 0.875 0.3 5 800 0.297518 496.596 40.4978
1000 8 0.12201 0.18 0.14 0.88889 0.3 5 800 0.314091 456.0982 38.6879
1000 9 0.12127 0.18 0.14 0.9 0.3 5 800 0.330658 417.4103 36.9239
1000 10 0.12066 0.18 0.14 0.90909 0.3 5 800 0.34722 380.4865
1000 0 0.18 0.18 0.14 0 0.4 5 800 0.18 501.0421 64.13345
1000 1 0.13679 0.18 0.14 0.5 0.4 5 800 0.189578 565.1755 4.73089
1000 2 0.12201 0.18 0.14 0.66667 0.4 5 800 0.19803 569.9064 9.5017
1000 3 0.11454 0.18 0.14 0.75 0.4 5 800 0.206172 560.4047 14.7815
1000 4 0.11004 0.18 0.14 0.8 0.4 5 800 0.214184 545.6233 17.1025
1000 5 0.10702 0.18 0.14 0.83333 0.4 5 800 0.22213 528.5208 18.1709
1000 6 0.10486 0.18 0.14 0.85714 0.4 5 800 0.230037 510.3499 18.6246
1000 7 0.10324 0.18 0.14 0.875 0.4 5 800 0.23792 491.7254 18.7461
1000 8 0.10198 0.18 0.14 0.88889 0.4 5 800 0.245786 472.9793 18.6762
1000 9 0.10096 0.18 0.14 0.9 0.4 5 800 0.253642 454.3031 18.4911
1000 10 0.10014 0.18 0.14 0.90909 0.4 5 800 0.261488 435.812
1000 0 0.18 0.18 0.14 0 0.5 5 800 0.18 250.8684 116.0669
1000 1 0.12572 0.18 0.14 0.5 0.5 5 800 0.181448 366.9353 41.1323
1000 2 0.10702 0.18 0.14 0.66667 0.5 5 800 0.181065 408.0676 22.57738
1000 3 0.09754 0.18 0.14 0.75 0.5 5 800 0.180162 430.645 15.19888
1000 4 0.09181 0.18 0.14 0.8 0.5 5 800 0.179041 445.8439 11.52994
1000 5 0.08797 0.18 0.14 0.83333 0.5 5 800 0.177806 457.3738 9.446706
1000 6 0.08522 0.18 0.14 0.85714 0.5 5 800 0.176505 466.8205 8.154973
1000 7 0.08315 0.18 0.14 0.875 0.5 5 800 0.175162 474.9755 7.302458
1000 8 0.08153 0.18 0.14 0.88889 0.5 5 800 0.173792 482.278 6.713275
1000 9 0.08024 0.18 0.14 0.9 0.5 5 800 0.172401 488.9912 6.291579
1000 10 0.07918 0.18 0.14 0.90909 0.5 5 800 0.170996 495.2828
1000 0 0.18 0.18 0.14 0 0.6 5 800 0.18 0.694727 160.0655
1000 1 0.11454 0.18 0.14 0.5 0.6 5 800 0.173086 160.7602 70.95083
1000 2 0.09181 0.18 0.14 0.66667 0.6 5 800 0.163424 231.711 49.78654
1000 3 0.08024 0.18 0.14 0.75 0.6 5 800 0.15296 281.4976 42.12961
1000 4 0.07323 0.18 0.14 0.8 0.6 5 800 0.142153 323.6272 39.00243
1000 5 0.06853 0.18 0.14 0.83333 0.6 5 800 0.131168 362.6296 37.85743
1000 6 0.06515 0.18 0.14 0.85714 0.6 5 800 0.120078 400.487 37.74625
1000 7 0.06262 0.18 0.14 0.875 0.6 5 800 0.108922 438.2333 38.25211
1000 8 0.06064 0.18 0.14 0.88889 0.6 5 800 0.097721 476.4854 39.17065
1000 9 0.05905 0.18 0.14 0.9 0.6 5 800 0.086488 515.656 40.39427
1000 10 0.05775 0.18 0.14 0.90909 0.6 5 800 0.075231 556.0503
1000 0 0.18 0.18 0.14 0 0.7 5 800 0.18 249.479 195.3877
1000 1 0.10324 0.18 0.14 0.5 0.7 5 800 0.16448 54.0913 92.40829
1000 2 0.07635 0.18 0.14 0.66667 0.7 5 800 0.145057 38.31702 69.68464
1000 3 0.06262 0.18 0.14 0.75 0.7 5 800 0.124461 108.0017 63.19622
1000 4 0.05427 0.18 0.14 0.8 0.7 5 800 0.103355 171.1979 62.43475
1000 5 0.04866 0.18 0.14 0.83333 0.7 5 800 0.081982 233.6326 64.46977
1000 6 0.04464 0.18 0.14 0.85714 0.7 5 800 0.060453 298.1024 68.26526
1000 7 0.0416 0.18 0.14 0.875 0.7 5 800 0.038822 366.3677 73.42597
1000 8 0.03924 0.18 0.14 0.88889 0.7 5 800 0.017124 439.7936 79.82524
1000 9 0.03734 0.18 0.14 0.9 0.7 5 800 0.00462 519.6189 87.47314
1000 10 0.03578 0.18 0.14 0.90909 0.7 5 800 0.0264 607.092
1000 0 0.18 0.18 0.14 0 0.8 5 800 0.18 499.653 221.1945
1000 1 0.09181 0.18 0.14 0.5 0.8 5 800 0.155616 278.458 103.2179
1000 2 0.06064 0.18 0.14 0.66667 0.8 5 800 0.125907 175.24 78.69376
1000 3 0.04464 0.18 0.14 0.75 0.8 5 800 0.094544 96.5465 73.65304
1000 4 0.03489 0.18 0.14 0.8 0.8 5 800 0.062454 22.8934 76.11182
1000 5 0.02833 0.18 0.14 0.83333 0.8 5 800 0.029979 53.21839 82.93806
1000 6 0.02361 0.18 0.14 0.85714 0.8 5 800 0.00272 136.1565 93.28915
1000 7 0.02005 0.18 0.14 0.875 0.8 5 800 0.03557 229.4456 107.1925
1000 8 0.01728 0.18 0.14 0.88889 0.8 5 800 0.06852 336.6381 125.1636
1000 9 0.01505 0.18 0.14 0.9 0.8 5 800 0.10154 461.8017 148.1245
1000 10 0.01322 0.18 0.14 0.90909 0.8 5 800 0.13462 609.9262
1000 0 0.18 0.18 0.14 0 0.9 5 800 0.18 749.826 236.5329
1000 1 0.08024 0.18 0.14 0.5 0.9 5 800 0.14648 513.293 100.4127
1000 2 0.04464 0.18 0.14 0.66667 0.9 5 800 0.105908 412.881 71.49601
1000 3 0.02627 0.18 0.14 0.75 0.9 5 800 0.063074 341.385 65.36206
1000 4 0.01505 0.18 0.14 0.8 0.9 5 800 0.019228 276.023 68.55205
1000 5 0.00747 0.18 0.14 0.83333 0.9 5 800 0.02516 207.471 77.93497
1000 6 0.00202 0.18 0.14 0.85714 0.9 5 800 0.06987 129.536 93.29474
1000 7 0.0021 0.18 0.14 0.875 0.9 5 800 0.11479 36.2409 115.8841
1000 8 0.0053 0.18 0.14 0.88889 0.9 5 800 0.15985 79.64322 148.3017
1000 9 0.0079 0.18 0.14 0.9 0.9 5 800 0.20501 227.945 194.9563
1000 10 0.01 0.18 0.14 0.90909 0.9 5 800 0.25024 422.9012
project
Fig. 16.8 Dependence of ΔNPV on leverage level L at fixed levels of tax on profit rate t for a 5-year
project
Ten-Year Project
16.33, 16.34, and 16.35; Figs. 16.9 and 16.10).
1000 0 0.18 0.18 0.14 0 0.3 10 800 0.18 1516.688 51.935
1000 1 0.14854 0.18 0.14 0.5 0.3 10 800 0.19907 1464.753 101.47
1000 2 0.13773 0.18 0.14 0.66667 0.3 10 800 0.217182 1363.283 104.843
1000 3 0.13226 0.18 0.14 0.75 0.3 10 800 0.235022 1258.441 100.263
1000 4 0.12895 0.18 0.14 0.8 0.3 10 800 0.252747 1158.178 93.8156
1000 5 0.12674 0.18 0.14 0.83333 0.3 10 800 0.270413 1064.362 87.1129
1000 6 0.12515 0.18 0.14 0.85714 0.3 10 800 0.288045 977.2493 80.6768
1000 7 0.12396 0.18 0.14 0.875 0.3 10 800 0.305654 896.5725 74.6812
1000 8 0.12303 0.18 0.14 0.88889 0.3 10 800 0.323249 821.8913 69.1705
1000 9 0.12228 0.18 0.14 0.9 0.3 10 800 0.340834 752.7207 64.1369
1000 10 0.12167 0.18 0.14 0.90909 0.3 10 800 0.358411 688.5839
1000 0 0.18 0.18 0.14 0 0.4 10 800 0.18 1157.161 61.10029
1000 1 0.13773 0.18 0.14 0.5 0.4 10 800 0.191455 1218.262 18.517
1000 2 0.12303 0.18 0.14 0.66667 0.4 10 800 0.201083 1199.745 35.7995
1000 3 0.11554 0.18 0.14 0.75 0.4 10 800 0.210169 1163.945 41.1321
1000 4 0.111 0.18 0.14 0.8 0.4 10 800 0.21902 1122.813 42.6427
1000 5 0.10796 0.18 0.14 0.83333 0.4 10 800 0.22775 1080.17 42.6081
1000 6 0.10577 0.18 0.14 0.85714 0.4 10 800 0.236408 1037.562 41.8669
1000 7 0.10413 0.18 0.14 0.875 0.4 10 800 0.24502 995.6955 40.7844
1000 8 0.10284 0.18 0.14 0.88889 0.4 10 800 0.253602 954.9111 39.5386
1000 9 0.10182 0.18 0.14 0.9 0.4 10 800 0.262161 915.3725 38.2228
1000 10 0.10097 0.18 0.14 0.90909 0.4 10 800 0.270705 877.1497
1000 0 0.18 0.18 0.14 0 0.5 10 800 0.18 797.6345 44.2013
1000 1 0.14484 0.20056 0.14 0.5 0.5 10 800 0.219687 753.4333 104.707
1000 2 0.13178 0.20836 0.14 0.66667 0.5 10 800 0.255351 648.7259 103.671
1000 3 0.125 0.21253 0.14 0.75 0.5 10 800 0.290005 545.0552 93.6005
1000 4 0.12084 0.21513 0.14 0.8 0.5 10 800 0.32421 451.4547 82.6797
1000 5 0.11803 0.2169 0.14 0.83333 0.5 10 800 0.358168 368.775 72.7174
1000 6 0.116 0.21819 0.14 0.85714 0.5 10 800 0.391982 296.0576 64.0269
1000 7 0.11446 0.21917 0.14 0.875 0.5 10 800 0.425702 232.0307 56.5734
1000 8 0.11326 0.21994 0.14 0.88889 0.5 10 800 0.459362 175.4573 50.1953
1000 9 0.1123 0.22055 0.14 0.9 0.5 10 800 0.492979 125.262 44.7383
1000 10 0.11151 0.22106 0.14 0.90909 0.5 10 800 0.526564 80.52365
1000 0 0.18 0.18 0.14 0 0.6 10 800 0.18 438.1076 244.5668
1000 1 0.11554 0.18 0.14 0.5 0.6 10 800 0.175084 682.6744 125.4304
1000 2 0.09247 0.18 0.14 0.66667 0.6 10 800 0.165407 808.1048 101.3662
1000 3 0.08054 0.18 0.14 0.75 0.6 10 800 0.154162 909.471 95.93652
1000 4 0.07324 0.18 0.14 0.8 0.6 10 800 0.142206 1005.408 97.02629
1000 5 0.06831 0.18 0.14 0.83333 0.6 10 800 0.129869 1102.434 101.3309
1000 6 0.06476 0.18 0.14 0.85714 0.6 10 800 0.117304 1203.765 107.7015
1000 7 0.06207 0.18 0.14 0.875 0.6 10 800 0.10459 1311.466 115.7055
1000 8 0.05998 0.18 0.14 0.88889 0.6 10 800 0.091775 1427.172 125.2046
1000 9 0.05829 0.18 0.14 0.9 0.6 10 800 0.078888 1552.376 136.2059
1000 10 0.0569 0.18 0.14 0.90909 0.6 10 800 0.065947 1688.582
1000 0 0.18 0.18 0.14 0 0.7 10 800 0.18 78.58071 310.4744
1000 1 0.10413 0.18 0.14 0.5 0.7 10 800 0.166255 389.0551 177.1979
1000 2 0.0765 0.18 0.14 0.66667 0.7 10 800 0.145497 566.253 160.5402
1000 3 0.06207 0.18 0.14 0.75 0.7 10 800 0.122295 726.7932 169.9063
1000 4 0.05319 0.18 0.14 0.8 0.7 10 800 0.097953 896.6995 191.9196
1000 5 0.04716 0.18 0.14 0.83333 0.7 10 800 0.072986 1088.619 224.1724
1000 6 0.04281 0.18 0.14 0.85714 0.7 10 800 0.04764 1312.791 267.4019
1000 7 0.03951 0.18 0.14 0.875 0.7 10 800 0.022047 1580.193 323.9861
1000 8 0.03692 0.18 0.14 0.88889 0.7 10 800 0.00372 1904.18 397.7601
1000 9 0.03484 0.18 0.14 0.9 0.7 10 800 0.0296 2301.94 494.3094
1000 10 0.03313 0.18 0.14 0.90909 0.7 10 800 0.05558 2796.249
1000 0 0.18 0.18 0.14 0 0.8 10 800 0.18 280.946 355.2633
1000 1 0.09247 0.18 0.14 0.5 0.8 10 800 0.156938 74.31716 204.8466
1000 2 0.05998 0.18 0.14 0.66667 0.8 10 800 0.123925 279.1638 198.4863
1000 3 0.04281 0.18 0.14 0.75 0.8 10 800 0.087223 477.6501 232.7806
1000 4 0.03215 0.18 0.14 0.8 0.8 10 800 0.048741 710.4306 297.8303
1000 5 0.02488 0.18 0.14 0.83333 0.8 10 800 0.009262 1008.261 400.9259
1000 6 0.0196 0.18 0.14 0.85714 0.8 10 800 0.03083 1409.187 560.3743
1000 7 0.01558 0.18 0.14 0.875 0.8 10 800 0.07133 1969.561 809.4944
1000 8 0.01243 0.18 0.14 0.88889 0.8 10 800 0.11211 2779.056 1207.425
1000 9 0.00989 0.18 0.14 0.9 0.8 10 800 0.1531 3986.481 1861.112
1000 10 0.0078 0.18 0.14 0.90909 0.8 10 800 0.19424 5847.593
1000 0 0.18 0.18 0.14 0 0.9 10 800 0.18 640.473 375.0978
1000 1 0.08054 0.18 0.14 0.5 0.9 10 800 0.147081 265.375 194.2145
1000 2 0.04281 0.18 0.14 0.66667 0.9 10 800 0.100417 71.1609 186.9461
1000 3 0.02258 0.18 0.14 0.75 0.9 10 800 0.048303 115.7852 239.586
1000 4 0.00989 0.18 0.14 0.8 0.9 10 800 0.00655 355.3712 356.4744
1000 5 0.00117 0.18 0.14 0.83333 0.9 10 800 0.06297 711.8456 583.6021
1000 6 0.0052 0.18 0.14 0.85714 0.9 10 800 0.12039 1295.448 1032.383
1000 7 0.0101 0.18 0.14 0.875 0.9 10 800 0.17847 2327.831 1967.211
1000 8 0.0139 0.18 0.14 0.88889 0.9 10 800 0.23701 4295.041 4054.338
1000 9 0.017 0.18 0.14 0.9 0.9 10 800 0.2959 8349.379 9115.336
1000 10 0.0195 0.18 0.14 0.90909 0.9 10 800 0.35504 17,464.72
project
5-year project
16.2 Dependence of NPV on Tax on Profit Rate at Fixed Leverage Levels L 321
16.2 Dependence of NPV on Tax on Profit Rate at Fixed

Leverage Levels L
Below we study the dependence of NPV on tax on profit rate at fixed leverage
levels L.

Five-Year Project
16.40, and 16.41; Figs. 16.11 and 16.12).
Table 16.36 Dependence of NPV and ΔNPV on tax on profit rate t at fixed leverage level L for a
5-year project at L ¼ 0
1000 0 0.18 0.18 0.14 0 0 5 800 0.18 1501.74 250.174
1000 0 0.18 0.18 0.14 0 0.1 5 800 0.18 1251.56 250.174
1000 0 0.18 0.18 0.14 0 0.2 5 800 0.18 1001.39 250.174
1000 0 0.18 0.18 0.14 0 0.3 5 800 0.18 751.22 250.174
1000 0 0.18 0.18 0.14 0 0.4 5 800 0.18 501.04 250.174
1000 0 0.18 0.18 0.14 0 0.5 5 800 0.18 250.87 250.174
1000 0 0.18 0.18 0.14 0 0.6 5 800 0.18 0.69 250.174
1000 0 0.18 0.18 0.14 0 0.7 5 800 0.18 249.48 250.174
1000 0 0.18 0.18 0.14 0 0.8 5 800 0.18 499.65 250.174
1000 0 0.18 0.18 0.14 0 0.9 5 800 0.18 749.83 250.174
1000 0 0.18 0.18 0.14 0 1 5 800 0.18 1000.00
Table 16.37 Dependence of NPV and ΔNPV on tax on profit rate t at fixed leverage level L for a 5-year project
1000 2 0.18 0.18 0.14 0.66667 0 5 800 0.26 1108.06 120.
1000 2 0.16577 0.18 0.14 0.66667 0.1 5 800 0.245315 987.07 129.
1000 2 0.15137 0.18 0.14 0.66667 0.2 5 800 0.230116 857.87 138.
1000 2 0.13679 0.18 0.14 0.66667 0.3 5 800 0.214367 719.28 149.
1000 2 0.12201 0.18 0.14 0.66667 0.4 5 800 0.19803 569.91 161.
1000 2 0.10702 0.18 0.14 0.66667 0.5 5 800 0.181065 408.07 176.
1000 2 0.09181 0.18 0.14 0.66667 0.6 5 800 0.163424 231.71 193.
1000 2 0.07635 0.18 0.14 0.66667 0.7 5 800 0.145057 38.32 213.
1000 2 0.06064 0.18 0.14 0.66667 0.8 5 800 0.125907 175.24 237.
1000 2 0.04464 0.18 0.14 0.66667 0.9 5 800 0.105908 412.88 266.
1000 2 0.02833 0.18 0.14 0.66667 1 5 800 0.084989 679.58
1000 4 0.18 0.18 0.14 0.8 0 5 800 0.34 808.33 51.044
1000 4 0.16291 0.18 0.14 0.8 0.1 5 800 0.31053 757.29 59.2842
1000 4 0.14556 0.18 0.14 0.8 0.2 5 800 0.279807 698.00 69.6148
1000 4 0.12795 0.18 0.14 0.8 0.3 5 800 0.24773 628.39 82.763
1000 4 0.11004 0.18 0.14 0.8 0.4 5 800 0.214184 545.62 99.7794
1000 4 0.09181 0.18 0.14 0.8 0.5 5 800 0.179041 445.84 122.217
1000 4 0.07323 0.18 0.14 0.8 0.6 5 800 0.142153 323.63 152.429
1000 4 0.05427 0.18 0.14 0.8 0.7 5 800 0.103355 171.20 194.091
1000 4 0.03489 0.18 0.14 0.8 0.8 5 800 0.062454 22.89 253.129
1000 4 0.01505 0.18 0.14 0.8 0.9 5 800 0.019228 276.02 339.472
1000 4 0.0053 0.18 0.14 0.8 1 5 800 0.02658 615.49
1000 6 0.18 0.18 0.14 0.85714 0 5 800 0.42 574.85 6.23744
1000 6 0.16168 0.18 0.14 0.85714 0.1 5 800 0.375729 568.61 11.31
1000 6 0.14306 0.18 0.14 0.85714 0.2 5 800 0.329434 557.30 18.3975
1000 6 0.12413 0.18 0.14 0.85714 0.3 5 800 0.280937 538.90 28.5544
1000 6 0.10486 0.18 0.14 0.85714 0.4 5 800 0.230037 510.35 43.5294
1000 6 0.08522 0.18 0.14 0.85714 0.5 5 800 0.176505 466.82 66.3335
1000 6 0.06515 0.18 0.14 0.85714 0.6 5 800 0.120078 400.49 102.385
1000 6 0.04464 0.18 0.14 0.85714 0.7 5 800 0.060453 298.10 161.946
1000 6 0.02361 0.18 0.14 0.85714 0.8 5 800 0.00272 136.16 265.692
1000 6 0.00202 0.18 0.14 0.85714 0.9 5 800 0.06987 129.54 458.495
1000 6 0.0202 0.18 0.14 0.85714 1 5 800 0.14147 588.03
1000 8 0.18 0.18 0.14 0.88889 0 5 800 0.5 389.30 23.47489
1000 8 0.16099 0.18 0.14 0.88889 0.1 5 800 0.440923 412.78 22.6083
1000 8 0.14167 0.18 0.14 0.88889 0.2 5 800 0.379039 435.38 20.71462
1000 8 0.12201 0.18 0.14 0.88889 0.3 5 800 0.314091 456.10 16.88106
1000 8 0.10198 0.18 0.14 0.88889 0.4 5 800 0.245786 472.98 9.298693
1000 8 0.08153 0.18 0.14 0.88889 0.5 5 800 0.173792 482.28 5.79258
1000 8 0.06064 0.18 0.14 0.88889 0.6 5 800 0.097721 476.49 36.6918
1000 8 0.03924 0.18 0.14 0.88889 0.7 5 800 0.017124 439.79 103.156
1000 8 0.01728 0.18 0.14 0.88889 0.8 5 800 0.06852 336.64 256.995
1000 8 0.0053 0.18 0.14 0.88889 0.9 5 800 0.15985 79.64 652.415
1000 8 0.0286 0.18 0.14 0.88889 1 5 800 0.25759 572.77
1000 10 0.18 0.18 0.14 0.90909 0 5 800 0.58 239.23 43.49836
1000 10 0.16056 0.18 0.14 0.90909 0.1 5 800 0.506115 282.73 46.87962
1000 10 0.14078 0.18 0.14 0.90909 0.2 5 800 0.428635 329.61 50.87829
1000 10 0.12066 0.18 0.14 0.90909 0.3 5 800 0.34722 380.49 55.32552
1000 10 0.10014 0.18 0.14 0.90909 0.4 5 800 0.261488 435.81 59.47085
1000 10 0.07918 0.18 0.14 0.90909 0.5 5 800 0.170996 495.28 60.76747
1000 10 0.05775 0.18 0.14 0.90909 0.6 5 800 0.075231 556.05 51.04171
1000 10 0.03578 0.18 0.14 0.90909 0.7 5 800 0.0264 607.09 2.834166
1000 10 0.01322 0.18 0.14 0.90909 0.8 5 800 0.13462 609.93 187.024
1000 10 0.01 0.18 0.14 0.90909 0.9 5 800 0.25024 422.90 985.964
1000 10 0.034 0.18 0.14 0.90909 1 5 800 0.37429 563.06
Fig. 16.11 Dependence of NPV on tax on profit rate t at fixed leverage level L for a 5-year project
Fig. 16.12 Dependence of ΔNPV on tax on profit rate t at fixed leverage level L for a 5-year project
Ten-Year Project
16.46, and 16.47; Figs. 16.13 and 16.14).
1000 0 0.18 0.18 0.14 0 0 10 800 0.18 2595.27 359.527
1000 0 0.18 0.18 0.14 0 0.1 10 800 0.18 2235.74 359.527
1000 0 0.18 0.18 0.14 0 0.2 10 800 0.18 1876.22 359.527
1000 0 0.18 0.18 0.14 0 0.3 10 800 0.18 1516.69 359.527
1000 0 0.18 0.18 0.14 0 0.4 10 800 0.18 1157.16 359.527
1000 0 0.18 0.18 0.14 0 0.5 10 800 0.18 797.63 359.527
1000 0 0.18 0.18 0.14 0 0.6 10 800 0.18 438.11 359.527
1000 0 0.18 0.18 0.14 0 0.7 10 800 0.18 78.58 359.527
1000 0 0.18 0.18 0.14 0 0.8 10 800 0.18 280.95 359.527
1000 0 0.18 0.18 0.14 0 0.9 10 800 0.18 640.47 359.527
1000 0 0.18 0.18 0.14 0 1 10 800 0.18 1000.00
1000 2 0.18 0.18 0.14 0.66667 0 10 800 0.26 1771.84 125.137
1000 2 0.16618 0.18 0.14 0.66667 0.1 10 800 0.24654 1646.71 135.437
1000 2 0.1521 0.18 0.14 0.66667 0.2 10 800 0.232299 1511.27 147.987
1000 2 0.13773 0.18 0.14 0.66667 0.3 10 800 0.217182 1363.28 163.538
1000 2 0.12303 0.18 0.14 0.66667 0.4 10 800 0.201083 1199.74 183.17
1000 2 0.10796 0.18 0.14 0.66667 0.5 10 800 0.183875 1016.58 208.47
1000 2 0.09247 0.18 0.14 0.66667 0.6 10 800 0.165407 808.10 241.852
1000 2 0.0765 0.18 0.14 0.66667 0.7 10 800 0.145497 566.25 287.089
1000 2 0.05998 0.18 0.14 0.66667 0.8 10 800 0.123925 279.16 350.325
1000 2 0.04281 0.18 0.14 0.66667 0.9 10 800 0.100417 71.16 442.002
1000 2 0.02488 0.18 0.14 0.66667 1 10 800 0.074631 513.16
1000 4 0.18 0.18 0.14 0.8 0 10 800 0.34 1226.89 475.625
1000 4 0.18316 0.20056 0.14 0.8 0.1 10 800 0.411801 751.26 139.495
1000 4 0.17256 0.20836 0.14 0.8 0.2 10 800 0.414791 611.77 74.4553
1000 4 0.15772 0.21253 0.14 0.8 0.3 10 800 0.396579 537.31 54.8815
1000 4 0.14072 0.21513 0.14 0.8 0.4 10 800 0.367589 482.43 52.0879
1000 4 0.12227 0.2169 0.14 0.8 0.5 10 800 0.331331 430.34 60.1971
1000 4 0.10261 0.21819 0.14 0.8 0.6 10 800 0.289071 370.14 80.4792
1000 4 0.08181 0.21917 0.14 0.8 0.7 10 800 0.241069 289.66 120.753
1000 4 0.0598 0.21994 0.14 0.8 0.8 10 800 0.186991 168.91 202.021
1000 4 0.0364 0.22055 0.14 0.8 0.9 10 800 0.126013 33.11 382.685
1000 4 0.01135 0.22106 0.14 0.8 1 10 800 0.056769 415.80
1000 6 0.18 0.18 0.14 0.85714 0 10 800 0.42 847.62 37.06285
1000 6 0.16218 0.18 0.14 0.85714 0.1 10 800 0.379295 884.68 42.53552
1000 6 0.14392 0.18 0.14 0.85714 0.2 10 800 0.335473 927.22 50.03126
1000 6 0.12515 0.18 0.14 0.85714 0.3 10 800 0.288045 977.25 60.31305
1000 6 0.10577 0.18 0.14 0.85714 0.4 10 800 0.236408 1037.56 74.23617
1000 6 0.08569 0.18 0.14 0.85714 0.5 10 800 0.179813 1111.80 91.96624
1000 6 0.06476 0.18 0.14 0.85714 0.6 10 800 0.117304 1203.76 109.0267
1000 6 0.04281 0.18 0.14 0.85714 0.7 10 800 0.04764 1312.79 96.39537
1000 6 0.0196 0.18 0.14 0.85714 0.8 10 800 0.03083 1409.19 113.739
1000 6 0.0052 0.18 0.14 0.85714 0.9 10 800 0.12039 1295.45 1669.51
1000 6 0.032 0.18 0.14 0.85714 1 10 800 0.22431 374.07
1000 8 0.18 0.18 0.14 0.88889 0 10 800 0.5 572.25 67.74227
1000 8 0.16152 0.18 0.14 0.88889 0.1 10 800 0.445653 640.00 80.91054
1000 8 0.14255 0.18 0.14 0.88889 0.2 10 800 0.386973 720.91 100.9849
1000 8 0.12303 0.18 0.14 0.88889 0.3 10 800 0.323249 821.89 133.0198
1000 8 0.10284 0.18 0.14 0.88889 0.4 10 800 0.253602 954.91 187.1372
1000 8 0.08188 0.18 0.14 0.88889 0.5 10 800 0.17692 1142.05 285.1235
1000 8 0.05998 0.18 0.14 0.88889 0.6 10 800 0.091775 1427.17 477.0078
1000 8 0.03692 0.18 0.14 0.88889 0.7 10 800 0.00372 1904.18 874.876
1000 8 0.01243 0.18 0.14 0.88889 0.8 10 800 0.11211 2779.06 1515.986
1000 8 0.0139 0.18 0.14 0.88889 0.9 10 800 0.23701 4295.04 4645.92
1000 8 0.0426 0.18 0.14 0.88889 1 10 800 0.38375 350.88
1000 10 0.18 0.18 0.14 0.90909 0 10 800 0.58 365.08 85.01433
1000 10 0.16109 0.18 0.14 0.90909 0.1 10 800 0.512008 450.10 103.8568
1000 10 0.14168 0.18 0.14 0.90909 0.2 10 800 0.438456 553.96 134.6286
1000 10 0.12167 0.18 0.14 0.90909 0.3 10 800 0.358411 688.58 188.5659
1000 10 0.10097 0.18 0.14 0.90909 0.4 10 800 0.270705 877.15 292.3814
1000 10 0.07944 0.18 0.14 0.90909 0.5 10 800 0.173857 1169.53 519.0512
1000 10 0.0569 0.18 0.14 0.90909 0.6 10 800 0.065947 1688.58 1107.667
1000 10 0.03313 0.18 0.14 0.90909 0.7 10 800 0.05558 2796.25 3051.344
1000 10 0.0078 0.18 0.14 0.90909 0.8 10 800 0.19424 5847.59 11,617.12
1000 10 0.0195 0.18 0.14 0.90909 0.9 10 800 0.35504 17,464.71 17,800.8
1000 10 0.0496 0.18 0.14 0.90909 1 10 800 0.54557 336.13
Fig. 16.14 Dependence of ΔNPV on tax on profit rate t at fixed leverage level L for a 10-year
project
Perpetuity Limit
For perpetuity projects, we get the following results (Tables 16.48 and 16.49;
Fig. 16.15).
perpetuity project at L ¼ 8
t L k0 kd I NOI NPV ΔNPV
0 8 0.18 0.14 1000 800 32111.1 5003.72
0.1 8 0.18 0.14 1000 800 37,114.8 7713.12
0.2 8 0.18 0.14 1000 800 44,828 12,659.2
0.3 8 0.18 0.14 1000 800 57,487.2 23,580
0.4 8 0.18 0.14 1000 800 81,067.2 57,266.1
0.5 8 0.18 0.14 1000 800 138,333 326,333
0.6 8 0.18 0.14 1000 800 464,667 816,960.8
0.7 8 0.18 0.14 1000 800 352,294.1 222,466
0.8 8 0.18 0.14 1000 800 129,828.3 49,261
0.9 8 0.18 0.14 1000 800 80,567.25 21,567.3
1 8 0.18 0.14 1000 800 59,000
perpetuity project at L ¼ 10
t L k0 kd I NOI NPV ΔNPV
0 10 0.18 0.14 1000 800 41,000 9090.91
0.1 10 0.18 0.14 1000 800 50,090.9 15,909.1
0.2 10 0.18 0.14 1000 800 66,000 32,692.3
0.3 10 0.18 0.14 1000 800 98,692.3 99,450.5
0.4 10 0.18 0.14 1000 800 198,143 8.6E + 19
0.5 10 0.18 0.14 1000 800 8.6E + 19 8.65E + 19
0.6 10 0.18 0.14 1000 800 202,750 99,632.4
0.7 10 0.18 0.14 1000 800 103,117.6 33,006.5
0.8 10 0.18 0.14 1000 800 70,111.11 16,374.3
0.9 10 0.18 0.14 1000 800 53,736.84 9736.84
1 10 0.18 0.14 1000 800 44,000
Fig. 16.15 Dependence of ΔNPV on tax on profit rate t at fixed leverage level L for a perpetuity
project

the Perspective of the Equity and Debt Holders
Five-Year Project
16.54, and 16.55; Figs. 16.16 and 16.17).
1000 0 0.18 0.18 0.14 0 0 5 800 0.18 1501.737 250.174
1000 0 0.18 0.18 0.14 0 0.1 5 800 0.18 1251.563 250.174
1000 0 0.18 0.18 0.14 0 0.2 5 800 0.18 1001.389 250.174
1000 0 0.18 0.18 0.14 0 0.3 5 800 0.18 751.2158 250.174
1000 0 0.18 0.18 0.14 0 0.4 5 800 0.18 501.0421 250.174
1000 0 0.18 0.18 0.14 0 0.5 5 800 0.18 250.8684 250.174
1000 0 0.18 0.18 0.14 0 0.6 5 800 0.18 0.694727 250.174
1000 0 0.18 0.18 0.14 0 0.7 5 800 0.18 249.479 250.174
1000 0 0.18 0.18 0.14 0 0.8 5 800 0.18 499.653 250.174
1000 0 0.18 0.18 0.14 0 0.9 5 800 0.18 749.826 250.174
1000 0 0.18 0.18 0.14 0 1 5 800 0.18 1000
1000 2 0.18 0.18 0.14 0.66667 0 5 800 0.26 1108.057 120.983
1000 2 0.16577 0.18 0.14 0.66667 0.1 5 800 0.245315 987.0733 129.204
1000 2 0.15137 0.18 0.14 0.66667 0.2 5 800 0.230116 857.869 138.59
1000 2 0.13679 0.18 0.14 0.66667 0.3 5 800 0.214367 719.2786 149.372
1000 2 0.12201 0.18 0.14 0.66667 0.4 5 800 0.19803 569.9064 161.839
1000 2 0.10702 0.18 0.14 0.66667 0.5 5 800 0.181065 408.0676 176.357
1000 2 0.09181 0.18 0.14 0.66667 0.6 5 800 0.163424 231.711 193.394
1000 2 0.07635 0.18 0.14 0.66667 0.7 5 800 0.145057 38.31702 213.557
1000 2 0.06064 0.18 0.14 0.66667 0.8 5 800 0.125907 175.24 237.64
1000 2 0.04464 0.18 0.14 0.66667 0.9 5 800 0.105908 412.881 266.698
1000 2 0.02833 0.18 0.14 0.66667 1 5 800 0.084989 679.579
1000 4 0.18 0.18 0.14 0.8 0 5 800 0.34 808.3293 51.044
1000 4 0.16291 0.18 0.14 0.8 0.1 5 800 0.31053 757.2853 59.2842
1000 4 0.14556 0.18 0.14 0.8 0.2 5 800 0.279807 698.0011 69.6148
1000 4 0.12795 0.18 0.14 0.8 0.3 5 800 0.24773 628.3863 82.763
1000 4 0.11004 0.18 0.14 0.8 0.4 5 800 0.214184 545.6233 99.7794
1000 4 0.09181 0.18 0.14 0.8 0.5 5 800 0.179041 445.8439 122.217
1000 4 0.07323 0.18 0.14 0.8 0.6 5 800 0.142153 323.6272 152.429
1000 4 0.05427 0.18 0.14 0.8 0.7 5 800 0.103355 171.1979 194.091
1000 4 0.03489 0.18 0.14 0.8 0.8 5 800 0.062454 22.8934 253.129
1000 4 0.01505 0.18 0.14 0.8 0.9 5 800 0.019228 276.023 339.472
1000 4 0.0053 0.18 0.14 0.8 1 5 800 0.02658 615.495
1000 6 0.18 0.18 0.14 0.85714 0 5 800 0.42 574.8492 6.23744
1000 6 0.16168 0.18 0.14 0.85714 0.1 5 800 0.375729 568.6118 11.31
1000 6 0.14306 0.18 0.14 0.85714 0.2 5 800 0.329434 557.3019 18.3975
1000 6 0.12413 0.18 0.14 0.85714 0.3 5 800 0.280937 538.9044 28.5544
1000 6 0.10486 0.18 0.14 0.85714 0.4 5 800 0.230037 510.3499 43.5294
1000 6 0.08522 0.18 0.14 0.85714 0.5 5 800 0.176505 466.8205 66.3335
1000 6 0.06515 0.18 0.14 0.85714 0.6 5 800 0.120078 400.487 102.385
1000 6 0.04464 0.18 0.14 0.85714 0.7 5 800 0.060453 298.1024 161.946
1000 6 0.02361 0.18 0.14 0.85714 0.8 5 800 0.00272 136.1565 265.692
1000 6 0.00202 0.18 0.14 0.85714 0.9 5 800 0.06987 129.536 458.495
1000 6 0.0202 0.18 0.14 0.85714 1 5 800 0.14147 588.03
1000 8 0.18 0.18 0.14 0.88889 0 5 800 0.5 389.3004 23.47489
1000 8 0.16099 0.18 0.14 0.88889 0.1 5 800 0.440923 412.7753 22.6083
1000 8 0.14167 0.18 0.14 0.88889 0.2 5 800 0.379039 435.3836 20.71462
1000 8 0.12201 0.18 0.14 0.88889 0.3 5 800 0.314091 456.0982 16.88106
1000 8 0.10198 0.18 0.14 0.88889 0.4 5 800 0.245786 472.9793 9.298693
1000 8 0.08153 0.18 0.14 0.88889 0.5 5 800 0.173792 482.278 5.79258
1000 8 0.06064 0.18 0.14 0.88889 0.6 5 800 0.097721 476.4854 36.6918
1000 8 0.03924 0.18 0.14 0.88889 0.7 5 800 0.017124 439.7936 103.156
1000 8 0.01728 0.18 0.14 0.88889 0.8 5 800 0.06852 336.6381 256.995
1000 8 0.0053 0.18 0.14 0.88889 0.9 5 800 0.15985 79.64322 652.415
1000 8 0.0286 0.18 0.14 0.88889 1 5 800 0.25759 572.772
1000 10 0.18 0.18 0.14 0.90909 0 5 800 0.58 239.2302 43.49836
1000 10 0.16056 0.18 0.14 0.90909 0.1 5 800 0.506115 282.7286 46.87962
1000 10 0.14078 0.18 0.14 0.90909 0.2 5 800 0.428635 329.6082 50.87829
1000 10 0.12066 0.18 0.14 0.90909 0.3 5 800 0.34722 380.4865 55.32552
1000 10 0.10014 0.18 0.14 0.90909 0.4 5 800 0.261488 435.812 59.47085
1000 10 0.07918 0.18 0.14 0.90909 0.5 5 800 0.170996 495.2828 60.76747
1000 10 0.05775 0.18 0.14 0.90909 0.6 5 800 0.075231 556.0503 51.04171
1000 10 0.03578 0.18 0.14 0.90909 0.7 5 800 0.0264 607.092 2.834166
1000 10 0.01322 0.18 0.14 0.90909 0.8 5 800 0.13462 609.9262 187.024
1000 10 0.01 0.18 0.14 0.90909 0.9 5 800 0.25024 422.9017 985.964
1000 10 0.034 0.18 0.14 0.90909 1 5 800 0.37429 563.062
Fig. 16.17 Dependence of ΔNPV on tax on profit rate t at fixed leverage level L for a 5-year project
Ten-Year Projects
16.60, and 16.61; Figs. 16.18, 16.19, 16.20, and 16.21).
1000 0 0.18 0.18 0.14 0 0 10 800 0.18 2595.269 359.527
1000 0 0.18 0.18 0.14 0 0.1 10 800 0.18 2235.742 359.527
1000 0 0.18 0.18 0.14 0 0.2 10 800 0.18 1876.215 359.527
1000 0 0.18 0.18 0.14 0 0.3 10 800 0.18 1516.688 359.527
1000 0 0.18 0.18 0.14 0 0.4 10 800 0.18 1157.161 359.527
1000 0 0.18 0.18 0.14 0 0.5 10 800 0.18 797.6345 359.527
1000 0 0.18 0.18 0.14 0 0.6 10 800 0.18 438.1076 359.527
1000 0 0.18 0.18 0.14 0 0.7 10 800 0.18 78.58071 359.527
1000 0 0.18 0.18 0.14 0 0.8 10 800 0.18 280.946 359.527
1000 0 0.18 0.18 0.14 0 0.9 10 800 0.18 640.473 359.527
1000 0 0.18 0.18 0.14 0 1 10 800 0.18 1000
1000 2 0.18 0.18 0.14 0.66667 0 10 800 0.26 1771.845 125.137
1000 2 0.16618 0.18 0.14 0.66667 0.1 10 800 0.24654 1646.708 135.437
1000 2 0.1521 0.18 0.14 0.66667 0.2 10 800 0.232299 1511.27 147.987
1000 2 0.13773 0.18 0.14 0.66667 0.3 10 800 0.217182 1363.283 163.538
1000 2 0.12303 0.18 0.14 0.66667 0.4 10 800 0.201083 1199.745 183.17
1000 2 0.10796 0.18 0.14 0.66667 0.5 10 800 0.183875 1016.575 208.47
1000 2 0.09247 0.18 0.14 0.66667 0.6 10 800 0.165407 808.1048 241.852
1000 2 0.0765 0.18 0.14 0.66667 0.7 10 800 0.145497 566.253 287.089
1000 2 0.05998 0.18 0.14 0.66667 0.8 10 800 0.123925 279.1638 350.325
1000 2 0.04281 0.18 0.14 0.66667 0.9 10 800 0.100417 71.1609 442.002
1000 2 0.02488 0.18 0.14 0.66667 1 10 800 0.074631 513.163
1000 4 0.18 0.18 0.14 0.8 0 10 800 0.34 1226.885 475.625
1000 4 0.18316 0.20056 0.14 0.8 0.1 10 800 0.411801 751.2601 139.495
1000 4 0.17256 0.20836 0.14 0.8 0.2 10 800 0.414791 611.7654 74.4553
1000 4 0.15772 0.21253 0.14 0.8 0.3 10 800 0.396579 537.3101 54.8815
1000 4 0.14072 0.21513 0.14 0.8 0.4 10 800 0.367589 482.4286 52.0879
1000 4 0.12227 0.2169 0.14 0.8 0.5 10 800 0.331331 430.3407 60.1971
1000 4 0.10261 0.21819 0.14 0.8 0.6 10 800 0.289071 370.1436 80.4792
1000 4 0.08181 0.21917 0.14 0.8 0.7 10 800 0.241069 289.6644 120.753
1000 4 0.0598 0.21994 0.14 0.8 0.8 10 800 0.186991 168.9112 202.021
1000 4 0.0364 0.22055 0.14 0.8 0.9 10 800 0.126013 33.1095 382.685
1000 4 0.01135 0.22106 0.14 0.8 1 10 800 0.056769 415.795
1000 6 0.18 0.18 0.14 0.85714 0 10 800 0.42 847.6197 37.06285
1000 6 0.16218 0.18 0.14 0.85714 0.1 10 800 0.379295 884.6825 42.53552
1000 6 0.14392 0.18 0.14 0.85714 0.2 10 800 0.335473 927.218 50.03126
1000 6 0.12515 0.18 0.14 0.85714 0.3 10 800 0.288045 977.2493 60.31305
1000 6 0.10577 0.18 0.14 0.85714 0.4 10 800 0.236408 1037.562 74.23617
1000 6 0.08569 0.18 0.14 0.85714 0.5 10 800 0.179813 1111.799 91.96624
1000 6 0.06476 0.18 0.14 0.85714 0.6 10 800 0.117304 1203.765 109.0267
1000 6 0.04281 0.18 0.14 0.85714 0.7 10 800 0.04764 1312.791 96.39537
1000 6 0.0196 0.18 0.14 0.85714 0.8 10 800 0.03083 1409.187 113.739
1000 6 0.0052 0.18 0.14 0.85714 0.9 10 800 0.12039 1295.448 1669.51
1000 6 0.032 0.18 0.14 0.85714 1 10 800 0.22431 374.066
1000 8 0.18 0.18 0.14 0.88889 0 10 800 0.5 572.2536 67.74227
1000 8 0.16152 0.18 0.14 0.88889 0.1 10 800 0.445653 639.9958 80.91054
1000 8 0.14255 0.18 0.14 0.88889 0.2 10 800 0.386973 720.9064 100.9849
1000 8 0.12303 0.18 0.14 0.88889 0.3 10 800 0.323249 821.8913 133.0198
1000 8 0.10284 0.18 0.14 0.88889 0.4 10 800 0.253602 954.9111 187.1372
1000 8 0.08188 0.18 0.14 0.88889 0.5 10 800 0.17692 1142.048 285.1235
1000 8 0.05998 0.18 0.14 0.88889 0.6 10 800 0.091775 1427.172 477.0078
1000 8 0.03692 0.18 0.14 0.88889 0.7 10 800 0.00372 1904.18 874.876
1000 8 0.01243 0.18 0.14 0.88889 0.8 10 800 0.11211 2779.056 1515.986
1000 8 0.0139 0.18 0.14 0.88889 0.9 10 800 0.23701 4295.041 4645.92
1000 8 0.0426 0.18 0.14 0.88889 1 10 800 0.38375 350.883
1000 10 0.18 0.18 0.14 0.90909 0 10 800 0.58 365.0841 85.01433
1000 10 0.16109 0.18 0.14 0.90909 0.1 10 800 0.512008 450.0984 103.8568
1000 10 0.14168 0.18 0.14 0.90909 0.2 10 800 0.438456 553.9552 134.6286
1000 10 0.12167 0.18 0.14 0.90909 0.3 10 800 0.358411 688.5839 188.5659
1000 10 0.10097 0.18 0.14 0.90909 0.4 10 800 0.270705 877.1497 292.3814
1000 10 0.07944 0.18 0.14 0.90909 0.5 10 800 0.173857 1169.531 519.0512
1000 10 0.0569 0.18 0.14 0.90909 0.6 10 800 0.065947 1688.582 1107.667
1000 10 0.03313 0.18 0.14 0.90909 0.7 10 800 0.05558 2796.249 3051.344
1000 10 0.0078 0.18 0.14 0.90909 0.8 10 800 0.19424 5847.593 11,617.12
1000 10 0.0195 0.18 0.14 0.90909 0.9 10 800 0.35504 17,464.71 17,800.8
1000 10 0.0496 0.18 0.14 0.90909 1 10 800 0.54557 336.131
(more detailed)
project
project (more detailed)
It is seen from Fig. 16.19 that falling trend at L ¼ 0, 2, and 4 alternates by growing
trend at higher leverage levels L ¼ 6, 8, and 10.
The observed increase of NPV at high leverage levels (starting from L ¼ 6) with
growth of tax on profit rate t takes place at all values of t, which means that this is an
entirely new effect in investments, which can be applied in a real economic practice
for the optimization of the management of investments.
Let us consider more detailed figure.
References 335
Conclusions Within the modern theory of capital cost and capital structure by
Brusov–Filatova–Orekhova (BFO theory) and modern investment models created
within this theory, the influence of the growth of tax on profit rate on the efficiency of
the investment is investigated. It has been shown that for arbitrary duration projects
as well as for perpetuity projects, the growth of tax on profit rate changes the nature
of the NPV dependence on leverage at some value t*: there is a transition from the
diminishing function NPV(L ) when t < t* to the growing function NPV(L ) at t > t*.
The t* value depends on the duration of the project, cost of capital (equity and debt)
values, and other parameters of the project.
At high leverage levels, this leads to a qualitatively new effect in investments:
growth of the efficiency of the investments with the growth of tax on profit rate.
capital.
The observed increase of NPV at high leverage levels (starting from L ¼ 6) with
growth of tax on profit rate t takes place at all values of t, which means that this is an
entirely new effect in investments which can be applied in a real economic practice
for the optimization of the management of investments.
So, two very important qualitatively new effects in investments have been
discovered:
1. Change of the character of NPV dependence on leverage with growth of tax on
profit rate
2. Growth of the efficiency of the investments with growth of tax on profit rate
Both effects could be used in practice to optimize the investments.
References
(11):815–824
org/10.1080/23322039.2014.946150

7:37–62
Econ Rev 53:147–175
1954–1957. Am Econ Rev 56:333–391
Chapter 17
Optimizing the Investment Structure
of the Telecommunication Sector Company
In this chapter developed by the authors models on the evaluation of the dependence
of the effectiveness of investments on debt financing are applied for the analysis of
investments of one of the telecommunication company for 2010–2012 from the
point of view of optimal structure of investment. The analysis revealed that only in
2011, the company’s investment structure was close to the optimal.
17.1 Introduction
Investments in tangible and intangible assets play an important role in the activities
of any company. They are a necessary condition for structural adjustment and
economic growth and provide the creation of new and enhancement of existing
basic funds and industries. The role of investment, which is always one of the most
important, is increased many times at the current stage.
For example, in Russia a priority of budget will be the reduced of dependence of
the price of oil and gas. The main issue that helps at least to start the movement on
this way is, of course, investments. In this way, the role of investment at the present
stage is indeed increasing dramatically. In this regard, the role of the evaluation of
the efficiency of investment projects, which in the context of scarcity and limited
investment resources allows the realization of the most effective projects, increases.
Since virtually all investment projects use debt financing, the purpose of the study of
the impact of debt financing and capital structure on the efficiency of investment
projects, determining the optimal level leverage, is especially actual at the
present time.
The hope to determine the optimal capital structure, in which one or more
parameters of the efficiency of the project (NPV, IRR, etc.) are maximum, more
than half a century has encouraged researchers to deal with the issue. Some of the
major problems in the assessment of the effectiveness of the projects are the
following:

https://doi.org/10.1007/978-3-319-99686-8_17
338 17 Optimizing the Investment Structure of the Telecommunication Sector Company
– What are financial flows and why are they necessary to take into account when
calculating parameters of efficiency of the project (NPV, IRR, etc.)?
– How many discount rates should be used for financial flows associated with
investments?
– How can these discount rates be accurately determined?
Discussion concerning the first two problems is ongoing. On the third issue, one
needs to note that, in recent years, there has been a significant progress in the
accurate determination of the cost of the equity capital of the company and its
weighted average cost, which are the discount rates when evaluating the NPV of
the project. The progress is associated with work performed by Brusov, Filatova, and
2014a, b, 2015, 2018a, b, c, d; Filatova et al. 2008; Brusova 2011), in which the
general theory of capital cost of the company (equity cost as well as weighted
average cost) was established and its dependence on leverage and on lifetime (age)
of company was found for the companies with arbitrary lifetime (age). The main
difference between their theory and theory by Modigliani and Miller is that the
former one waives from the perpetuity of the companies, which leads to significant
differences of a new theory from theory of Nobel laureates Мodigliani and Мiller
(1958, 1963, 1966).
The lack of modern methods of evaluation for effectiveness of investment pro-
jects with account of the debt financing, with the correct assessment of discount rate,
used in investment models, has identified the need for research. The establishment of
such modern models, considering problem from the point of view of equity capital
owners as well as from the point of view of equity and debt capital owners, with the
use of modern theory by Brusov, Filatova, and Orekhova that assesses the equity
capital cost and weighted average cost of capital of the company (Мodigliani and
Мiller 1958, 1963, 1966), which play the role of discount rate in the investment
models, can significantly contribute to the problem of the assessment of investment
projects’ effectiveness.
17.2 Investment Analysis and Recommendations

for Telecommunication Company “Nastcom Plus”
Based on the method, developed by the authors (Brusov and Filatova 2011; Brusov
et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b; Filatova et al. 2008), let us analyze
the efficiency of investments of one of the leading companies in the telecommuni-
cation sector “Nastcom Plus” for 2010–2012 from the point of view of optimal
structure of investment. The source data for the analysis are presented in Table 17.1.
Quantity k0 is the equity cost of financially independent company (or equity cost
at zero leverage) and for “Nastcom Plus” is equal to 23.67% (Brusova 2011). Here
are also calculated dependence of weighted average cost of capital WACC and the
equity cost ke on leverage (Fig. 17.1).
17.2 Investment Analysis and Recommendations for Telecommunication Company. . . 339
Table 17.1 Data of “Nastcom Plus” for 2010–2012

Indicator 2010 2011 2012
Investment I, million dollars 1.124 2.05 2.763
Revenue, million dollars 7204.335 8232.172 9418.773
Net operating income for the year before taxing, NOI, 2161.3 2469.174 2826
million dollars
Equity cost at zero leverage, k0, % 23.67 23.67 23.67
Debt cost kd , % 8.26 7.4 6.69
Return on investment for 1 year, β ¼ I/NOI 1.92 1.204 1.02
Amount of debt financing, % 35 50 50
Amount of equity, % 65 50 50
Leverage level, L 0.54 1 1
Amount of equity capital S, million dollars 730.6 1025 1381.5
K
60
Ke
50 Ke
40 4
5
6
30 Ke
1 WACC
2
20 3 WACC
WACC
10
L
0 0.5 1 1.5 2 2.5 3
Fig. 17.1 Dependence of weighted average cost of capital WACC and the equity cost ke on
leverage: 1, 4 within Brusov–Filatova–Orekhova theory; 2, 5 within Modigliani–Miller theory; 3,
6 within traditional approach
17.2.1 The Dependence of NPV on Investment Capital

Structure
Analysis of investment will be continued with use of the formula provided in the
works (Brusov and Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b,
2014a, b; Filatova et al. 2008):

1 1
NPV ¼ S 1 þ L ð1 t Þ 1 þ
ð1 þ k d Þn ð1 þ k d Þn

þ 1 , ð17:1Þ
ke ð1 þ k e Þn
where:
NPV—net present value
S—equity capital amount
L—leverage level
t—tax on profit rate
kd—debt cost
n—project duration
β—return on investment for 1 year
ke—equity cost
Analysis of Investments in 2010 Using Nastcom Plus company’s data
(Table 17.1), we compute the WACC, ke, and NPV (Tables 17.2, 17.3, and 17.4;
Figs. 17.1 and 17.2).
In the company’s investment in 2010, equity capital accounted for 65%, and debt
35%, i.e., the leverage level was equal to L ¼ 0.54. The term for hardware
depreciation, into establishment of which investment was done, was 5 years.
Curve 2 (Fig. 17.2) corresponds to dependence of NPV on leverage level for the
5-year project. Optimum NPV is achieved when L ¼ 2. At this leverage level,
NPV ¼ 3624.5 million dollars.
The level leverage with which “Nastcom Plus” has carried out its investment
projects (L ¼ 0.54) was lying far from optimum and provided NPV ¼ 2979.2 million
dollars, which is approximately 645 million dollars less than the optimal value
of NPV.
Since the equipment can be operated, after depreciation, one can estimate the
NPV for a more long-term perspective. For example, for the 7-year project, the
optimal leverage value is L ¼ 2.0, when the NPV ¼ 4157.6 million dollars, which is
562.8 million dollars more than nonoptimal values of NPV ¼ 3594.8 million dollars,
obtained by the company. For the 10-year project, the optimal leverage level is
L ¼ 1.5, with NPV ¼ 4509.1 million dollars, which is 422.9 million dollars more
than nonoptimal values of NPV ¼ 4086.2 million dollars, obtained by the company
(Fig. 17.2; Tables 17.2, 17.3, and 17.4).
Analysis of Investments in 2011 Using company data, we compute the WACC, ke,
and NPV (Tables 17.5, 17.6, and 17.7; Fig. 17.3).
In the company’s investment in 2011, equity capital accounted for 50%, and debt
capital for 50% as well, i.e., the leverage level was equal to L ¼ 1. The term for
hardware depreciation, into establishment of which investment was done, was
5 years. Curve 2 (Fig. 17.3) corresponds to dependence of NPV on leverage level
17.2
Table 17.2 Weighted average cost of capital, WACC, in 2010

Leverage level L
Project duration n 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
2 0.2367 0.2284 0.2242 0.2217 0.2201 0.2189 0.2180 0.2173 0.2167 0.2163 0.2159
5 0.2367 0.2262 0.2209 0.2177 0.2156 0.2141 0.2130 0.2121 0.2114 0.2108 0.2103
7 0.2367 0.2256 0.2199 0.2166 0.2143 0.2127 0.2116 0.2106 0.2099 0.2093 0.2087
10 0.2366 0.2250 0.2190 0.2155 0.2131 0.2114 0.2101 0.2091 0.2083 0.2076 0.2071
Investment Analysis and Recommendations for Telecommunication Company. . .
341
342
17
Table 17.3 Equity cost, ke, in 2010

Leverage level L
2 0.2367 0.3096 0.3824 0.4552 0.5280 0.6008 0.6736 0.7464 0.8192 0.8920 0.9649
5 0.2367 0.3063 0.3758 0.4452 0.5147 0.5841 0.6536 0.7230 0.7925 0.8619 0.9314
7 0.2367 0.3053 0.3738 0.4423 0.5107 0.5791 0.6480 0.7165 0.7850 0.8535 0.9220
10 0.2366 0.3044 0.3720 0.4396 0.5071 0.5746 0.6422 0.7097 0.7772 0.8447 0.9122
Optimizing the Investment Structure of the Telecommunication Sector Company
17.2
Table 17.4 Net present value, NPV, in 2010, million dollars

Leverage level L
2 910.5 1181.8 1358.3 1458.5 1496.3 1482.8 1426.6 1334.6 1212.4 1064.5 894.5
5 2371.6 2979.2 3347.7 3547.1 3624.5 3612.4 3533.6 3404.2 3236.1 3038.0 2816.2
7 2939.0 3594.8 3955.1 4121.6 4157.6 4103.6 3981.6 3817.6 3619.9 3397.1 3155.1
10 3444.5 4086.2 4396.9 4509.1 4497.4 4405.3 4258.9 4074.9 3863.8 3632.7 3386.5
343
NPV
5000
4000
4
3000 3
2
2000
1000
1
0 L
0 1 2 3 4 5 6
Fig. 17.2 Dependence of NPV on leverage L at t ¼ 20% in 2010: 1 2-year income from
investments; 2 5-year income from investments (the term for hardware depreciation); 3 7 years of
investment income; 4 10 years of investment income
for the 5-year project. Optimum NPV is achieved approximately at L ¼ 1. More

accurate calculations show that the optimal value of NPV ¼ 2133.7 million dollars is
achieved when L ¼ 1.1.
The level leverage with which “Nastcom Plus” has carried out its investment
projects (L ¼ 0.1) was lying in the vicinity of optimum and provided NPV ¼ 2131.8
million dollars, which is just 2 million dollars less than the optimal value of NPV.
You can take it that, in 2011, investment in “Nastcom Plus” company has been
carried out with almost optimal structure.
Analysis of Investments in 2012 Using company’s data, we compute the WACC,
ke, and NPV (Tables 17.8, 17.9, and 17.10; Fig. 17.4).
The company’s investment structure in 2012 was the same as in 2011: equity
capital accounted for 50%, and debt capital for 50%, i.e., the leverage level was
equal to L ¼ 1. The term hardware for depreciation, into establishment of which
investment was done, was 5 years. Curve 2 (Fig. 17.4) corresponds to dependence of
NPV on leverage level for the 5-year project. Optimum NPV is achieved when
L ¼ 0.5. More accurate calculations show that the optimal value of NPV ¼ 1987.7
million dollars is achieved when L ¼ 0.7 (Table 17.11, Fig. 17.5).
The level leverage, with which “Nastcom Plus” has carried out its investment
projects (L ¼ 0.1), did not correspond to optimum value (L ¼ 0.7) and provided
NPV ¼ 1954.6 million dollars, which is 31.7 million dollars less than the optimal
value of NPV (Figs. 17.4 and 17.5; Tables 17.10 and 17.11).
Since the equipment can be operated after depreciation, one can estimate the NPV
for a more long-term perspective. For example, for the 7-year project, the optimal
leverage value is L ¼ 0.65, when the NPV ¼ 2580.6 million dollars, which is 51.7
million dollars more than nonoptimal values of NPV ¼ 2528.9 million dollars,
obtained by the company. For the 10-year project, the optimal leverage level
17.2

Leverage level L
2 0.2367 0.3096 0.3824 0.4552 0.5280 0.6008 0.6736 0.7464 0.8192 0.8920 0.9649
5 0.2367 0.3063 0.3758 0.4452 0.5147 0.5841 0.6536 0.7230 0.7925 0.8619 0.9314
7 0.2367 0.3053 0.3738 0.4423 0.5107 0.5791 0.6480 0.7165 0.7850 0.8535 0.9220
10 0.2366 0.3044 0.3720 0.4396 0.5071 0.5746 0.6422 0.7097 0.7772 0.8447 0.9122
345
346
17

Leverage level L
2 0.2367 0.3142 0.3916 0.4690 0.5464 0.6239 0.7013 0.7787 0.8561 0.9335 1.0110
5 0.2367 0.3110 0.3853 0.4595 0.5338 0.6080 0.6822 0.7565 0.8307 0.9049 0.9791
7 0.2367 0.3100 0.3833 0.4565 0.5297 0.6029 0.6761 0.7493 0.8230 0.8963 0.9695
10 0.2366 0.3091 0.3813 0.4536 0.5258 0.5980 0.6702 0.7424 0.8146 0.8868 0.9589
17.2
Table 17.7 Net present value, NPV, of the company in 2011, million dollars
Leverage level L
2 418.8 460.5 415.8 302.3 133.3 80.9 332.5 615.0 923.5 1254.0 1603.1
5 1704.2 2025.4 2131.8 2089.9 1943.2 1721.0 1443.5 1124.7 774.8 400.9 8.5
7 2203.4 2558.0 2650.5 2576.1 2392.2 2134.4 1825.6 1480.7 1105.7 715.0 309.8
10 2648.2 2982.3 3028.1 2907.1 2685.2 2399.5 2071.6 1715.0 1338.0 946.0 542.9
347
NPV
4000
3000
2000
1000
4
3
0 2 L
–1000
1
–2000
0 1 2 3 4 5 6
Fig. 17.3 Dependence of NPV on leverage L at t ¼ 20% in 2011: 1 for 2-year income from
investments; 2 for 5-year income from investments (the term for hardware depreciation); 3 for
7 years of investment income; 4 for 10 years of investment income
L ¼ 0.55, with NPV ¼ 3043.5 million dollars, which is 98 million dollars more than
nonoptimal values of NPV ¼ 2945.5 million dollars, obtained by the company.
17.2.2 The Dependence of NPV on the Equity Capital Value

and Coefficient β
Let us investigate the dependence of NPV on the equity capital value and coefficient
β (Tables 17.12, 17.13, 17.14, and 17.15; Figs. 17.6, 17.7, 17.8, and 17.9).
With increase of the equity value, optimum is observed for all of the values
S when leverage level is approximately equal to L ¼ 0.7, and the optimum value as
well as the NPV value is growing with increasing S, as long as the project remains
effective (up to the leverage level approximately L ¼ 3.7).
With the decrease of the return on investment (β ¼ 0.5), the dependence of the
NPV on leverage changes significantly: now NPV monotonically decreases with the
leverage at all values of equity capital S (Fig. 17.7).
With the increase of the return on investment (β ¼ 1.5), the NPV of the project
has an optimum at all values of equity capital S at leverage level L ¼ 1.5, and NPV
(L ) curve is going up with the increase in S until the project remains effective (up to
the leverage level approximately L ¼ 7). The optimum position (value L0) almost
does not depend on the equity value S (L0 ¼ 1.5). This means the possibility of a
17.2

Leverage level L
2 0.2367 0.2298 0.2264 0.2243 0.2229 0.2219 0.2212 0.2206 0.2202 0.2198 0.2195
5 0.2367 0.2278 0.2234 0.2207 0.2189 0.2176 0.2167 0.2159 0.2153 0.2148 0.2144
7 0.2367 0.2272 0.2224 0.2195 0.2176 0.2162 0.2152 0.2143 0.2137 0.2132 0.2127
10 0.2366 0.2265 0.2213 0.2183 0.2162 0.2147 0.2136 0.2127 0.2120 0.2115 0.2110
349
350
17

Leverage level L
2 0.2367 0.3180 0.3992 0.4805 0.5617 0.6430 0.7242 0.8055 0.8867 0.9680 1.0492
5 0.2367 0.3150 0.3933 0.4715 0.5497 0.6279 0.7062 0.7844 0.8626 0.9408 1.0190
7 0.2367 0.3140 0.3913 0.4685 0.5457 0.6229 0.7001 0.7772 0.8544 0.9316 1.0088
10 0.2366 0.3130 0.3892 0.4653 0.5415 0.6177 0.6938 0.7699 0.8461 0.9222 0.9983
17.2
Table 17.10 Net present value, NPV, in 2012, million dollars

Leverage level L
2 267.0 200.9 33.4 214.0 525.3 888.3 1293.4 1733.4 2202.4 2695.8 3209.9
5 1734.8 1968.9 1954.6 1771.8 1472.1 1089.6 647.1 160.6 358.9 903.4 1467.2
7 2304.7 2566.9 2528.9 2304.4 1960.4 1537.2 1060.3 545.9 4.7 556.0 1131.2
10 2812.6 3041.6 2945.5 2667.4 2281.9 1829.9 1335.0 811.1 266.8 292.2 862.1
351
NPV
5000
3000
1000
0 L
4
–1000 3
2
–3000
1
–5000
0 1 2 3 4 5 6
Fig. 17.4 Dependence of NPV on leverage L at t ¼ 20% in 2012: 1 for 2-year income from
investments; 2 for 5-year income from investments (the term for hardware depreciation); 3 for
7 years of investment income; 4 for 10 years of investment income
tabulation of obtained results by the known values k0 and kd for large values β 1,
when in dependence of NPV(L) there is an optimum.
With the further increase of the return on investment (β ¼ 2), NPV of the project
has an optimum for all values S at leverage level which is already approximately
equal to L ¼ 1.8, and the value of optimum as well as of NPV in general is growing
with increasing S, until the project remains an effective (up to leverage level of order
L ¼ 8.5, see Fig. 17.9).
In this way, the analysis of the dependence of NPV on the equity value S and on
the return on investment β allows us to conclude that in contrast to the parameters
I and NOI, the change of parameters S and β, both individually and simultaneously,
can significantly change the nature of the dependence of NPV on leverage level.
With the increase of return on investment (with the increased β), there is a
transition from the monotonic decrease of NPV of the project with leverage
(Fig. 17.7) to the existence of the optimum at all values of S (see Figs. 17.6 and
17.8). The growth of β leads to the growth of NPV as well as to the growth of the
limit leverage value, up to which the project remains effective.
This means the inability of tabulation of the results, obtained in the general case
of a constant value of equity capital; in this case, it is necessary to use the formulas
obtained by authors in their works (Brusov and Filatova 2011; Brusov et al. 2011a,
b, c, 2012a, b, 2013a, b, 2014a, b; Filatova et al. 2008) to determine the NPV at the
existing leverage level as well as for optimization of existing investment structure.
Tabulation is possible only in the case of large β values (β 1), when there is an
optimum in the dependence of NPV on the leverage level.
17.2
Table 17.11 Net present value, NPV, at leverage level from 0.5 up to 1.05 in 2012, million dollars
Leverage level L
Project duration n 0.5 0.55 0.6 0.65 0.7 0.75 0.8 0.85 0.9 0.95 1 1.05
2 200.9 188.3 174.8 160.2 144.8 128.4 111.1 92.9 73.9 54.1 33.4 12.0
5 1968.9 1977.0 1982.8 1986.3 1987.7 1987.0 1984.2 1979.5 1973.0 1964.6 1954.6 1942.8
7 2566.9 2574.2 2578.8 2580.6 2580.0 2576.9 2571.5 2563.9 2554.2 2542.5 2528.9 2513.5
10 3041.6 3043.5 3042.4 3038.5 3032.0 3023.1 3011.7 2998.2 2982.6 2965.0 2945.5 2924.3
353
NPV
4000
3000 4
2000 2
1000
1
0 L
0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2
Fig. 17.5 Dependence of NPV on leverage L at t ¼ 20% in 2012 in the vicinity of optimum: 1 for
2-year income from investments; 2 for 5-year income from investments (the term for hardware
depreciation); 3 for 7 years of investment income; 4 for 10 years of investment income
17.3 Effects of Taxation on the Optimal Capital Structure

of Companies in the Telecommunication Sector
We continue the analysis of activity of “Nastcom Plus.” In this paragraph, we

examine the effect of change of tax on profit rate, both in the case of its increase
and decrease, on the optimal structure of investments at different project durations.
It is shown that the increase of tax on profit rate leads to the degradation
(decreasing) of NPV, and the degradation is reduced with an increase of project
duration. In particular, for the 5-year project (amortization period), when the tax on
profit rate decreases to 1%, NPV decreases to 1.5–2.34% in different years.
The impact of change of tax on the profit rate on the optimum position while it
exists (change optimum position) is changed for 2-year and 10-year projects in 2010
and for the 5-year project in 2012 [for 0.5–1 (in L units)]; nevertheless the optimum
position turns out to be sufficiently stable (Figs. 17.10, 17.11, 17.12, 17.13, 17.14,
17.15, 17.16, 17.17, 17.18, 17.19, 17.20, and 17.21; Tables 17.16, 17.17, 17.18,
17.19, 17.20, and 17.21).
It is shown that the increase of tax on profit rate leads to the degradation
(decreasing) of NPV, and the degradation is reduced with an increase of project
duration. Note that for the 5-year project (amortization period), when the tax on
profit rate decreases by 1%, NPV decreases by 2.34% in 2012, by 2.04% in 2011,
and by 1.49% in 2010.
17.3
Table 17.12 Net present value, NPV, at β ¼ 1.02, million dollars

Leverage level L
Equity S 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
1382 1734.8 1968.9 1954.6 1771.8 1472.1 1089.6 647.1 160.6 358.9 903.4 1467.2
1000 1255.7 1425.2 1414.8 1282.5 1065.6 788.7 468.4 116.2 259.8 653.9 1062.0
1200 1506.8 1710.2 1697.8 1539.0 1278.7 946.4 562.1 139.5 311.8 784.7 1274.4
1600 2009.1 2280.3 2263.7 2052.0 1705.0 1261.9 749.5 186.0 415.7 1046.3 1699.2
1800 2260.3 2565.3 2546.7 2308.5 1918.1 1419.7 843.2 209.2 467.6 1177.1 1911.6
Effects of Taxation on the Optimal Capital Structure of Companies in. . .
355
356
17

Leverage level L
Equity S 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
1382 146.1 71.8 411.5 833.8 1313.3 1833.5 2383.1 2954.2 3541.6 4141.1 4750.2
1000 105.7 52.0 297.9 603.5 950.7 1327.2 1725.0 2138.4 2563.6 2997.6 3438.4
1200 126.9 62.4 357.4 724.2 1140.8 1592.6 2070.0 2566.1 3076.3 3597.1 4126.1
1600 169.2 83.2 476.6 965.6 1521.0 2123.5 2760.0 3421.5 4101.7 4796.1 5501.4
1800 190.3 93.6 536.2 1086.3 1711.2 2388.9 3105.0 3849.2 4614.4 5395.6 6189.1
17.3

Leverage level L
Equity S 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
1382 3201.2 3852.6 4138.6 4176.9 4043.3 3787.8 3444.2 3035.8 2578.9 2085.3 1563.3
1000 2317.2 2788.7 2995.8 3023.5 2926.8 2741.8 2493.1 2197.5 1866.7 1509.4 1131.6
1200 2780.7 3346.5 3594.9 3628.2 3512.1 3290.2 2991.7 2637.0 2240.1 1811.3 1357.9
1600 3707.5 4462.0 4793.2 4837.6 4682.8 4386.9 3989.0 3515.9 2986.8 2415.1 1810.6
1800 4171.0 5019.7 5392.4 5442.3 5268.2 4935.3 4487.6 3955.4 3360.1 2716.9 2036.9
Effects of Taxation on the Optimal Capital Structure of Companies in. . .
357
358
17

Leverage level L
Equity S 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
1382 4728.8 5814.9 6413.7 6682.3 6721.7 6598.5 6357.9 6030.8 5639.2 5198.5 4720.0
1000 3423.0 4209.1 4642.6 4837.0 4865.5 4776.3 4602.2 4365.4 4081.9 3762.9 3416.6
1200 4107.5 5050.9 5571.1 5804.4 5838.6 5731.6 5522.6 5238.5 4898.3 4515.5 4099.9
1600 5476.7 6734.5 7428.1 7739.2 7784.8 7642.1 7363.4 6984.7 6531.1 6020.6 5466.6
1800 6161.3 7576.4 8356.6 8706.6 8757.9 8597.4 8283.9 7857.8 7347.4 6773.2 6149.9
17.3 Effects of Taxation on the Optimal Capital Structure of Companies in. . . 359
NPV
4000 4
5
2000
1 2 3
1000
–1000
–2000 L
1 2 3 4 5 6
Fig. 17.6 Dependence of NPV on leverage at different values of equity cost S at β ¼ 1.02, million
dollars: 1 S ¼ 1382.2 million dollars; 2 S ¼ 1000 million dollars; 3 S ¼ 1200 million dollars; 4
S ¼ 1600 million dollars; 5 S ¼ 1800 million dollars
NPV
1000
0
–1000
–2000
–3000
2
–4000 3
–5000 1
4
–6000
5
–7000 L
1 2 3 4 5 6
NPV
6000
5000
4000
3000
5
2000 4
1
3
1000 2
0 L
1 2 3 4 5 6
NPV
10000
9000
8000
7000
6000
5000
4000
3000
2000
1000
0 L
1 2 3 4 5 6
Fig. 17.9 Dependence of NPV on leverage at different values of equity cost S at β ¼ 2, million
NPV 2010, n=2

2500.00
2000.00
T=0.15
1500.00 T=0.2
NPV
T=0.25
1000.00
500.00
0.00
0 2 4 6
L
Fig. 17.10 Dependence of NPV on leverage level L for three values of tax on profit rate: T ¼ 15%,
20%, 25% for the 2-year project in 2010
NPV 2010, n=5

4500.00
4000.00
3500.00
3000.00
2500.00
NPV
T=0.15
2000.00
T=0.2
1500.00
T=0.25
1000.00
500.00
0.00
0 2 4 6
L
Fig. 17.11 Dependence of NPV on leverage level L for three values of tax on profit rate: T ¼ 15%,
20%, 25% for the 5-year project in 2010
Fig. 17.12 Dependence of NPV 2010, n=7

NPV on leverage level L for 5000.00
three values of tax on profit 4500.00
rate: T ¼ 15%, 20%, 25% 4000.00
for the 7-year project 3500.00
in 2010 3000.00
NPV
2500.00 T=0.15
2000.00 T=0.2
1500.00
T=0.25
1000.00
500.00
0.00
0 1 2 3 4 5 6
L

rate: T ¼ 15%, 20%, 25%
in 2010
NPV
3000.00 T=0,15
T=0,2
2000.00
T=0,25
1000.00
0.00
0 2 4 6
L

three values of tax on profit
rate: T ¼ 15%, 20%, 25% 500.00
for the 2-year project
0.00
in 2011
0 2 4 6
NPV
T=0.15
–500.00
T=0.2
–1000.00 T=0.25
–1500.00
–2000.00
L

rate: T ¼ 15%, 20%, 25%
in 2011
NPV
1500.00 T=0.15
1000.00 T=0.2
T=0.25
500.00
0.00
0 1 2 3 4 5 6
–500.00
L

rate: T ¼ 15%, 20%, 25%
in 2011
NPV
2000.00
T=0.15
1500.00
T=0.2
1000.00 T=0.25
500.00
0.00
0 1 2 3 4 5 6
L

rate: T ¼ 15%, 20%, 25% 3000.00
2500.00
in 2011
NPV
2000.00 T=0.15
1500.00 T=0.2
1000.00 T=0.25
500.00
0.00
0 1 2 3 4 5 6
L

rate: T ¼ 15%, 20%, 25% 0.00
for the 2-year project –500.00 0 2 4 6
in 2012 –1000.00 T=0.15
NPV
–1500.00
T=0.2
–2000.00
T=0.25
–2500.00
–3000.00
–3500.00
–4000.00
L

rate: T ¼ 15%, 20%, 25% 1500.00
in 2012 1000.00
500.00 T=0.15
NPV
0.00 T=0.2
0 2 4 6 T=0.25
–500.00
–1000.00
–1500.00
–2000.00
L

rate: T ¼ 15%, 20%, 25% 2500.00
in 2012 1500.00
T=0.15
NPV
1000.00
500.00 T=0.2
0.00 T=0.25
–500.00 0 1 2 3 4 5 6
–1000.00
–1500.00
–2000.00
L

rate: T ¼ 15%, 20%, 25% 3000.00
in 2012 2000.00
T=0.15
NPV
1500.00
1000.00 T=0.2
500.00 T=0.25
0.00
–500.00 0 2 4 6
–1000.00
–1500.00
L
Table 17.16 Dependence of n

optimum position L0 of
2010, t (%) 2 5 7 10
investment structure in 2010
on tax on profit rate and 15 3 2 2 2
project duration 20 2 2 2 1.5
25 2 2 2 2
Table 17.17 Absolute and 2010 t ¼ 20–15% t ¼ 25–20% On 5% (%) On 1% (%)

relative change of NPV with
n¼2 418/487 204 34 6.8
increase/decrease of tax on
profit rate on 5% (1%) in 2010 5 266 273 7.45 1.49
7 263 271 6.88 1.37
10 245 256 5.56 1.11

2011, t (%) 2 5 7 10
on tax on profit rate and 15 0.5 1 1 1
project duration 20 0.5 1 1 1
25 0.5 1 1 1

n¼2 119 118 25.8 5.16
profit rate on 5% (1%) in 2011 5 222 223 10.2 2.04
7 236 239 8.75 1.75
10 238 242 7.7 1.54

2012, t (%) 2 5 7 10
on tax on profit rate and 15 0 1 0.5 0.5
project duration 20 0 0.5 0.5 0.5
25 0 0.5 0.5 0.5

n¼2 104 103 39 7.8
profit rate on 5% (1%) in 2012 5 229 229 11.7 2.34
7 253 256 9.9 1.98
10 269 271 8.9 1.74
17.4 Conclusions
In 2010, the company “Nastcom Plus” worked at leverage level L ¼ 0.54 instead of
optimal value L ¼ 2.0. The NPV loss amounted to 645 million dollars.
In 2012, the company worked at leverage level L ¼ 1.0 instead of optimal value
L ¼ 0.7. The NPV loss amounted from 32 to 98 million dollars, depending on the
term of operation of equipment.
The authors have evaluated effectiveness of investment at existing level of debt
financing and have developed recommendations on the optimum level of leverage
for the Russian company “Nastcom Plus” in 2010–2012.
The results indicate that if in 2011 the financial structure of the investment of
“Nastcom Plus” was close to the optimal and NPV was only 2 million dollars less
than the optimal value, in 2010, when the leverage level was L ¼ 0.54, NPV was
645 million dollars less than optimal value (the optimal leverage level should be
equal to L ¼ 2).
In 2012 the leverage level, with which “Nastcom Plus” has carried out its
investment projects (L ¼ 0.1), did not correspond to optimum value (L ¼ 0.7) and
provided NPV ¼ 1954.6 million dollars, which is 31.7 million dollars less than the
optimal value of NPV (Tables 17.10 and 17.11; Figs. 17.4 and 17.5).
Since the equipment can be operated after depreciation, one can estimate the NPV
for a more long-term perspective. For example, for the 7-year project, the optimal
leverage value is L ¼ 0.65, when the NPV ¼ 2580.6 million dollars, which is 51.7
million dollars more than nonoptimal values of NPV ¼ 2528.9 million dollars,
obtained by the company. For the 10-year project, the optimal leverage level
L ¼ 0.55, with NPV ¼ 3043.5 million dollars, which is 98 million dollars more
than nonoptimal values of NPV ¼ 2945.5 million dollars, obtained by the company.
References
capital structure of the company. Financ and Credit 435:2–8
(11):815–824
structure, different from suggested by trade off theory. Cogent Econ Financ 2:1–13. https://doi.
org/10.1080/23322039.2014.946150
Brusov P, Filatova T, Orehova N, Kulk, Weil I (2018a) New meaningful effects in modern capital
7:37–62
Econ Rev 53:147–175
1954–1957. Am Econ Rev 56:333–391
Chapter 18
The Golden Age of the Company (Three
Colors of Company’s Time)
In this chapter we return back to corporate finance in order to describe a very

important discovery, made by us recently (Brusov et al. 2015a, b). We investigate
the dependence of attracting capital cost on the age of company n at various leverage
levels, at various values of capital costs with the aim of define of minimum cost of
attracting capital. All calculations have been done within modern theory of capital
cost and capital structure by Brusov–Filatova–Orekhova (Brusov and Filatova 2011;
Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b, 2015a, b, 2018a, b, c, d;
Filatova et al. 2008; Brusova 2011).
It is shown for the first time that valuation of weighted average cost of capital
(WACC) in the Modigliani–Miller theory (Мodigliani and Мiller 1958, 1963,
1966) is not minimal and valuation of the company capitalization is not maxi-
mal, as all financiers supposed up to now: at some age of the company, its WACC
value turns out to be lower than in Modigliani–Miller theory, and company
capitalization V turns out to be greater than V in Modigliani–Miller theory.
It is shown that, from the point of view of cost of attracting capital, there are two
types of dependences of WACC on the age of company n: monotonic descending of
WACC with n and descending of WACC with passage through minimum, followed
by a limited growth (Brusov et al. 2015a, b). The companies with the latter type of
dependence of WACC on the age of company n can take advantage of the benefits
given at a certain stage of development by discovered effect. Moreover, since the
“golden age” of company depends on the company’s capital costs, ke and kd, by
controlling them (e.g., by modifying the value of dividend payments that reflect the
equity cost, etc.), the company may extend its “golden age” when the cost to attract
capital becomes minimal (less than perpetuity limit) and the capitalization of com-
panies becomes maximal (above than perpetuity assessment) up to a specified time
interval.
It has been concluded that existing presentations concerning the results of the
theory of Modigliani–Miller (Мodigliani and Мiller 1958, 1963, 1966) in these
aspects are incorrect. We discuss the use of opened effects in economics.

https://doi.org/10.1007/978-3-319-99686-8_18
368 18 The Golden Age of the Company (Three Colors of Company’s Time)
18.1 Introduction
It is well known that the company goes through several stages in its development
process: adolescence, maturity, and old age. Within the modern theory of capital cost
and capital structure by Brusоv–Filаtоvа–Orekhоvа (BFO theory) (Brusov and
Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b; Filatova
et al. 2008; Brusova 2011), it is shown that the problem of the company development
has an interpretation, which is absolutely different from the generally accepted one.
One of the most important problems in corporate finance is the problem of capital
cost and capital structure. Before 2008 there were just two kinds of valuations of cost
of capital: the first one was the first quantitative theory by Nobel Prize winners
Мodigliani and Мiller (1958, 1963, 1966), applicable to perpetuity (with infinite
lifetime) companies, and the second one was the valuation applicable to 1-year
companies by Steve Myers (1984).
So, before 2008, when the modern theory of capital cost and capital structure by
Brusоv–Filаtоvа–Orekhоvа (BFO theory) has been created (Brusov and Filatova
2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b; Filatova et al. 2008;
Brusova 2011), only two points in time interval have been known: 1 year and
infinity. At that time Steve Myers (1984) has supposed that the Modigliani–Miller
(MM) theory (Мodigliani and Мiller 1958, 1963, 1966) gave the lowest assessment
for WACC and consequently, the highest assessment for company capitalization.
This means that the WACC monotonically descends with the time of life of
company, n, approaching its perpetuity limit (Fig. 18.1), and, consequently, com-
pany capitalization monotonically increases, approaching its perpetuity limit
(Fig. 18.3).
Created in 2008 the modern theory of capital cost and capital structure by
Brusоv–Filаtоvа–Orekhоvа (BFO theory) (Brusov and Filatova 2011; Brusov
et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b; Filatova et al. 2008; Brusova
2011) turned out to be able to make valuation of capital cost and company
Fig. 18.1 Monotonic WACC

dependence of WACC on M
the lifetime (age) of the WACC1
company n
BFO
MM
WACC
0 1 n
18.1 Introduction 369
capitalization for companies with arbitrary lifetime (of arbitrary age): this completes
the whole time interval from n ¼ 1 up to n ¼ 1. A lot of qualitative effects in
corporate finance, investments, taxations, etc. have been made within BFO theory.
In this chapter with BFO theory, it is shown that Steve Myers’ suggestion (Myers
1984) turns out to be wrong.
Choosing of optimal capital structure of the company, i.e., proportion of debt and
equity, which minimizes the weighted average cost of capital and maximizes the
company capitalization, is one of the most important tasks of financial manager and
the management of a company. The search for an optimal capital structure attracts
the attention of economists and financiers during many tens of years. And it is clear
why one can, nothing making but only by changing the proportion between the
values of equity capital and debt of the company, significantly enhance the company
capitalization, in other words fulfill the primary task, to reach the critical goal of
business management. Spend a little less of your own, loan slightly more (or vice
versa), and company capitalization reaches a maximum.
Before, the search for an optimal capital structure was made by studying the
dependence of WACC on leverage level in order to determine the optimal leverage
level L0, at which the WACC is minimal and capitalization V is maximal. Here we
apply an absolutely different method, studying the dependence of WACC on the time
of life (age) of company n. Note that before the appearance of BFO theory, study of
such kind of dependences was impossible due the absence of “time” parameter in
perpetuity Modigliani–Miller theory (Мodigliani and Мiller 1958, 1963, 1966).
As it is shown in this chapter, from the point of view of cost of capital, there are two
types of dependences of WACC on the time of life (age) of company n: monotonic
descending of WACC with n and descending of WACC with passage through
minimum, followed by a limited growth (Figs. 18.1 and 18.2) (Brusov et al. 2015a, b).
The first type of behavior is linked with the comment by Myers (1984) that the
Modigliani–Miller (MM) theory (Мodigliani and Мiller 1958, 1963, 1966) gives the
lowest assessment for WACC that, as shown by us within the BFO theory, is,

WACC on the lifetime (age)
M
of the company n, showing WACC 1
descending of WACC with
passage through minimum
and then showing a limited
growth to perpetuity
(MM) limit
BFO MM
WACC
WACC 0
0 1 n0 n
CC, V
2'
V
V 1'
WACC 1
k0(1-wd t )
2
0 1 n0 n
Fig. 18.3 Two kinds of dependences of WACC and company capitalization, V, on the lifetime
(age) of the company n ¼ 1–10 , monotonic descending of WACC and monotonic increase of
company capitalization, V, with the lifetime of the company n ¼ 2–20 descending of WACC with
passage through minimum and then showing a limited growth and increase of V with passage
through maximum (at n0) and then a limited descending to perpetuity (MM) limit
generally speaking, incorrect. The second type of behavior of dependence of WACC

on the time of life (age) of company n is descending of WACC with passage through
minimum, followed by a limited growth.
Thus, in the general case, the comment by Myers (1984) turns out to be wrong,
and in the life of company, there is a “golden age” or “the golden century” when the
cost of attracting capital becomes minimal and company capitalization becomes
maximal (Figs. 18.2 and 18.3) (Brusov et al. 2015a, b). In the life of company, the
same number of stages as usual can be allocated: youth, maturity, and old age. In
youth the WACC decreases with n, in the maturity the value of attracting capital cost
becomes minimal, and in the old age this cost grows, approaching its perpetuity
limit.
So, figuratively speaking, a current investigation transforms “black and white
business world” (with monotonic descending of WACC with the time of life of
company n) into “color business world” (with descending of WACC with n with
passage through minimum, followed by a limited growth): really there are three
colors of company’s time.
The conclusion made in this chapter for the first time that the assessment of the
WACC in the theory of Modigliani and Miller (MM) (Мodigliani and Мiller
1958, 1963, 1966) is not the minimal and capitalization is not maximal seems to
be very significant and important.
18.2 Dependence of WACC on the Age of the Company n at Different Leverage Levels 371
18.2 Dependence of WACC on the Age of the Company n at

Different Leverage Levels
In this section we study the dependence of WACC on the age of the company n at
different leverage levels.
For L ¼ 1 one has
For L ¼ 2 we have
For L ¼ 3 one has
For L ¼ 5 one has
For L ¼ 7 one has
The analysis in Tables 18.1, 18.2, 18.3, 18.4, and 18.5 and Fig. 18.4 allows us to
make the following conclusions:
1. In all examined cases (at all leverage levels), at current values of capital costs
(equity, k0, and debt, kd, ones), the second type of behavior of dependence of
WACC on the lifetime (age) of the company, n, takes place, namely, descending
of WACC with n with passage through minimum with subsequent limited
growth.
Table 18.1 Dependence of L WACC k0 kd wd t n ke

WACC on the age of the
1 0.1843 0.2 0.15 0.5 0.2 1 0.2487
company n at L ¼ 1
1 0.1798 0.2 0.15 0.5 0.2 2 0.2397
1 0.1780 0.2 0.15 0.5 0.2 3 0.2360
1 0.1772 0.2 0.15 0.5 0.2 4 0.2345
1 0.1769 0.2 0.15 0.5 0.2 5 0.2339
1 0.1769 0.2 0.15 0.5 0.2 6 0.2338
1 0.1770 0.2 0.15 0.5 0.2 7 0.2340
1 0.1771 0.2 0.15 0.5 0.2 8 0.2343
1 0.1773 0.2 0.15 0.5 0.2 9 0.2346
1 0.1775 0.2 0.15 0.5 0.2 10 0.2351

2 0.1791 0.2 0.15 0.66667 0.2 1 0.2974
company n at L ¼ 2
2 0.1731 0.2 0.15 0.66667 0.2 2 0.2793
2 0.1706 0.2 0.15 0.66667 0.2 3 0.2719
2 0.1696 0.2 0.15 0.66667 0.2 4 0.2687
2 0.1692 0.2 0.15 0.66667 0.2 5 0.2675
2 0.1691 0.2 0.15 0.66667 0.2 6 0.2672
2 0.1692 0.2 0.15 0.66667 0.2 7 0.2675
2 0.1694 0.2 0.15 0.66667 0.2 8 0.2681
2 0.1696 0.2 0.15 0.66667 0.2 9 0.2689
2 0.1699 0.2 0.15 0.66667 0.2 10 0.2697

3 0.1765 0.2 0.15 0.75 0.2 1 0.3461
company n at L ¼ 3
3 0.1697 0.2 0.15 0.75 0.2 2 0.3189
3 0.1669 0.2 0.15 0.75 0.2 3 0.3078
3 0.1657 0.2 0.15 0.75 0.2 4 0.3029
3 0.1653 0.2 0.15 0.75 0.2 5 0.3010
3 0.1651 0.2 0.15 0.75 0.2 6 0.3006
3 0.1653 0.2 0.15 0.75 0.2 7 0.3010
3 0.1655 0.2 0.15 0.75 0.2 8 0.3019
3 0.1658 0.2 0.15 0.75 0.2 9 0.3030
3 0.1661 0.2 0.15 0.75 0.2 10 0.3042

5 0.1739 0.2 0.15 0.83333 0.2 1 0.4435
company n at L ¼ 5
5 0.1663 0.2 0.15 0.83333 0.2 2 0.3980
5 0.1632 0.2 0.15 0.83333 0.2 3 0.3795
5 0.1619 0.2 0.15 0.83333 0.2 4 0.3713
5 0.1613 0.2 0.15 0.83333 0.2 5 0.3680
5 0.1612 0.2 0.15 0.83333 0.2 6 0.3672
5 0.1613 0.2 0.15 0.83333 0.2 7 0.3679
5 0.1615 0.2 0.15 0.83333 0.2 8 0.3693
5 0.1619 0.2 0.15 0.83333 0.2 9 0.3711
5 0.1622 0.2 0.15 0.83333 0.2 10 0.3732

7 0.1726 0.2 0.15 0.875 0.2 1 0.5409
company n at L ¼ 7
7 0.1646 0.2 0.15 0.875 0.2 2 0.4771
7 0.1614 0.2 0.15 0.875 0.2 3 0.4511
7 0.1599 0.2 0.15 0.875 0.2 4 0.4396
7 0.1594 0.2 0.15 0.875 0.2 5 0.4349
7 0.1592 0.2 0.15 0.875 0.2 6 0.4338
7 0.1593 0.2 0.15 0.875 0.2 7 0.4347
7 0.1596 0.2 0.15 0.875 0.2 8 0.4366
7 0.1599 0.2 0.15 0.875 0.2 9 0.4392
7 0.1603 0.2 0.15 0.875 0.2 10 0.4421
2. The minimum cost of attracting capital (WACC) is achieved at all leverage levels
at the same company’s age at n ¼ 6 (only when L ¼ 1, minimum is spread for
2 years (n ¼ 5 and n ¼ 6)).
3. The value of minimum WACC, at a fixed n, significantly depends on the level of
leverage, L, and, of course, decreases with increasing L.
18.3 Dependence of WACC on the Age of the Company n at Different. . . 373
WACC(n)
0.1900
0.1850
0.1800
L=1
WACC
0.1750
L=2
0.1700 L=3
0.1650 L=5
0.1600 L=7
0.1550
0 2 4 6 8 10 12
n
Fig. 18.4 Dependence of WACC on the age of the company n at different leverage levels

1 0.0758 0.08 0.04 0.5 0.2 1 0.1197
company n at L ¼ 1, k0 ¼ 8%,
kd ¼ 4% 1 0.0745 0.08 0.04 0.5 0.2 2 0.1170
1 0.0738 0.08 0.04 0.5 0.2 3 0.1157
1 0.0735 0.08 0.04 0.5 0.2 4 0.1149
1 0.0732 0.08 0.04 0.5 0.2 5 0.1144
1 0.0731 0.08 0.04 0.5 0.2 6 0.1141
1 0.0729 0.08 0.04 0.5 0.2 7 0.1139
1 0.0729 0.08 0.04 0.5 0.2 8 0.1137
1 0.0728 0.08 0.04 0.5 0.2 9 0.1136
1 0.0728 0.08 0.04 0.5 0.2 10 0.1135

Different Values of Capital Costs (Equity, k0,
and Debt, kd) and Fixed Leverage Levels
The analysis in Tables 18.6, 18.7, 18.8, and 18.9 and Figs. 18.5 and 18.6 allows us to
make the following conclusions:
1. The type of behavior of dependence of WACC on the age of the company, n, at
fixed leverage level significantly depends on values of capital costs (equity, k0,
and debt, kd). At the values of capital costs that are specific to developing
countries (including Russia) (k0 ¼ 20%, kd ¼ 15%), there is a second type of
dependence of WACC on the age of the company, n, namely, descending of
WACC with n with passage through minimum with subsequent limited growth.
And at the capital cost values, characteristic to the West (k0 ¼ 8%, kd ¼ 4%), there

1 0.1843 0.2 0.15 0.5 0.2 1 0.2487
company n at L ¼ 1,
k0 ¼ 20%, kd ¼ 15% 1 0.1798 0.2 0.15 0.5 0.2 2 0.2397
1 0.1780 0.2 0.15 0.5 0.2 3 0.2360
1 0.1772 0.2 0.15 0.5 0.2 4 0.2345
1 0.1769 0.2 0.15 0.5 0.2 5 0.2339
1 0.1769 0.2 0.15 0.5 0.2 6 0.2338
1 0.1770 0.2 0.15 0.5 0.2 7 0.2340
1 0.1771 0.2 0.15 0.5 0.2 8 0.2343
1 0.1773 0.2 0.15 0.5 0.2 9 0.2346
1 0.1775 0.2 0.15 0.5 0.2 10 0.2351

3 0.1765 0.2 0.15 0.75 0.2 1 0.3461
k0 ¼ 20%, kd ¼ 15% 3 0.1697 0.2 0.15 0.75 0.2 2 0.3189
3 0.1669 0.2 0.15 0.75 0.2 3 0.3078
3 0.1657 0.2 0.15 0.75 0.2 4 0.3029
3 0.1653 0.2 0.15 0.75 0.2 5 0.3010
3 0.1651 0.2 0.15 0.75 0.2 6 0.3006
3 0.1653 0.2 0.15 0.75 0.2 7 0.3010
3 0.1655 0.2 0.15 0.75 0.2 8 0.3019
3 0.1658 0.2 0.15 0.75 0.2 9 0.3030
3 0.1661 0.2 0.15 0.75 0.2 10 0.3042

3 0.0738 0.08 0.04 0.75 0.2 1 0.1991
company n at L ¼ 3, k0 ¼ 8%,
kd ¼ 4% 3 0.0717 0.08 0.04 0.75 0.2 2 0.1909
3 0.0707 0.08 0.04 0.75 0.2 3 0.1870
3 0.0702 0.08 0.04 0.75 0.2 4 0.1847
3 0.0698 0.08 0.04 0.75 0.2 5 0.1832
3 0.0696 0.08 0.04 0.75 0.2 6 0.1822
3 0.0694 0.08 0.04 0.75 0.2 7 0.1815
3 0.0693 0.08 0.04 0.75 0.2 8 0.1810
3 0.0692 0.08 0.04 0.75 0.2 9 0.1806
3 0.0691 0.08 0.04 0.75 0.2 10 0.1803
is a first type of dependence of WACC on the age of company n, namely, the

monotonic descending of WACC with n.
Current suggestion has been made before the detailed investigation of
condition of existing of gold age effect has been done. As we will see in the
next chapter, the existence of the “golden age” of company does not depend on
the value of capital costs of the company, but depends on the difference value
between equity, k0, and debt, kd, costs.
WACC(n)
0.2000
0.1800
0.1600
0.1400
WACC
0.1200
0.1000
0.0800 k0=0.2; kd=0.15
0.0600
k0=0.08, kd=0.04
0.0400
0.0000
0.0000
0 2 4 6 8 10 12
n
Fig. 18.5 Dependence of WACC on the age of the company n at different values of capital costs
(equity, k0, and debt, kd, ones) and fixed leverage level L ¼ 1
WACC(n)
0.2000
0.1500
WACC
0.1000
k0=0.2; kd=0.15
0.0500 k0=0.08, kd=0.04
0.0000
0 2 4 6 8 10 12
n
Fig. 18.6 Dependence of WACC on the age of the company n at different values of capital costs
(equity, k0, and debt, kd) and fixed leverage level L ¼ 3
2. The same features are observed in both considering cases: at the leverage values
L ¼ 1 and L ¼ 3.
Put L ¼ 3.

Different Values of Debt Capital Cost, kd, and Fixed
Equity Cost, k0, and Fixed Leverage Levels
different values of debt capital cost, kd, and fixed equity cost, k0, and fixed leverage
levels.
Put first L ¼ 1.
The analysis in Tables 18.10, 18.11, 18.12, 18.13, 18.14, 18.15, 18.16, and 18.17
and Figs. 18.7 and 18.8 allows us to make the following conclusions:
1. At fixed equity cost, k0, and at fixed leverage level, the type of behavior of
dependence of WACC on the age of the company, n, significantly depends on

1 0.1843 0.2 0.15 0.5 0.2 1 0.2487
k0 ¼ 20%, kd ¼ 15% 1 0.1798 0.2 0.15 0.5 0.2 2 0.2397
1 0.1780 0.2 0.15 0.5 0.2 3 0.2360
1 0.1772 0.2 0.15 0.5 0.2 4 0.2345
1 0.1769 0.2 0.15 0.5 0.2 5 0.2339
1 0.1769 0.2 0.15 0.5 0.2 6 0.2338
1 0.1770 0.2 0.15 0.5 0.2 7 0.2340
1 0.1771 0.2 0.15 0.5 0.2 8 0.2343
1 0.1773 0.2 0.15 0.5 0.2 9 0.2346
1 0.1775 0.2 0.15 0.5 0.2 10 0.2351

1 0.1871 0.2 0.12 0.5 0.2 1 0.2783
k0 ¼ 20%, kd ¼ 12% 1 0.1832 0.2 0.12 0.5 0.2 2 0.2705
1 0.1815 0.2 0.12 0.5 0.2 3 0.2670
1 0.1807 0.2 0.12 0.5 0.2 4 0.2653
1 0.1802 0.2 0.12 0.5 0.2 5 0.2644
1 0.1799 0.2 0.12 0.5 0.2 6 0.2639
1 0.1798 0.2 0.12 0.5 0.2 7 0.2636
1 0.1798 0.2 0.12 0.5 0.2 8 0.2636
1 0.1798 0.2 0.12 0.5 0.2 9 0.2635
1 0.1798 0.2 0.12 0.5 0.2 10 0.2636

1 0.1826 0.2 0.17 0.5 0.2 1 0.2291
k0 ¼ 20%, kd ¼ 17% 1 0.1777 0.2 0.17 0.5 0.2 2 0.2194
1 0.1759 0.2 0.17 0.5 0.2 3 0.2158
1 0.1752 0.2 0.17 0.5 0.2 4 0.2144
1 0.1750 0.2 0.17 0.5 0.2 5 0.2141
1 0.1751 0.2 0.17 0.5 0.2 6 0.2143
1 0.1754 0.2 0.17 0.5 0.2 7 0.2148
1 0.1757 0.2 0.17 0.5 0.2 8 0.2154
1 0.1760 0.2 0.17 0.5 0.2 9 0.2160
1 0.1763 0.2 0.17 0.5 0.2 10 0.2167

1 0.1891 0.2 0.1 0.5 0.2 1 0.2982
k0 ¼ 20%, kd ¼ 10% 1 0.1857 0.2 0.1 0.5 0.2 2 0.2913
1 0.1841 0.2 0.1 0.5 0.2 3 0.2881
1 0.1832 0.2 0.1 0.5 0.2 4 0.2864
1 0.1827 0.2 0.1 0.5 0.2 5 0.2853
1 0.1823 0.2 0.1 0.5 0.2 6 0.2846
1 0.1821 0.2 0.1 0.5 0.2 7 0.2842
1 0.1819 0.2 0.1 0.5 0.2 8 0.2838
1 0.1818 0.2 0.1 0.5 0.2 9 0.2836
1 0.1817 0.2 0.1 0.5 0.2 10 0.2834

3 0.1765 0.2 0.15 0.75 0.2 1 0.3461
k0 ¼ 20%, kd ¼ 15% 3 0.1697 0.2 0.15 0.75 0.2 2 0.3189
3 0.1669 0.2 0.15 0.75 0.2 3 0.3078
3 0.1657 0.2 0.15 0.75 0.2 4 0.3029
3 0.1653 0.2 0.15 0.75 0.2 5 0.3010
3 0.1651 0.2 0.15 0.75 0.2 6 0.3006
3 0.1653 0.2 0.15 0.75 0.2 7 0.3010
3 0.1655 0.2 0.15 0.75 0.2 8 0.3019
3 0.1658 0.2 0.15 0.75 0.2 9 0.3030
3 0.1661 0.2 0.15 0.75 0.2 10 0.3042

3 0.1807 0.2 0.12 0.75 0.2 1 0.4349
k0 ¼ 20%, kd ¼ 12% 3 0.1748 0.2 0.12 0.75 0.2 2 0.4113
3 0.1722 0.2 0.12 0.75 0.2 3 0.4009
3 0.1709 0.2 0.12 0.75 0.2 4 0.3955
3 0.1702 0.2 0.12 0.75 0.2 5 0.3927
3 0.1698 0.2 0.12 0.75 0.2 6 0.3911
3 0.1696 0.2 0.12 0.75 0.2 7 0.3903
3 0.1695 0.2 0.12 0.75 0.2 8 0.3900
3 0.1695 0.2 0.12 0.75 0.2 9 0.3899
3 0.1695 0.2 0.12 0.75 0.2 10 0.3900
value of debt capital cost, kd: with the growth of kd, it is changing from monotonic
descending of WACC with n to descending of WACC with n with passage
through minimum with subsequent limited growth.
2. At kd ¼ 10% and kd ¼ 12% (k0 ¼ 20%), the monotonic descending of WACC
with n is observed, while at higher debt costs, kd ¼ 15% and kd ¼ 17%
(k0 ¼ 20%), descending of WACC with n with passage through minimum with
subsequent limited growth takes place. The optimum age of the company is

3 0.1738 0.2 0.17 0.75 0.2 1 0.2874
k0 ¼ 20%, kd ¼ 17% 3 0.1665 0.2 0.17 0.75 0.2 2 0.2581
3 0.1637 0.2 0.17 0.75 0.2 3 0.2469
3 0.1626 0.2 0.17 0.75 0.2 4 0.2426
3 0.1624 0.2 0.17 0.75 0.2 5 0.2415
3 0.1625 0.2 0.17 0.75 0.2 6 0.2420
3 0.1628 0.2 0.17 0.75 0.2 7 0.2433
3 0.1633 0.2 0.17 0.75 0.2 8 0.2451
3 0.1638 0.2 0.17 0.75 0.2 9 0.2470
3 0.1643 0.2 0.17 0.75 0.2 10 0.2490

3 0.1836 0.2 0.1 0.75 0.2 1 0.4945
k0 ¼ 20%, kd ¼ 10% 3 0.1785 0.2 0.1 0.75 0.2 2 0.4739
3 0.1761 0.2 0.1 0.75 0.2 3 0.4642
3 0.1747 0.2 0.1 0.75 0.2 4 0.4588
3 0.1739 0.2 0.1 0.75 0.2 5 0.4556
3 0.1734 0.2 0.1 0.75 0.2 6 0.4535
3 0.1730 0.2 0.1 0.75 0.2 7 0.4520
3 0.1727 0.2 0.1 0.75 0.2 8 0.4510
3 0.1726 0.2 0.1 0.75 0.2 9 0.4502
3 0.1724 0.2 0.1 0.75 0.2 10 0.4496
WACC(n)
0.1900
0.1880
0.1860
0.1840
WACC
kd=0.15
0.1820
0.1800 kd=0.12
0.1780 kd=0.17
0.1760 kd=0.1
0.1740
0 2 4 6 8 10 12
n
Fig. 18.7 Dependence of WACC on the age of the company n at different values of debt capital
cost, kd, and fixed equity cost, k0, and fixed leverage level L ¼ 1
WACC(n)
0.1850
0.1800
WACC
0.1750 kd=0.15
kd=0.12
0.1700
kd=0.17
0.1650 kd=0.1
0.1600
0 2 4 6 8 10 12
n
Fig. 18.8 Dependence of WACC on the age of the company n at different values of debt capital
cost, kd, and fixed equity cost, k0, and fixed leverage level L ¼ 3
growing with kd decreasing: it is equal to 5 years at kd ¼ 17% and 6 years at

kd ¼ 15%.
3. The conclusions are saved at both considered values of leverage level: L ¼ 1 and
L ¼ 3.
Put then L ¼ 3.

Different Values of Equity Cost, k0, and Fixed Debt
Capital Cost, kd, and Fixed Leverage Levels
different values of equity cost, k0, and fixed debt capital cost, kd, and fixed leverage
levels.
The analysis in Tables 18.18, 18.19, 18.20, 18.21, 18.22, and 18.23 and
Figs. 18.9 and 18.10 allows us to make the following conclusions:
1. At fixed debt capital cost, kd, and at fixed leverage level in all considered cases
(at all equity costs k0 and all leverage levels L ), the second type of dependence of
WACC on the age of the company, n, namely, descending of WACC with n with
passage through minimum with subsequent limited growth, takes place.
2. The “golden age” of the company slightly fluctuates under change of the equity
value k0; these fluctuations are described in Table 18.24 (age is in years).
Put L ¼ 3.

1 0.1646 0.18 0.15 0.5 0.2 1 0.2092
k0 ¼ 18%, kd ¼ 15% 1 0.1602 0.18 0.15 0.5 0.2 2 0.2005
1 0.1585 0.18 0.15 0.5 0.2 3 0.1970
1 0.1578 0.18 0.15 0.5 0.2 4 0.1956
1 0.1576 0.18 0.15 0.5 0.2 5 0.1952
1 0.1576 0.18 0.15 0.5 0.2 6 0.1952
1 0.1578 0.18 0.15 0.5 0.2 7 0.1955
1 0.1580 0.18 0.15 0.5 0.2 8 0.1960
1 0.1583 0.18 0.15 0.5 0.2 9 0.1965
1 0.1585 0.18 0.15 0.5 0.2 10 0.1970

1 0.1843 0.2 0.15 0.5 0.2 1 0.2487
k0 ¼ 20%, kd ¼ 15% 1 0.1798 0.2 0.15 0.5 0.2 2 0.2397
1 0.1780 0.2 0.15 0.5 0.2 3 0.2360
1 0.1772 0.2 0.15 0.5 0.2 4 0.2345
1 0.1769 0.2 0.15 0.5 0.2 5 0.2339
1 0.1769 0.2 0.15 0.5 0.2 6 0.2338
1 0.1770 0.2 0.15 0.5 0.2 7 0.2340
1 0.1771 0.2 0.15 0.5 0.2 8 0.2343
1 0.1773 0.2 0.15 0.5 0.2 9 0.2346
1 0.1775 0.2 0.15 0.5 0.2 10 0.2351

1 0.2041 0.22 0.15 0.5 0.2 1 0.2882
k0 ¼ 22%, kd ¼ 15% 1 0.1994 0.22 0.15 0.5 0.2 2 0.2789
1 0.1975 0.22 0.15 0.5 0.2 3 0.2751
1 0.1967 0.22 0.15 0.5 0.2 4 0.2733
1 0.1963 0.22 0.15 0.5 0.2 5 0.2726
1 0.1962 0.22 0.15 0.5 0.2 6 0.2723
1 0.1962 0.22 0.15 0.5 0.2 7 0.2723
1 0.1962 0.22 0.15 0.5 0.2 8 0.2725
1 0.1964 0.22 0.15 0.5 0.2 9 0.2727
1 0.1965 0.22 0.15 0.5 0.2 10 0.2730

High Values of Capital Cost (Equity, k0, and Debt, kd)
and High Lifetime of the Company
Let us study the dependence of WACC on the age of the company n at high values of
capital cost (equity, k0, and debt, kd) and big age of the company.
18.6 Dependence of WACC on the Age of the Company n at High Values. . . 381

3 0.1569 0.18 0.15 0.75 0.2 1 0.2677
k0 ¼ 18%, kd ¼ 15% 3 0.1503 0.18 0.15 0.75 0.2 2 0.2412
3 0.1477 0.18 0.15 0.75 0.2 3 0.2307
3 0.1466 0.18 0.15 0.75 0.2 4 0.2264
3 0.1462 0.18 0.15 0.75 0.2 5 0.2249
3 0.1462 0.18 0.15 0.75 0.2 6 0.2250
3 0.1464 0.18 0.15 0.75 0.2 7 0.2258
3 0.1468 0.18 0.15 0.75 0.2 8 0.2271
3 0.1471 0.18 0.15 0.75 0.2 9 0.2286
3 0.1475 0.18 0.15 0.75 0.2 10 0.2302

3 0.1765 0.2 0.15 0.75 0.2 1 0.3461
k0 ¼ 20%, kd ¼ 15% 3 0.1697 0.2 0.15 0.75 0.2 2 0.3189
3 0.1669 0.2 0.15 0.75 0.2 3 0.3078
3 0.1657 0.2 0.15 0.75 0.2 4 0.3029
3 0.1653 0.2 0.15 0.75 0.2 5 0.3010
3 0.1651 0.2 0.15 0.75 0.2 6 0.3006
3 0.1653 0.2 0.15 0.75 0.2 7 0.3010
3 0.1655 0.2 0.15 0.75 0.2 8 0.3019
3 0.1658 0.2 0.15 0.75 0.2 9 0.3030
3 0.1661 0.2 0.15 0.75 0.2 10 0.3042

3 0.1961 0.22 0.15 0.75 0.2 1 0.4245
k0 ¼ 22%, kd ¼ 15% 3 0.1891 0.22 0.15 0.75 0.2 2 0.3965
3 0.1862 0.22 0.15 0.75 0.2 3 0.3848
3 0.1849 0.22 0.15 0.75 0.2 4 0.3795
3 0.1843 0.22 0.15 0.75 0.2 5 0.3770
3 0.1840 0.22 0.15 0.75 0.2 6 0.3762
3 0.1840 0.22 0.15 0.75 0.2 7 0.3761
3 0.1841 0.22 0.15 0.75 0.2 8 0.3766
3 0.1843 0.22 0.15 0.75 0.2 9 0.3773
3 0.1845 0.22 0.15 0.75 0.2 10 0.3781
1. At Fixed Leverage Level

From Fig. 18.11 it follows that:
1. In all considered cases (at all leverage levels L) at high values of capital cost
(equity, k0 ¼ 40%, and debt, kd ¼ 35%), the second type of dependence of
WACC on the age of the company, n, namely, descending of WACC with n with
WACC(n)
0.2500
0.2000
WACC
0.1500
k0=0.2
0.1000
k0=0.18
0.0500 k0=0.22
0.0000
0 2 4 6 8 10 12
n
Fig. 18.9 Dependence of WACC on the age of the company n at different values of equity cost, k0,
and fixed debt capital cost, kd, and fixed leverage level L ¼ 1
WACC(n)
0.2500
0.2000
0.1500
WACC
k0=0.2
0.1000 k0=0.18
k0=0.22
0.0500
0.0000
0 2 4 6 8 10 12
n
Fig. 18.10 Dependence of WACC on the age of the company n at different values of equity cost,
k0, and fixed debt capital cost, kd, and fixed leverage level L ¼ 3
Table 18.24 Dependence of k0

“golden age” of the company
L 18% 20% 22%
n on L and k0
1 5–6 5–6 6–8
3 5–6 6 6–7
passage through minimum with subsequent limited growth up to perpetuity limit,

takes place.
2. A minimum value of attracting capital cost (WACC) is achieved at all leverage
levels in the same age, when n ¼ 4. This means that, at high value of capital costs,
WACC(n)
0.3700
0.3600
0.3500 L=1
WACC
0.3400 L=2
L=3
0.3300
L=5
0.3200
L=7
0.3100
0 10 20 30 40 50
n
Fig. 18.11 Dependence of WACC on the age of the company n at high values of capital cost
(equity, k0 ¼ 40%, and debt, kd ¼ 35%) at different leverage levels L (up to high values of lifetime
of the company)
Table 18.25 The difference between the optimal (minimal) value of WACC and its perpetuity
limit
L 1 2 3 5 7
ΔWACC, % 0.72 0.99 1.12 1.25 1.33
the company age, at which minimal value of attracting capital cost is achieved, is
shifted forward lower (younger) values. We just remind that at k0 ¼ 20% and
kd ¼ 15% (see above), the “golden age” was 6 years.
3. The shift of curves to lower values of WACC with increase of leverage level L is
associated with decrease of WACC with leverage.
4. An interesting thing is the analysis of the value of detected effect, i.e., how much
is the difference between the minimum of the attracting capital, found in the BFO
theory, and its perpetuity limit value, which has been considered as minimal value
up to now. In Table 18.25 the dependence of the difference between the minimum
of the attracting capital and its perpetuity limit value on leverage level L is shown.
Perpetuity limit value of WACC is calculated by using Modigliani–Miller for-
mula (Мodigliani and Мiller 1958, 1963, 1966) with accounting of corporate taxes:
WACC ¼ k 0 ð1 wd t Þ ð18:1Þ
From Fig. 18.11, it is seen that at high values of age of company (n 30), the
WACC practically does not differ from its perpetuity limit.
From Table 18.25 it is seen that the gain value is from 0.7% up to 1.5% and grows
with the increase of the leverage level of company, L.
2. Under Change of the Debt Capital Cost, kd

Under change of the debt capital cost, kd, a depth of pit in dependence of WACC on the
age of the company, n, is changed as well: from Fig. 18.12 it is seen that pit (accounted
from perpetuity value) is changed from 0.49% (at kd ¼ 0.3) up to 0.72% (at kd ¼ 0.35).
Note that as it is seen from Fig. 18.12, a perpetuity limit of WACC does not
depend on debt cost, kd, that is in accordance with the Modigliani–Miller formula
(18.1) for WACC, which does not contain a debt capital cost, kd, that means
independence of perpetuity limit of WACC values from kd, while the intermediate
WACC values (for finite lifetime (age) of company, n) depend on the debt capital
cost, kd [see BFO theory (Brusov and Filatova 2011; Brusov et al. 2011a, b, c, 2012a,
b, 2013a, b, 2014a, b; Filatova et al. 2008)].
From Fig. 18.13 it is seen that with the increase of debt cost, kd, the character of
dependence of WACC on the age of the company n is changed from monotonic
descending of WACC with n to descending of WACC with n with passage through
WACC(n)
0.3700
0.3680
0.3660
0.3640
WACC
0.3620
0.3600
0.3580 kd=0.35
0.3560 kd=0.3
0.3540
0.3520
0.3500
0 10 20 30 40 50
n
Fig. 18.12 Dependence of WACC on the age of the company n at fixed high value of equity cost,
k0 ¼ 40%, and two values of debt cost, kd ¼ 30% and 35%, at leverage level L ¼ 1
WACC(n), k0=0.2
19.2000%
19.0000%
18.8000%
18.6000%
18.4000%
WACC
18.2000% Kd=0.18
18.0000% Kd=0.15
17.8000%
Kd=0.10
17.6000%
17.4000% Kd=0.08
17.2000%
0 10 20 30 40 50
n
Fig. 18.13 Dependence of WACC on the age of the company n at fixed value of equity cost,
k0 ¼ 20%, and at four values of debt cost, kd ¼ 8%, 10%, 15%, and 18%, at leverage level L ¼ 1
minimum, followed by a limited growth (Tables 18.26, 18.27, 18.28, 18.29, and
18.30).
3. Under Change of the Equity Capital Cost, k0 (Tables 18.31, 18.32, 18.33,
18.34, 18.35, and 18.36)
Depth of gap, ΔWACC, is decreased with equity cost, k0 (Fig. 18.14).
4. Under Change of the Tax on Profit Rate, t (Tables 18.37 and 18.38)
The depth of gap in dependence of WACC on n, which is equal to 0.41% at t ¼ 0.2,
is increased in 2.2 times and becomes equal to 0.92% at t ¼ 0.4, i.e., it is increased in
2.2 times, when tax on profit rate is increased in two times (Fig. 18.15).
We see from Fig. 18.16 that at fixed capital costs, k0 ¼ 30% and kd ¼ 15%, and at
different values of tax on profit rate, t, there is no minimum in WACC at finite age of
Table 18.26 Dependence of WACC (%) k0 kd L n t

18.2889 0.2 0.18 1 1 0.2
k0 ¼ 20%, kd ¼ 18% 17.4859 0.2 0.18 1 3 0.2
17.4155 0.2 0.18 1 5 0.2
17.4654 0.2 0.18 1 7 0.2
17.5833 0.2 0.18 1 10 0.2
17.8641 0.2 0.18 1 20 0.2
17.9629 0.2 0.18 1 30 0.2
17.9909 0.2 0.18 1 40 0.2

18.4736 0.2 0.15 1 1 0.2
k0 ¼ 20%, kd ¼ 15% 17.8200 0.2 0.15 1 3 0.2
17.6936 0.2 0.15 1 5 0.2
17.6967 0.2 0.15 1 7 0.2
17.7528 0.2 0.15 1 10 0.2
17.9192 0.2 0.15 1 20 0.2
17.9797 0.2 0.15 1 30 0.2
17.9957 0.2 0.15 1 40 0.2

18.6583 0.2 0.12 1 1 0.2
k0 ¼ 20%, kd ¼ 12% 18.1511 0.2 0.12 1 3 0.2
18.0181 0.2 0.12 1 5 0.2
17.9817 0.2 0.12 1 7 0.2
17.9789 0.2 0.12 1 10 0.2
18.0145 0.2 0.12 1 20 0.2
18.0175 0.2 0.12 1 30 0.2
18.0099 0.2 0.12 1 40 0.2

18.9082 0.2 0.1 1 1 0.2
k0 ¼ 20%, kd ¼ 10% 18.4030 0.2 0.1 1 3 0.2
18.2615 0.2 0.1 1 5 0.2
18.2045 0.2 0.1 1 7 0.2
18.1678 0.2 0.1 1 10 0.2
18.1146 0.2 0.1 1 20 0.2
18.0669 0.2 0.1 1 30 0.2
18.0330 0.2 0.1 1 40 0.2

19.1087 0.2 0.08 1 1 0.2
k0 ¼ 20%, kd ¼ 8% 18.6716 0.2 0.08 1 3 0.2
18.5297 0.2 0.08 1 5 0.2
18.4692 0.2 0.08 1 7 0.2
18.4040 0.2 0.08 1 10 0.2
18.2594 0.2 0.08 1 20 0.2
18.1532 0.2 0.08 1 30 0.2
18.0813 0.2 0.08 1 40 0.2

23.2477 0.25 0.15 1 1 0.2
k0 ¼ 25%, kd ¼ 15% 22.6690 0.25 0.15 1 3 0.2
22.5117 0.25 0.15 1 5 0.2
22.4913 0.25 0.15 1 7 0.2
22.4933 0.25 0.15 1 10 0.2
22.5219 0.25 0.15 1 20 0.2
22.5136 0.25 0.15 1 30 0.2
22.5045 0.25 0.15 1 40 0.2

20.3006 0.22 0.15 1 1 0.2
k0 ¼ 22%, kd ¼ 15% 19.7431 0.22 0.15 1 3 0.2
19.6171 0.22 0.15 1 5 0.2
19.6163 0.22 0.15 1 7 0.2
19.6514 0.22 0.15 1 10 0.2
19.7639 0.22 0.15 1 20 0.2
19.7960 0.22 0.15 1 30 0.2
19.8007 0.22 0.15 1 40 0.2

18.4717 0.2 0.15 1 1 0.2
k0 ¼ 20%, kd ¼ 15% 17.8015 0.2 0.15 1 3 0.2
17.6938 0.2 0.15 1 5 0.2
17.6972 0.2 0.15 1 7 0.2
17.7592 0.2 0.15 1 10 0.2
17.9192 0.2 0.15 1 20 0.2
17.9797 0.2 0.15 1 30 0.2
17.9957 0.2 0.15 1 40 0.2

16.4350 0.18 0.15 1 1 0.2
k0 ¼ 18%, kd ¼ 15% 15.8519 0.18 0.15 1 3 0.2
15.7610 0.18 0.15 1 5 0.2
15.7793 0.18 0.15 1 7 0.2
15.8561 0.18 0.15 1 10 0.2
16.0683 0.18 0.15 1 20 0.2
16.1586 0.18 0.15 1 30 0.2
16.1884 0.18 0.15 1 40 0.2

14.4304 0.16 0.15 1 1 0.2
k0 ¼ 16%, kd ¼ 15% 13.9019 0.16 0.15 1 3 0.2
13.8278 0.16 0.15 1 5 0.2
13.8610 0.16 0.15 1 7 0.2
13.9481 0.16 0.15 1 10 0.2
14.2119 0.16 0.15 1 20 0.2
14.3324 0.16 0.15 1 30 0.2
14.3781 0.16 0.15 1 40 0.2
Table 18.36 Dependence of depth of gap ΔWACC on k0 value

k0 0.16 0.18 0.20 0.22 0.25
ΔWACC, % 0.55 0.43 0.30 0.18 0.03
the company: minimal value of WACC is reached at n ¼ 1. Note that this is a

feature of particular values of capital costs (probably, too big difference between k0
and kd).
WACC(n)
23.0000%
21.0000%
19.0000% Ko=0.25
WACC
Ko=0.22
17.0000% Ko=0.2
Ko=0.18
15.0000% Ko=0.16
13.0000%
0 10 20 30 40 50
n
Fig. 18.14 Dependence of WACC on the age of the company n at fixed value of debt cost,
kd ¼ 15%, and five values of equity cost, k0 ¼ 16%, 18%, 20%, 22%, and 25%, at leverage level
L¼1
Table 18.37 Dependence of L WACC (%) k0 kd t n

2 17.84 0.2 0.15 0.2 1
k0 ¼ 20%, kd ¼ 15%, t ¼ 20% 2 17.07 0.2 0.15 0.2 3
2 16.92 0.2 0.15 0.2 5
2 16.92 0.2 0.15 0.2 7
2 16.99 0.2 0.15 0.2 10
2 17.12 0.2 0.15 0.2 15
2 17.30 0.2 0.15 0.2 30
2 17.33 0.2 0.15 0.2 45
Table 18.38 Dependence of L WACC (%) k0 kd t n

2 15.72 0.2 0.15 0.4 1
k0 ¼ 20%, kd ¼ 15%, t ¼ 40% 2 14.09 0.2 0.15 0.4 3
2 13.76 0.2 0.15 0.4 5
2 13.73 0.2 0.15 0.4 7
2 13.86 0.2 0.15 0.4 10
2 14.13 0.2 0.15 0.4 15
2 14.56 0.2 0.15 0.4 30
2 14.65 0.2 0.15 0.4 45
18.7 Further Investigation of Effect 389
WACC(n)
18.00%
17.00%
WACC
16.00%
15.00% t=0.2
t=0.4
14.00%
13.00%
0 10 20 30 40 50
n
Fig. 18.15 Dependence of WACC on the age of the company n at fixed capital costs, k0 ¼ 20%,
kd ¼ 15%, and two values of tax on profit rate t ¼ 0.2 and t ¼ 0.4 and at leverage level L ¼ 2
WACC(n)
30.00%
29.00%
28.00%
27.00% t=0
WACC
26.00% t=0.1
25.00%
t=0.2
24.00%
t=0.3
23.00%
t=0.4
22.00%
0 10 20 30 40 50
n
Fig. 18.16 Dependence of WACC on the age of the company n at fixed capital costs, k0 ¼ 30% and
kd ¼ 15%, and different values of tax on profit rate t ¼ 0, 0.1, 0.2, 0.3, and 0.4 and at leverage level
L¼2
18.7 Further Investigation of Effect
During further investigation of effect, we have discovered one more interesting

feature of dependence of WACC on n, WACC(n): we have called this effect
“Kulik effect” (Kulik is a graduate student of Management Department of Financial
University in Moscow, who has discovered this effect) (Brusov et al. 2015a, b)
(Tables 18.39 and 18.40).
Note that perpetuity limits for WACC(n), calculated by the Modigliani–Miller
formula (Мodigliani and Мiller 1958, 1963, 1966) (18.1), are equal to:
For L ¼ 1 WACC(1) ¼ 22.5%
Table 18.39 Dependence of L t k0 kd n wd WACC (%)

1 0.2 0.25 0.15 1 0.5 23.2270
k0 ¼ 25%, kd ¼ 15% 1 0.2 0.25 0.15 3 0.5 22.6725
1 0.2 0.25 0.15 5 0.5 22.5184
1 0.2 0.25 0.15 7 0.5 22.4914
1 0.2 0.25 0.15 10 0.5 22.4934
1 0.2 0.25 0.15 20 0.5 22.5220
1 0.2 0.25 0.15 30 0.5 22.5137
1 0.2 0.25 0.15 40 0.5 22.5045
1 0.2 0.25 0.15 1 0.5 21.50
Table 18.40 Dependence of L t k0 kd n wd WACC (%)

2 0.2 0.25 0.15 1 0.6667 22.8255
k0 ¼ 25%, kd ¼ 15% 2 0.2 0.25 0.15 3 0.6667 21.8935
2 0.2 0.25 0.15 5 0.6667 21.6843
2 0.2 0.25 0.15 7 0.6667 21.6431
2 0.2 0.25 0.15 10 0.6667 21.6448
2 0.2 0.25 0.15 20 0.6667 21.6895
2 0.2 0.25 0.15 30 0.6667 21.6842
2 0.2 0.25 0.15 40 0.6667 21.6742
2 0.2 0.25 0.15 1 0.6667 21.6665
WACC(n)
23.4000%
23.2000%
23.0000%
22.8000%
WACC
22.6000%
22.4000%
22.2000% L=1
22.0000%
L=2
21.8000%
21.6000%
21.4000%
0 10 20 30 40 50
n
kd ¼ 15%, and different values of leverage level L ¼ 1 and L ¼ 2
For L ¼ 2 WACC(1) ¼ 21.6665% (Figs. 18.17, 18.18 and 18.19)

It turns out that at particular values of capital costs, for example, at k0 ¼ 25% and
kd ¼ 15%, a third modification of dependences of WACC on the age of company
n takes place: descending of WACC with passage through minimum, followed by a
growth with passage through maximum, and finally with trend to perpetuity limit
WACC(n)
22.6000%
22.5000%
22.4000%
22.3000%
22.2000%
WACC
22.1000%
22.0000% L=1
21.9000%
L=2
21.8000%
21.7000%
21.6000%
0 10 20 30 40 50
n
kd ¼ 15%, and different values of leverage level L ¼ 1 and L ¼ 2 (larger scale)
WACC(n)
22.5300%
22.5250%
22.5200%
WACC
22.5150%
22.5100%
22.5050% L=1
22.5000% L=2
22.4950%
22.4900%
0 10 20 30 40 50
n
kd ¼ 15%, and different values of leverage level L ¼ 1 and L ¼ 2 (the largest scale)
from bigger values (remind that at the second type of WACC(n) behavior, the curve
WACC(n) tends to perpetuity limit from lower values). We have called this effect
“Kulik effect.” It gives a third type of dependence of WACC on the age of company
n, which is represented at Fig. 18.20.
18.8 Conclusions
In this chapter it is shown for the first time (Brusov et al. 2015a, b) within BFO
theory (Brusov and Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b,
2014a, b; Filatova et al. 2008) that valuation of WACC in the Modigliani–Miller
theory (Мodigliani and Мiller 1958, 1963, 1966) is not minimal and valuation of the
Fig. 18.20 “Kulik” effect: CC, V

behavior 3 for WACC(n)
and 30 for V(n) V 2'
1'
3'
V
WACC
3
1
k0(1-wd t ) 2
0 1 n0 n1 n
company capitalization is not maximal, as all financiers supposed up to now: at some

age of the company, its WACC value turns out to be lower than in Modigliani–Miller
theory, and company capitalization V turns out to be greater than V in Modigliani–
Miller theory (Мodigliani and Мiller 1958, 1963, 1966). Thus, existing presenta-
tions concerning the results of the Modigliani–Miller theory in this aspect (Myers
1984) turn out to be incorrect (Brusov et al. 2015a, b).
It is shown that from the point of view of cost of attracting capital, there are two
(really three) types of dependences of WACC on the time of life (age) of company n:
monotonic descending of WACC with n and descending of WACC with passage
through minimum, followed by a limited growth [there is a third modification of
dependences WACC(n) (“Kulik” behavior), which leaves all conclusions valid
(Brusov et al. 2015a, b)].
A hypothesis was put forward (Brusov et al. 2015a, b) that the character of the
WACC(n) dependence is determined by the equity cost k0.The first type takes place
for the companies with low-cost capital, characteristic for the Western companies.
The second type takes place for higher-cost capital of the company, characteristic for
companies from developing countries (including Russia). This means that the latter
companies, in contrast to the Western ones, can take advantage of the benefits given
at a certain stage of development by discovered effect (Brusov et al. 2015a, b).
Whether or not this hypothesis turned out to be right, we will see in Chap. 19,
where we investigate the conditions of existing of “the golden age” of the company
effect and discover a new important effect, which we called “the silver age” of the
company.
It is important to note that since the “golden age” of company depends on the
company’s capital costs, by controlling them (e.g., by modifying the value of
dividend payments that reflects the equity cost), the company may extend the
“golden age” of the company when the cost to attract capital becomes minimal
References 393
(less than perpetuity limit) and the capitalization of companies becomes maximal
(above than perpetuity assessment) up to a specified time interval.
References
capital structure of the company. Financ and Credit 435:2–8
(11):815–824
org/10.1080/23322039.2014.946150
Brusov P, Filatova T, Orehova N, Eskindarov M (2015a) Modern corporate finance, investment and
Brusov P, Filatova T, Orehova N, Kulik V (2015b) The golden age of the company. J Rev Global
Econ 4:21–42
7:37–62
Econ Rev 53:147–175
1954–1957. Am Econ Rev 56:333–391
Chapter 19
A “Golden Age” of the Companies:
Conditions of Its Existence
A few years ago, we have discovered the effect of the “golden age” of the company
(Brusov et al. 2015a, b): it was shown for the first time that valuation of the weighted
average cost of capital, WACC, in the Modigliani–Miller theory (Modigliani and
Мiller 1958, 1963, 1966) is not minimal and valuation of the company capitalization
is not maximal, as all financiers supposed up to this discovery; at some age of the
company, its WACC value turns out to be lower than in Modigliani–Miller theory,
and company capitalization V turns out to be greater than V in 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 descending with n and descending 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 continue to study this problem and investigate which compa-
nies have the “golden age,” i.e., obey the latter type of dependence of WACC on
n (Brusov et al. 2018b). With this aim we study the dependence of WACC on the age
of company n at various leverage levels within a wide spectrum of capital costs
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 and Filatova 2011; Brusov
et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b, 2015a, b, 2018a, b, c, d; Filatova et al.
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 kd costs. The “golden age” of company exists at small
enough difference between k0 and kd costs, while at high value of this difference, the
“golden age” of the company is absent: curve WACC(n) monotonic descends with n.
For the companies with the “golden age,” curve WACC(L ) for perpetuity companies
lies between curves WACC(L) for company ages n ¼ 1 and n ¼ 3, while for the
companies without the “golden age,” curve WACC(L ) for perpetuity companies is
the lowest one.

https://doi.org/10.1007/978-3-319-99686-8_19
396 19 A “Golden Age” of the Companies: Conditions of Its Existence
In our paper (Brusov et al. 2015a, b), we have found also a third type of WACC
(n) dependence: descending with passage through minimum, which lies below the
perpetuity limit value, and then going through maximum followed by a limited
descending. We called this effect “Kulik effect.” In this chapter we have found a
variety of “Kulik effect”: descending with passage through minimum of WACC,
which lies above the perpetuity limit value, and then going through maximum
followed by a limited descending. 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, the study of WACC behavior is
very important for rating procedures. The account of effects of the “golden (silver)
age” could change the valuation of creditworthiness of issuers.
Remind that, since the “golden age” of company depends on the company’s
capital costs, by controlling them (e.g., by modifying the value of dividend payments
that reflect the equity cost), the company may extend the “golden age” of the
company, when the cost to attract capital becomes a 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 opened effects in
developing economics.
19.1 Introduction
In this chapter we answer the following question: which companies have “a golden
age,” i.e., obey the following type of dependence of WACC on n: WACC(n)
descending with passage through minimum, followed by a limited growth. With
this aim we study the dependence of WACC on the age of company n at various
leverage levels within wide spectrum of capital costs values as well as the depen-
dence 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
2012a, b, 2013a, b, 2014a, b; Filatova et al. 2008). We make calculations for equity
cost k0 (at L ¼ 0) between 6% and 30% and debt cost kd between 4% and 28% for a
lot of pairs (k0, kd), accounting that the inequality k0 kd is always valid via the fact
that equity cost is more risky than debt one. We present in paper only some examples
of our calculations (one to two in each group), and readers should understand that
other results in each group give more or less qualitatively similar results.
We have shown that the existence of the “golden age” of company depends not on
the value of capital costs of the company, but on the difference between equity k0 and
debt kd costs. The “golden age” of company exists at small enough difference
between k0 and kd costs, while at high value of this difference, the “golden age” of
company is absent: curve WACC(n) monotonic descends with n. For the companies
with the “golden age,” curve WACC(L ) for perpetuity limit (n ¼ 1) lies between
curves WACC(L ) for 1-year (n ¼ 1) and 3-year (n ¼ 3) companies, while for the
19.2 Companies Without the “Golden Age” (Large Difference Between k0 and kd Costs) 397
companies without the “golden age,” curve WACC(L ) for perpetuity limit is the
lowest one.
The problem of the existence of the “golden age” of company is very important in
ratings because the discount rate (WACC value), used in discounting of cash flows
in ratings, depends on the existence or the nonexistence of the “golden age” of
company.
19.2 Companies Without the “Golden Age” (Large

Difference Between k0 and kd Costs)
As an example of companies without the “golden age” (with large difference

between k0 and kd costs), we present the calculations for equity cost k0 (at L ¼ 0)
equals to 20% and debt cost kd equals to 9%.
19.2.1 Dependence of the Weighted Average Cost of Capital,

WACC, on the Company Age n at Different Leverage
Levels
We study below the dependence of the weighted average cost of capital, WACC, on
the company age n at different leverage levels (L ¼ 1, 2, 3), using the BFO formula:
½1 ð1 þ WACCÞn ½1 ð1 þ k 0 Þn
¼ : ð19:1Þ
WACC k 0 ½1 ωd t ð1 ð1 þ kd Þn Þ
Leverage level L is presented in BFO formula through the share of debt capital
wd ¼ L/(1 þ L ).
The results of our calculations are shown below in tables and figures.
For L ¼ 1, one has the following.
For L ¼ 2, we have the following.
For L ¼ 3, one has the following.
It is seen from Tables 19.1, 19.2, and 19.3 and Fig. 19.1 that 1 10 , behavior
(from Fig. 19.2), takes place: monotonic dependence of weighted average cost of
capital, WACC, and company capitalization, V, on the company age n for all
considered leverage levels (L ¼ 1, 2, 3); this means that the “golden age” of
company is absent. The ordering of curves is the following: the lower curve
corresponds the greater leverage level.
From Tables 19.4, 19.5, and 19.6 and Fig. 19.3, it is seen that the ordering of
curves WACC(L ) is the following: the lower curve corresponds the greater company
age n. We will see below that under the existence of the “golden age” of the
Table 19.1 Dependence of WACC on the age of the company n at L ¼ 1, k0 ¼ 20%, kd ¼ 9%

n t L WACC(L ¼ 1) k0 kd wd A(n) БФО
1 0.2 1 0.19001348 0.2 0.09 0.50 0.840271 0.000055264
2 0.2 1 0.18679105 0.2 0.09 0.50 1.552355 0.000242408
3 0.2 1 0.18521681 0.2 0.09 0.50 2.155589 0.000643588
4 0.2 1 0.18453895 0.2 0.09 0.50 2.666482 0.000008562
5 0.2 1 0.18398934 0.2 0.09 0.50 3.099102 0.000019534
6 0.2 1 0.18361179 0.2 0.09 0.50 3.465420 0.000038686
7 0.2 1 0.18333561 0.2 0.09 0.50 3.775614 0.000068644
8 0.2 1 0.18312210 0.2 0.09 0.50 4.038322 0.000111902
9 0.2 1 0.18294855 0.2 0.09 0.50 4.260871 0.000170582
10 0.2 1 0.18280097 0.2 0.09 0.50 4.449469 0.000246231
20 0.2 1 0.18181178 0.2 0.09 0.50 5.305460 0.000013165
30 0.2 1 0.18103559 0.2 0.09 0.50 5.486207 0.000041589
40 0.2 1 0.18052092 0.2 0.09 0.50 5.532205 0.000065502

1 0.2 2 0.18670845 0.2 0.09 0.67 0.8426098 0.000057189
2 0.2 2 0.18242414 0.2 0.09 0.67 1.5607236 0.000239282
3 0.2 2 0.18033977 0.2 0.09 0.67 2.1724715 0.000618675
4 0.2 2 0.17935211 0.2 0.09 0.67 2.6934467 0.000007915
5 0.2 2 0.17860838 0.2 0.09 0.67 3.1370358 0.000018207
6 0.2 2 0.17809570 0.2 0.09 0.67 3.5147106 0.000036130
7 0.2 2 0.17771992 0.2 0.09 0.67 3.8362859 0.000064261
8 0.2 2 0.17742943 0.2 0.09 0.67 4.1101468 0.000105021
9 0.2 2 0.17719390 0.2 0.09 0.67 4.3434469 0.000160484
10 0.2 2 0.17699457 0.2 0.09 0.67 4.5422818 0.000232186
20 0.2 2 0.17567694 0.2 0.09 0.67 5.4686271 0.000012229
30 0.2 2 0.17467722 0.2 0.09 0.67 5.6790746 0.000039727
40 0.2 2 0.17401430 0.2 0.09 0.67 5.7372042 0.000064124
company, this ordering will be a different one. We keep here the case of n ¼ 45 as
the case which is closed to perpetuity limit. An alternative method is the use of
Modigliani–Miller formula
WACC ¼ k0 ð1 ωd t Þ, ð19:2Þ
which follows from BFO formula (19.1) for perpetuity limit.

19.3 Companies with the “Golden Age” (Small Difference Between k0 and kd Costs) 399

1 0.2 3 0.18506498 0.2 0.09 0.75 0.8437839 0.000051714
2 0.2 3 0.18024369 0.2 0.09 0.75 1.5649420 0.000228517
3 0.2 3 0.17789664 0.2 0.09 0.75 2.1810121 0.000607678
4 0.2 3 0.17675215 0.2 0.09 0.75 2.7071344 0.000007660
5 0.2 3 0.17590910 0.2 0.09 0.75 3.1563532 0.000017650
6 0.2 3 0.17532683 0.2 0.09 0.75 3.5398852 0.000035095
7 0.2 3 0.17489950 0.2 0.09 0.75 3.8673589 0.000062558
8 0.2 3 0.17456914 0.2 0.09 0.75 4.1470258 0.000101532
9 0.2 3 0.17430145 0.2 0.09 0.75 4.3859468 0.000155351
10 0.2 3 0.17407533 0.2 0.09 0.75 4.5901557 0.000225050
20 0.2 3 0.17259416 0.2 0.09 0.75 5.5540330 0.000011720
30 0.2 3 0.17148952 0.2 0.09 0.75 5.7806846 0.000038586
40 0.2 3 0.17075742 0.2 0.09 0.75 5.8455083 0.000063263
WACC(n)
0.19500000
0.19000000
0.18500000
WACC
0.18000000
0.17500000
0.17000000
0.16500000
0 5 10 15 20 25 30 35 40 45
n
L=1 L=2 L=3
Fig. 19.1 The dependence of weighted average cost of capital, WACC, on the company age n at
different leverage levels (L ¼ 1, 2, 3)
19.3 Companies with the “Golden Age” (Small Difference

Between k0 and kd Costs)
As an example of companies with the “golden age” (with small difference between
k0 and kd costs), we present the calculations for equity cost k0 (at L ¼ 0) equals to
27% and debt cost kd equals to 25% (Fig. 19.4).
Fig. 19.2 Two kinds of dependences of the weighted average cost of capital, WACC, and company
capitalization, V, on lifetime of the company n ¼ 1 10 , monotonic dependence of the weighted
average cost of capital, WACC, and company capitalization, V, on lifetime of the company n ¼
2 20 , showing descending of WACC with n, and with the passage through a minimum and then a
limited growth and increase of V with the passage through a maximum (at n0) and then a limited
descending
Table 19.4 Dependence of WACC on the leverage level at the company age n ¼ 1, k0 ¼ 20%,
kd ¼ 9%
n t L WACC(n ¼ 1) k0 kd wd A(n) БФО
1 0.2 0 0.19990871 0.2 0.09 0.00 0.833333 0.000063399
1 0.2 1 0.18989673 0.2 0.09 0.50 0.840271 0.000137715
1 0.2 2 0.18675471 0.2 0.09 0.67 0.842610 0.000024342
1 0.2 3 0.18504185 0.2 0.09 0.75 0.843784 0.000068187
1 0.2 4 0.18395964 0.2 0.09 0.80 0.844490 0.000133490
1 0.2 5 0.18323424 0.2 0.09 0.83 0.844961 0.000179952
1 0.2 6 0.18270822 0.2 0.09 0.86 0.845298 0.000218846
1 0.2 7 0.18230907 0.2 0.09 0.88 0.845551 0.000251369
1 0.2 8 0.18203277 0.2 0.09 0.89 0.845748 0.000252248
1 0.2 9 0.18178544 0.2 0.09 0.90 0.845906 0.000271780
1 0.2 10 0.18158213 0.2 0.09 0.91 0.846034 0.000288455
It is seen from Tables 19.7, 19.8, and 19.9 and Fig. 19.5 that 2 20 , behavior
(from Fig. 19.2), takes place: descending of WACC with n, and with the passage
through a minimum and then a limited growth and increase of V with the passage
through a maximum (at n0 4) and then a limited descending. This means the
19.3 Companies with the “Golden Age” (Small Difference Between k0 and kd Costs) 401
kd ¼ 9%
3 0.2 0 0.19978349 0.2 0.09 0.00 2.106481 0.000714376
3 0.2 1 0.18521867 0.2 0.09 0.50 2.155589 0.000637220
3 0.2 2 0.18034194 0.2 0.09 0.67 2.172471 0.000611094
3 0.2 3 0.17789941 0.2 0.09 0.75 2.181012 0.000597961
3 0.2 4 0.17643254 0.2 0.09 0.80 2.186169 0.000590059
3 0.2 5 0.17545407 0.2 0.09 0.83 2.189620 0.000584783
3 0.2 6 0.17475488 0.2 0.09 0.86 2.192092 0.000581010
3 0.2 7 0.17423034 0.2 0.09 0.88 2.193950 0.000578178
3 0.2 8 0.17382227 0.2 0.09 0.89 2.195397 0.000575974
3 0.2 9 0.17349576 0.2 0.09 0.90 2.196556 0.000574210
3 0.2 10 0.17322858 0.2 0.09 0.91 2.197505 0.000572766
kd ¼ 9%
45 0.2 0 0.19999699 0.2 0.09 0.00 4.998633 0.000075004
45 0.2 1 0.18035710 0.2 0.09 0.50 5.541296 0.000073385
45 0.2 2 0.17380207 0.2 0.09 0.67 5.749351 0.000072648
45 0.2 3 0.17052242 0.2 0.09 0.75 5.859349 0.000072233
45 0.2 4 0.16855385 0.2 0.09 0.80 5.927391 0.000071966
45 0.2 5 0.16724112 0.2 0.09 0.83 5.973638 0.000071780
45 0.2 6 0.16630328 0.2 0.09 0.86 6.007115 0.000071642
45 0.2 7 0.16559980 0.2 0.09 0.88 6.032471 0.000071536
45 0.2 8 0.16505258 0.2 0.09 0.89 6.052340 0.000071451
45 0.2 9 0.16461477 0.2 0.09 0.90 6.068330 0.000071382
45 0.2 10 0.16425654 0.2 0.09 0.91 6.081476 0.000071325
presence of the “golden age” of company. The ordering of curves is the following:
the lower curve corresponds the greater leverage level.
From Tables 19.10, 19.11, and 19.12 and Fig. 19.6 the quite new effect follows:
the ordering of curves WACC(L) is the following: the top curve corresponds to the
company age n ¼ 1, the middle one corresponds to perpetuity company n0 ¼ 1
(we use n ¼ 49 to approximate perpetuity limit), and bottom one corresponds to the
company age n ¼ 3. Thus, the curve WACC(L) for perpetuity company lies between
curves corresponding to the company age n ¼ 1 and n 3.
Note that this ordering is quite different from the case when the “golden age” of
company is absent: in that case the lower curve corresponds the greater company age
n, the top curve corresponds to the company age n ¼ 1, the middle one corresponds
to the company age n ¼ 3, and bottom one corresponds to the perpetuity company.
WACC(L)
0.21000000
0.20000000
0.19000000
0.18000000
WACC
0.17000000
0.16000000
0.15000000
0.14000000
0 1 2 3 4 5 6 7 8 9 10
L
WACC(n=1) WACC (n=3) WACC(n=45)
Fig. 19.3 The dependence of the weighted average cost of capital, WACC, on the leverage level at
different company age n (n ¼ 1, 3, 45)
WACC (n)
0.2500
0.2450
0.2400
0.2350
WACC
L=1
0.2300 L=2
0.2250 L=3
0.2200
0.2150
0 10 20 30 40 50
n
Fig. 19.4 The dependence of weighted average cost of capital, WACC, on the company age n at
different leverage levels (L ¼ 1, 2, 3)
19.4 Companies with Abnormal “Golden Age” (Intermediate. . . 403
n t L WACC k0 kd wd A(n) BFO
1 0.2 1 0.2441 0.27 0.25 0.50 0.8035 0.000292
2 0.2 1 0.2381 0.27 0.25 0.50 1.4600 0.000038
3 0.2 1 0.2360 0.27 0.25 0.50 1.9928 0.000286
4 0.2 1 0.2357 0.27 0.25 0.50 2.4231 0.000046
5 0.2 1 0.2359 0.27 0.25 0.50 2.7688 0.000319
6 0.2 1 0.2363 0.27 0.25 0.50 3.0457 0.000877
7 0.2 1 0.2371 0.27 0.25 0.50 3.2668 0.000033
8 0.2 1 0.2377 0.27 0.25 0.50 3.4430 0.000070
9 0.2 1 0.2383 0.27 0.25 0.50 3.5830 0.000127
10 0.2 1 0.2389 0.27 0.25 0.50 3.6941 0.000204
20 0.2 1 0.2422 0.27 0.25 0.50 4.0755 0.000005
30 0.2 1 0.2429 0.27 0.25 0.50 4.1115 0.000009
40 0.2 1 0.2430 0.27 0.25 0.50 4.1149 0.000010
1 0.2 2 0.2361 0.27 0.25 0.67 0.8090 0.000024
2 0.2 2 0.2274 0.27 0.25 0.67 1.4784 0.000164
3 0.2 2 0.2246 0.27 0.25 0.67 2.0275 0.000411
4 0.2 2 0.2239 0.27 0.25 0.67 2.4748 0.000753
5 0.2 2 0.2244 0.27 0.25 0.67 2.8370 0.000018
6 0.2 2 0.2251 0.27 0.25 0.67 3.1288 0.000026
7 0.2 2 0.2259 0.27 0.25 0.67 3.3630 0.000037
8 0.2 2 0.2267 0.27 0.25 0.67 3.5504 0.000046
9 0.2 2 0.2276 0.27 0.25 0.67 3.6999 0.000054
10 0.2 2 0.2284 0.27 0.25 0.67 3.8189 0.000063
20 0.2 2 0.2328 0.27 0.25 0.67 4.2301 0.000110
30 0.2 2 0.2338 0.27 0.25 0.67 4.2694 0.000124
40 0.2 2 0.2340 0.27 0.25 0.67 4.2731 0.000128
19.4 Companies with Abnormal “Golden Age”

(Intermediate Difference Between k0 and kd Costs)
One example, which is different from two considered above cases, will be studied
below, where we present the calculations for equity cost k0 (at L ¼ 0) equals to 27%
and debt cost kd equals to 16%.
While in this case the “golden age” of the company is present, it is less pro-
nounced: the minimal WACC value (at some leverage value: in this case at L ¼ 1)
lies above the perpetuity WACC value. We call this situation the “silver age” of the
company (Table 19.13).
1 0.2 3 0.2318 0.27 0.25 0.75 0.8118 0.000064
2 0.2 3 0.2219 0.27 0.25 0.75 1.4877 0.000412
3 0.2 3 0.2190 0.27 0.25 0.75 2.0453 0.000020
4 0.2 3 0.2183 0.27 0.25 0.75 2.5015 0.000044
5 0.2 3 0.2186 0.27 0.25 0.75 2.8723 0.000076
6 0.2 3 0.2193 0.27 0.25 0.75 3.1721 0.000112
7 0.2 3 0.2203 0.27 0.25 0.75 3.4133 0.000154
8 0.2 3 0.2212 0.27 0.25 0.75 3.6067 0.000195
9 0.2 3 0.2222 0.27 0.25 0.75 3.7612 0.000234
10 0.2 3 0.2231 0.27 0.25 0.75 3.8845 0.000271
20 0.2 3 0.2281 0.27 0.25 0.75 4.3120 0.000497
30 0.2 3 0.2293 0.27 0.25 0.75 4.3530 0.000570
40 0.2 3 0.2295 0.27 0.25 0.75 4.3569 0.000590
WACC (L)
0.2700
0.2600
0.2500
WACC
0.2400
n=1
0.2300 n=3
0.2200 n=49
0.2100
0.2000
0 2 4 6 8 10 12
L
Fig. 19.5 The dependence of weighted average cost of capital, WACC, on leverage level L at
To be sure that the minimal WACC value at leverage level L ¼ 1 lies above the
perpetuity WACC value, we make more detailed calculations for this case (see
Table 19.16). We see that the minimal WACC value at n ¼ 8.2 is equal to
0.243095889, while perpetuity limit is equal 0.243 and lies below.
Let us study the dependence of the weighted average cost of capital, WACC, on
the leverage level at different company age n (n ¼ 1, 3, 1) (Fig. 19.7).
It is seen from Tables 19.14 and 19.15 and Fig. 19.6 that the following behavior
takes place for L ¼ 2 and 3: a third modification of dependences of the weighted
average cost of capital, WACC, on the company age n takes place—descending of
kd ¼ 25%
1 0.2 0 0.2697 0.27 0.25 0.00 0.7874 0.000188
1 0.2 1 0.2441 0.27 0.25 0.50 0.8035 0.000292
1 0.2 2 0.2360 0.27 0.25 0.67 0.8090 0.000064
1 0.2 3 0.2317 0.27 0.25 0.75 0.8118 0.000153
1 0.2 4 0.2290 0.27 0.25 0.80 0.8134 0.000216
1 0.2 5 0.2273 0.27 0.25 0.83 0.8146 0.000263
1 0.2 6 0.2260 0.27 0.25 0.86 0.8154 0.000298
1 0.2 7 0.2251 0.27 0.25 0.88 0.8160 0.000326
1 0.2 8 0.2243 0.27 0.25 0.89 0.8164 0.000349
1 0.2 9 0.2237 0.27 0.25 0.90 0.8168 0.000367
1 0.2 10 0.2232 0.27 0.25 0.91 0.8171 0.000382
kd ¼ 25%
3 0.2 0 0.2697 0.27 0.25 0.00 1.8956 0.000832
3 0.2 1 0.2361 0.27 0.25 0.50 1.9928 0.000174
3 0.2 2 0.2246 0.27 0.25 0.67 2.0275 0.000411
3 0.2 3 0.2188 0.27 0.25 0.75 2.0453 0.000542
3 0.2 4 0.2154 0.27 0.25 0.80 2.0561 0.000631
3 0.2 5 0.2131 0.27 0.25 0.83 2.0634 0.000694
3 0.2 6 0.2114 0.27 0.25 0.86 2.0687 0.000741
3 0.2 7 0.2102 0.27 0.25 0.88 2.0726 0.000778
3 0.2 8 0.2092 0.27 0.25 0.89 2.0757 0.000807
3 0.2 9 0.2084 0.27 0.25 0.90 2.0781 0.000830
3 0.2 10 0.2078 0.27 0.25 0.91 2.0802 0.000850
kd ¼ 25%
49 0.2 0 0.2700 0.27 0.25 0.00 3.7037 0.000037
49 0.2 1 0.2430 0.27 0.25 0.50 4.1152 0.000041
49 0.2 2 0.2340 0.27 0.25 0.67 4.2735 0.000159
49 0.2 3 0.2295 0.27 0.25 0.75 4.3572 0.000273
49 0.2 4 0.2268 0.27 0.25 0.80 4.4091 0.000368
49 0.2 5 0.2250 0.27 0.25 0.83 4.4444 0.000444
49 0.2 6 0.2237 0.27 0.25 0.86 4.4699 0.000505
49 0.2 7 0.2227 0.27 0.25 0.88 4.4893 0.000556
49 0.2 8 0.2220 0.27 0.25 0.89 4.5045 0.000598
49 0.2 9 0.2214 0.27 0.25 0.90 4.5167 0.000633
49 0.2 10 0.2209 0.27 0.25 0.91 4.5267 0.000664
WACC (n) L=1

L=2
L=3
0.248
0.243
WACC
0.238
0.233
0.228
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
n
Fig. 19.6 The dependence of the weighted average cost of capital, WACC, on the company age
n at different leverage levels (L ¼ 1, 2, 3)
n t L k0 kd wd WACC
1 0.2 1 0.27 0.16 0.5 0.252483428
2 0.2 1 0.27 0.16 0.5 0.247301552
3 0.2 1 0.27 0.16 0.5 0.245105573
4 0.2 1 0.27 0.16 0.5 0.244045922
5 0.2 1 0.27 0.16 0.5 0.243511488
6 0.2 1 0.27 0.16 0.5 0.243250247
7 0.2 1 0.27 0.16 0.5 0.24313388
8 0.2 1 0.27 0.16 0.5 0.243097298
9 0.2 1 0.27 0.16 0.5 0.243103247
10 0.2 1 0.27 0.16 0.5 0.243130071
20 0.2 1 0.27 0.16 0.5 0.243291667
30 0.2 1 0.27 0.16 0.5 0.243146312
40 0.2 1 0.27 0.16 0.5 0.243048121
1 0.2 1 0.27 0.16 0.5 0.243
WACC with passage through minimum at n ¼ 8, followed by a growth with passage

through maximum at n ¼ 20, and finally with trend to perpetuity limit from bigger
values [remind that at second type of WACC(n) behavior, the curve WACC(n) tends
to perpetuity limit from lower values]. We have called this effect “Kulik effect.”
The ordering of curves is the following: the lower curve corresponds the greater
leverage level.
WACC от L
0.27
0.26
0.25
WACC
n=1
n=3
0.24
n=∞
0.23
0.22
0 1 2 3 4 5 6 7 8 9 10
L
Fig. 19.7 The dependence of weighted average cost of capital, WACC, on the leverage level at
n t L k0 kd wd WACC
1 0.2 2 0.27 0.16 0.6(6) 0.246644883
2 0.2 2 0.27 0.16 0.6(6) 0.239710388
3 0.2 2 0.27 0.16 0.6(6) 0.236752006
4 0.2 2 0.27 0.16 0.6(6) 0.235311829
5 0.2 2 0.27 0.16 0.6(6) 0.234578628
6 0.2 2 0.27 0.16 0.6(6) 0.23421254
7 0.2 2 0.27 0.16 0.6(6) 0.234046353
8 0.2 2 0.27 0.16 0.6(6) 0.233991091
9 0.2 2 0.27 0.16 0.6(6) 0.233996344
10 0.2 2 0.27 0.16 0.6(6) 0.234032536
20 0.2 2 0.27 0.16 0.6(6) 0.234316362
30 0.2 2 0.27 0.16 0.6(6) 0.234174539
40 0.2 2 0.27 0.16 0.6(6) 0.234059889
1 0.2 2 0.27 0.16 0.6(6) 0.234
From Tables 19.16, 19.17, 19.18, and 19.19 and Fig. 19.6, it is seen that for
L ¼ 1, the following behavior takes place: descending of WACC with passage
through minimum at n ¼ 8.2 (which is higher than perpetuity limit), followed by a
growth with passage through maximum at n ¼ 20, and finally with trend to
perpetuity limit from bigger values. This means that the “golden age” in its purest
form presents at leverage levels for L ¼ 2 and 3, while at L ¼ 1 one has different
effect: we call it “silver age.”
Table 19.15 Dependence of n t L k0 kd wd WACC

1 0.2 3 0.27 0.16 0.75 0.243725045
k0 ¼ 27%, kd ¼ 16% 2 0.2 3 0.27 0.16 0.75 0.235910011
3 0.2 3 0.27 0.16 0.75 0.232564477
4 0.2 3 0.27 0.16 0.75 0.230926014
5 0.2 3 0.27 0.16 0.75 0.230090888
6 0.2 3 0.27 0.16 0.75 0.229669501
7 0.2 3 0.27 0.16 0.75 0.229475982
8 0.2 3 0.27 0.16 0.75 0.229409857
9 0.2 3 0.27 0.16 0.75 0.229414009
10 0.2 3 0.27 0.16 0.75 0.229454135
20 0.2 3 0.27 0.16 0.75 0.229812629
30 0.2 3 0.27 0.16 0.75 0.229682914
40 0.2 3 0.27 0.16 0.75 0.229564113
1 0.2 3 0.27 0.16 0.75 0.2295
Table 19.16 Dependence of L k0 kd t n wd WACC BFO

WACC (more detailed) on the
1 0.27 0.16 0.2 7 0.50 0.243133854 0.000
age of the company n at L ¼ 1,
k0 ¼ 27%, kd ¼ 16% 1 0.27 0.16 0.2 7.2 0.50 0.243121633 0.000
1 0.27 0.16 0.2 7.4 0.50 0.243112185 0.000
1 0.27 0.16 0.2 7.6 0.50 0.243105150 0.000
1 0.27 0.16 0.2 7.8 0.50 0.243100256 0.000
1 0.27 0.16 0.2 8 0.50 0.243097246 0.000
1 0.27 0.16 0.2 8.2 0.50 0.243095889 0.000
1 0.27 0.16 0.2 8.4 0.50 0.243095979 0.000
1 0.27 0.16 0.2 8.6 0.50 0.243097328 0.000
1 0.27 0.16 0.2 8.8 0.50 0.243099771 0.000
1 0.27 0.16 0.2 9 0.50 0.243103156 0.000
1 0.27 0.16 0.2 1 0.50 0.243 0.000
The ordering of curves is the following: the lower curve corresponds the greater
company age.
It turns out that at particular values of capital costs, for example, at k0¼27%;
kd¼16%, a third modification of dependences of the weighted average cost of
capital, WACC, on the company age n takes place: descending of WACC with
passage through minimum, followed by a growth with passage through maximum,
and finally with trend to perpetuity limit from bigger values [remind that at second
type of WACC(n) behavior, the curve WACC(n) tends to perpetuity limit from lower
values]. We have called this effect “Kulik effect.”

WACC on the leverage level
1 0.2 0 0.27 0.16 0 0.270000213
L at age of the company n ¼ 1,
k0 ¼ 27%, kd ¼ 16% 1 0.2 1 0.27 0.16 0.5 0.252483428
1 0.2 2 0.27 0.16 0.6(6) 0.246644883
1 0.2 3 0.27 0.16 0.75 0.243725045
1 0.2 4 0.27 0.16 0.8 0.241973361
1 0.2 5 0.27 0.16 0.8(3) 0.24080557
1 0.2 6 0.27 0.16 0.857142857 0.239971433
1 0.2 7 0.27 0.16 0.875 0.239345829
1 0.2 8 0.27 0.16 0.8(8) 0.238859248
1 0.2 9 0.27 0.16 0.9 0.238469982
1 0.2 10 0.27 0.16 0.(90) 0.238151492

3 0.2 0 0.27 0.16 0 0.270000842
L at age of the company n ¼ 3,
k0 ¼ 27%, kd ¼ 16% 3 0.2 1 0.27 0.16 0.5 0.245105573
3 0.2 2 0.27 0.16 0.6(6) 0.236752006
3 0.2 3 0.27 0.16 0.75 0.232564477
3 0.2 4 0.27 0.16 0.8 0.230048473
3 0.2 5 0.27 0.16 0.8(3) 0.228369673
3 0.2 6 0.27 0.16 0.857142857 0.22716981
3 0.2 7 0.27 0.16 0.875 0.226269517
3 0.2 8 0.27 0.16 0.(8) 0.225569054
3 0.2 9 0.27 0.16 0.9 0.225008535
3 0.2 10 0.27 0.16 0.(90) 0.224549831

1 0.2 0 0.27 0.16 0 0.27
L for the perpetuity company
(n ¼ 1) at k0 ¼ 27%, 1 0.2 1 0.27 0.16 0.5 0.243
kd ¼ 16% 1 0.2 2 0.27 0.16 0.(6) 0.234
1 0.2 3 0.27 0.16 0.75 0.2295
1 0.2 4 0.27 0.16 0.8 0.2268
1 0.2 5 0.27 0.16 0.8(3) 0.225
1 0.2 6 0.27 0.16 0.857142857 0.223714286
1 0.2 7 0.27 0.16 0.875 0.22275
1 0.2 8 0.27 0.16 0.(8) 0.222
1 0.2 9 0.27 0.16 0.9 0.2214
1 0.2 10 0.27 0.16 0.(90) 0.220909091
19.5 Comparing with Results from Previous Chapter
19.5.1 Under Change of the Debt Capital Cost, kd
From Fig. 19.8 it is seen that with increase of debt cost, kd, the character of
dependence of weighted average cost of capital, WACC, on the company age n is
changed from monotonic descending of WACC with n to descending of WACC
with n with passage through minimum, followed by a limited growth. It is seen from
Table 19.20 that the gap depth ΔWACC [the difference between the optimal
(minimal) value of weighted average cost of capital, WACC, and its perpetuity
limit] decreases with Δk ¼ k0 kd from 3.38% at Δk ¼ 0.02 up to 1.89% at
Δk ¼ 0.5. At Δk ¼ 0.10 and Δk ¼ 0.12, the minimum in dependence of WACC(n) is
absent (too big value of Δk ¼ k0 kd). This coincides with our conclusions in this
chapter.
The same conclusion could be made from Fig. 19.9 and Table 19.21 for higher
values of capital costs: it is seen that with increase of debt cost, kd, at fixed k0, i.e.,
with decrease Δk ¼ k0 kd, the gap depth ΔWACC is increased from 1.08% at
Δk ¼ 0.10 up to 1.85% at Δk ¼ 0.05. This as well coincides with our conclusions in
this paper.
WACC(n), k0=0.2
19.2000%
19.0000%
18.8000%
18.6000%
18.4000%
WACC
Kd=0,18
18.2000%
Kd=0,15
18.0000%
Kd=0,10
17.8000%
Kd=0,08
17.6000%
17.4000%
17.2000%
0 5 10 15 20 25 30 35 40 45
n
Fig. 19.8 Dependence of the weighted average cost of capital, WACC, on lifetime of the company
n at fixed value of equity cost, k0¼20%, and at four values of debt cost, kd¼8, 10, 15, and 18%, at
leverage level L ¼ 1
Table 19.20 Dependence of kd 0.18 0.15 0.10 0.08

ΔWACC on k and on Δk = k
Δk = k0 − kd 0.02 0.05 0.10 0.12
−kd
ΔWACC, % 3.38 1.89 NA NA
WACC(n)
0.3700
0.3680
0.3660
0.3640
0.3620
WACC
0.3600
kd=0,35
0.3580
kd=0,3
0.3560
0.3540
0.3520
0.3500
0 5 10 15 20 25 30 35 40 45
n
Fig. 19.9 Dependence of weighted average cost of capital, WACC, on lifetime of the company n at
fixed high value of equity cost, k0¼40%, and two values of debt cost, kd¼30% and 35%, at leverage
level L ¼ 1
Table 19.21 Dependence of k0 = 0.4; kd 0.35 0.3

ΔWACC on k (at fixed k = 0.4)
Δk = k0 − kd 0.05 0.10
and on Δk = k−kd
ΔWACC, % 1.85 1.08
19.5.2 Under Change of the Equity Capital Cost, k0
From Fig. 19.10 and Table 19.22, it is seen that the gap depth ΔWACC [the
difference between the optimal (minimal) value of weighted average cost of capital,
WACC, and its perpetuity limit] decreases with Δk ¼ k0 kd from 0.55% at
Δk ¼ 0.01 up to 0.03% at Δk ¼ 0.10. This as well coincides with our conclusions
in this paper.
In conclusion we present at Fig. 19.11 both the cases of “Kulik” effect: “the
golden age” of the company and the “silver age” of the company.
19.6 Conclusions
In our previous paper a few years ago (Brusov et al. 2015a, b), we have discovered
the effect of the “golden age” of company: it was shown for the first time that
valuation of the weighted average cost of capital, WACC, in the Modigliani–Miller
theory (Modigliani and Мiller 1958, 1963, 1966) is not minimal and valuation of the
company capitalization is not maximal, as all financiers supposed up to this discov-
ery; at some age of the company, its WACC value turns out to be lower than in
Modigliani–Miller theory, and company capitalization V turns out to be greater than
V in Modigliani–Miller theory (see previous chapter). It was shown that, from the
WACC(n)
23.0000%
21.0000%
Ko=0,25
WACC
19.0000%
Ko=0,22
Ko=0,2
17.0000%
Ko=0,18
15.0000% Ko=0,16
13.0000%
0 5 10 15 20 25 30 35 40 45
n
Fig. 19.10 Dependence of the weighted average cost of capital, WACC, on lifetime of the
company n at fixed value of debt cost, kd¼15%, and five values of equity cost, k0¼16, 18, 20,
22, and 25%, at leverage level L ¼ 1
Table 19.22 Dependence of k0 0.16 0.18 0.20 0.22 0.25

ΔWACC on k and on Δk = k
Δk = k0 − kd 0.01 0.03 0.05 0.07 0.10
−kd
ΔWACC, % 0.55 0.43 0.30 0.18 0.03
Fig. 19.11 Dependence of weighted average cost of capital, WACC, on company age of the
company n, which illustrate the presence of “the golden age” of the company (curve 1) and of “the
silver age” of the company (curve 2) under the existence of “Kulik” effect. Here n0 is “the golden
(silver) age” of the company, and n1 is the age of local maximum in dependence of WACC(n)
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
descending with n and descending 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 have continued the study of the effect of the “golden age” of
company and have investigated which companies have the “golden age,” i.e., obey
the latter type of dependence of WACC on n. With this aim we study the dependence
of WACC on the age of company n at various leverage levels within wide spectrum
of capital costs 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 and
Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b; Filatova et al.
2008).
We have shown that the existence of the “golden age” of company does not
depend on the value of capital costs of the company (as it was supposed in the
previous chapter), but depends on the difference value between equity, k0, and debt,
kd, costs. The “golden age” of company exists at small enough difference between k0
and kd costs, while at high value of this difference, the “golden age” of company is
absent: curve WACC(n) monotonic descends with company age n. For the compa-
nies with the “golden age,” curve WACC(L ) for perpetuity limit lies between curves
WACC(L ) at n ¼ 1 and n ¼ 3, while for the companies without the “golden age,”
curve WACC(L ) for perpetuity limit (n ¼ 1) is the lowest one. By other words, the
ordering of curves WACC(L) is different for the companies with the “golden age”
and without it.
In the previous chapter, we have found also a third type of WACC(n) depen-
dence: descending with passage through minimum, which lies below the perpetuity
limit value, and then going through maximum followed by a limited descending. We
called this effect “Kulik effect” (this is last name of student, who have discovered
this effect). In this paper we have found a variety of “Kulik effect”: descending with
passage through minimum of WACC, which lies above the perpetuity limit value,
then going through maximum followed by a limited descending. We call this
company age n, at which WACC has a minimum, which lies above the perpetuity
limit value, “the silver age” of the company. It takes place at intermediate difference
value between equity k0 and debt kd costs.
Because the cost of attracting capital is used in rating methodologies as
discounting rate under discounting of cash flows, the study of WACC behavior is
very important for rating procedures. The account of effects of the “golden (silver)
age” could change the valuation of creditworthiness of issuers.
Remind that, since the “golden age” of company depends on the company’s
capital costs, by controlling them (e.g., by modifying the value of dividend payments
that reflect the equity cost), the company may extend the “golden (silver) age” of the
company, when the cost to attract capital becomes a minimal [less (above) than
perpetuity limit)] and capitalization of companies becomes maximal [(above (below)
than perpetuity assessment] up to a specified time interval.
References
capital and equity cost of company. Finan Anal Prob Solut 34(76):36–42
(11):815–824
structure, different from suggested by trade off theory. Cogent Economics & Finance 2:1–13.
https://doi.org/10.1080/23322039.2014.946150
perpetuity limit – Modigliani–Miller theory. Journal of Reviews on Global Economics
3:175–185
Brusov P, Filatova T, Orehova N, Eskindarov M (2015a) Modern corporate finance, investments
and taxation, monograph, 1st edn, Springer International Publishing, Berlin, 368pp
Brusov P, Filatova T, Orehova N, Kulk V (2015b) The golden age of the company: (three colors of
company’s time). J Rev Global Econ 4:21–42
7:37–62
Econ Rev 53:147–175
1954–1957. Am Econ Rev 56:333–391
Chapter 20
The Role of the Central Bank
and Commercial Banks in Creating
and Maintaining a Favorable Investment
Climate in the Country
In this chapter we study the role of the Central Bank and commercial banks in
creating and maintaining a favorable investment climate in the country. Within the
framework of modern investment models created by the authors, the dependence of
the efficiency of investments on the level of debt financing within a wide range of
values of equity costs and debt capital costs under different project terms (long-term
projects as well as projects of arbitrary duration) and different investment profitabil-
ity coefficients β is investigated. The effectiveness of investments is determined by
Net Present Value, NPV. The study is conducted within the framework of invest-
ment models with debt repayment at the end of the project term.
It is found that NPV depends practically linearly on leverage level L, increasing or
decreasing depending on profitability coefficient β and credit rate values kd. The
cutoff credit rate values kd*, separating the range of increasing NPV(L) from range
of decreasing NPV(L ), are determined. The Central Bank should keep its key rate at
the level which allow commercial banks to keep their credit rates below the cutoff
credit rate kd* values in order to create and maintain a favorable investment climate
in the country.
20.1 Introduction
The investments play a very important role in an economy of each country. As a rule,
debt financing is always used in investments. In the current paper, we determine the
role of the Central Bank and commercial banks in creating and maintaining a
favorable investment climate in the country. Within the framework of modern
investment models created by the authors, the dependence of the efficiency of
investments on the level of debt financing within a wide range of values of equity
capital costs and debt capital costs under different project terms (long-term projects
as well as projects of arbitrary duration) and different investment profitability
coefficients β is investigated. The effectiveness of investments is determined by

https://doi.org/10.1007/978-3-319-99686-8_20
416 20 The Role of the Central Bank and Commercial Banks in Creating and. . .
Net Present Value, NPV. The study is conducted within the framework of invest-
ment models with debt repayment at the end of the project term.
decreasing depending on profitability coefficient β and credit rate values kd. The
cutoff credit rate values kd*, separating the range of increasing NPV(L) from range
of decreasing NPV(L ), are determined. The Central Bank should keep its key rate at
the level which allows commercial banks to keep their credit rates below the cutoff
credit rate values kd* in order to create and maintain a favorable investment climate
in the country.
20.2 Investment Models with Debt Repayment at the End

of the Project
The effectiveness of the investment project could be considered from two perspec-
tives: the owners of equity and debt and the equity holders only. For each of these
cases, NPV could be calculated in two ways: with the division of credit and
investment flows (and thus discounting of the payments using two different rates)
and without such a division (in this case, both flows are discounted using the same
rate, as which can be, obviously, chosen WACC). For each of the four situations, two
cases could be considered: (1) a constant value of equity S and (2) a constant value of
the total invested capital I ¼ S + D (D is value of debt funds).
As it was stated above, the effectiveness of the investment project is considered
from two perspectives: the owners of equity and debt and the equity holders only. In
the first case, the interest and duty paid by owners of equity (negative flows) returned
to the project because they are exactly equal to the flow (positive), obtained by
owners of debt capital. The only effect of leverage in this case is the effect of the tax
shield, generated from the tax relief: interest on the loan is entirely included into the
cost and thus reduces the tax base. After-tax flow of capital for each period in this
case is equal to
NOIð1 t Þ þ kd Dt ð20:1Þ
and the value of investments at the initial time moment T ¼ 0 is equal to

I ¼ S D.
Here NOI stands for net operating income (before taxes).
In the second case, investments at the initial time moment T ¼ 0 are equal to S
and the flow of capital for the period (in addition to the tax shields kd Dt it includes a

20.2 Investment Models with Debt Repayment at the End of the Project 417
shares kd D during all periods. Note that principal repayment is made at the end of the
last period.
We will consider the case of discounting, when operating and financial flows are
not separated and both are discounted, using the general rate (as which, obviously,
the weighted average cost of capital (WACC) can be selected). In this case, for long-
term (perpetuity) projects, the Modigliani–Miller formula (Мodigliani and Мiller
1958, 1963, 1966) for WACC will be used, and for projects of finite (arbitrary)
duration, Brusov–Filatova–Orekhova formula will be used (Brusov and Filatova
Note that debt capital is the least risky, because interest on credit is paid after
cost, whether of ordinary or of preference shares ke > kd; kp > kd. Here ke; kp is the
equity cost of ordinary or of preference shares consequently.

the Perspective of the Equity Holders Only (Without
Flow Separation)
In this case operating and financial flows are not separated and are discounted, using
The credit reimbursable at the end of the project (at the end of the period (n)) can
X
n
NPV ¼ S þ
ð1 þ WACCÞ i ð 1 þ WACC Þn
i¼1 ð20:3Þ
¼ S þ 1 :

Accounting that in the case S ¼ const NOI is proportional to the invested capital, I,
NOI ¼ βI ¼ βS(1 þ L ), and substituting D ¼ LS, we get

NPV ¼ S þ 1
WACC ð1 þ WACCÞn
D
, ð20:4Þ
ð1 þ WACCÞn

Lk d ð1 t Þ 1 L
NPV ¼ S 1 þ 1 þ

þ 1 : ð20:5Þ
WACC ð1 þ WACCÞn
20.2.1.1 Modigliani–Miller Limit (Long-Term (Perpetuity) Projects)

NPV ¼ S þ : ð20:6Þ
WACC
WACC

NPV ¼ S 1 þ þ
WACC WACC
ð20:8Þ
¼ S 1 þ þ :
In the last equation, we substituted the perpetuity (Modigliani–Miller) formula for

WACC:

Lt
WACC ¼ k0 1 : ð20:9Þ
1þL
Below we will investigate the dependence of the efficiency of investments on the

level of debt financing within a wide range of values of equity costs k0 and debt
capital costs kd under different project terms (long-term projects as well as projects of
arbitrary duration) and different investment profitability coefficients β.
For long-term project calculations, we use Formulas (20.8) and (20.9), while for
arbitrary duration project calculations, we use Formula (20.5) for NPV and BFO
formula for WACC:
¼ : ð20:10Þ
20.3 Modigliani–Miller Limit (Long-Term (Perpetuity) Projects) 419
Here, S is the value of equity capital of the company, wd ¼ DþS D

the share of debt
capital, ke , we ¼ DþS the cost and the share of the equity capital of the company, and
S
L ¼ D/S financial leverage.
20.3 Modigliani–Miller Limit (Long-Term (Perpetuity)

Projects)
Let us start from the long-term projects. We will study the dependence of the
efficiency of investments on the level of debt financing L for the values of equity
costs k0 from 6 to 32% and for different debt capital costs and different investment
profitability coefficient β values.
20.3.1 The Dependence of the Efficiency of Investments NPV

on the Level of Debt Financing L for the Values
of Equity Costs k0 ¼ 0.2
Below we represent the results of calculations for equity costs k0 ¼ 0.2; debt capital
costs kd ¼ 0.18, 0.16, 0.14, 0.12, 0.10, 0.08, and 0.06; S ¼ 250; and tax on profit rate
t ¼ 0.2.
Results are shown in Tables 20.1, 20.2, and 20.3 and Figs. 20.1, 20.2, and 20.3.
1. β ¼ 0.1
From Table 20.1 and Fig. 20.1, it is seen that NPV depends practically linearly on
leverage level L, increasing or decreasing depending on credit rate value kd. NPV(L )
Table 20.1 The dependence of NPV on the level of debt financing L for the values of equity costs
k0 ¼ 0.2 and for different debt capital costs kd ¼ 0.18, 0.16, 0.14, 0.12, 0.10, 0.08, and 0.06;
S ¼ 250; tax on profit rate t ¼ 0.2; and investment profitability coefficient β ¼ 0.1
NPV NPV NPV NPV NPV NPV NPV
L (kd ¼ 0.18) (kd ¼ 0.16) (kd ¼ 0.14) (kd ¼ 0.12) (kd ¼ 0.1) (kd ¼ 0.08) (kd ¼ 0.06)
0 150.00 150.00 150.00 150.00 150.00 150.00 150.00
1 227.78 205.56 183.33 161.11 138.89 116.67 94.44
2 319.23 273.08 226.92 180.77 134.62 88.46 42.31
3 414.71 344.12 273.53 202.94 132.35 61.76 8.82
4 511.90 416.67 321.43 226.19 130.95 35.71 59.52
5 610.00 490.00 370.00 250.00 130.00 10.00 110.00
6 708.62 563.79 418.97 274.14 129.31 15.52 160.34
7 807.58 637.88 468.18 298.48 128.79 40.91 210.61
8 906.76 712.16 517.57 322.97 128.38 66.22 260.81
9 1006.10 786.59 567.07 347.56 128.05 91.46 310.98
10 1105.56 861.11 616.67 372.22 127.78 116.67 361.11
0 130.00 130.00 130.00 130.00 130.00 130.00 130.00
1 183.33 161.11 138.89 116.67 94.44 72.22 50.00
2 250.00 203.85 157.69 111.54 65.38 19.23 26.92
3 320.59 250.00 179.41 108.82 38.24 32.35 102.94
4 392.86 297.62 202.38 107.14 11.90 83.33 178.57
5 466.00 346.00 226.00 106.00 14.00 134.00 254.00
6 539.66 394.83 250.00 105.17 39.66 184.48 329.31
7 613.64 443.94 274.24 104.55 65.15 234.85 404.55
8 687.84 493.24 298.65 104.05 90.54 285.14 479.73
9 762.20 542.68 323.17 103.66 115.85 335.37 554.88
10 836.67 592.22 347.78 103.33 141.11 385.56 630.00
0 110.00 110.00 110.00 110.00 110.00 110.00 110.00
1 138.89 116.67 94.44 72.22 50.00 27.78 5.56
2 180.77 134.62 88.46 42.31 3.85 50.00 96.15
3 226.47 155.88 85.29 14.71 55.88 126.47 197.06
4 273.81 178.57 83.33 11.90 107.14 202.38 297.62
5 322.00 202.00 82.00 38.00 158.00 278.00 398.00
6 370.69 225.86 81.03 63.79 208.62 353.45 498.28
7 419.70 250.00 80.30 89.39 259.09 428.79 598.48
8 468.92 274.32 79.73 114.86 309.46 504.05 698.65
9 518.29 298.78 79.27 140.24 359.76 579.27 798.78
10 567.78 323.33 78.89 165.56 410.00 654.44 898.89
increases at credit rate kd ¼ 0.06 and kd ¼ 0.08. The cutoff credit rate kd* value,
separating the range of increasing NPV(L ) from range of decreasing NPV(L ) for
investment profitability coefficient β ¼ 0.1, is equal to 0.1. At higher credit rate kd
values, NPV(L ) represents decreasing function.
2. β ¼ 0.12
increases at credit rate kd ¼ 0.06; kd ¼ 0.08 and kd ¼ 0.1. The cutoff credit rate value
kd*, separating the range of increasing NPV(L) from range of decreasing NPV(L ) for
investment profitability coefficient β ¼ 0.12, is equal to 0.12. At higher credit rate kd
values, NPV(L ) represents decreasing function.
NPV(L) at β=0,1
600,00
400,00
200,00
0,00 NPV (kd=0,18)

0 1 2 3 4 5 6 7 8 9 10 NPV (kd=0,16)
–200,00
NPV
NPV (kd=0,14)
NPV (kd=0,12)
–400,00
NPV (kd=0,1)
–600,00 NPV (kd=0,08)
NPV (kd=0,06)
–800,00
–1000,00
–1200,00
L
Fig. 20.1 The dependence of the Net Present Value, NPV, on the leverage level L for the equity
value k0 ¼ 20% and for different debt capital costs kd ¼ 0.18, 0.16, 0.14, 0.12, 0.10, 0.08, and 0.06;
NPV(L) at β=0,12
800,00
600,00
400,00
200,00 NPV (kd=0,18)

NPV (kd=0,16)
0,00 NPV (kd=0,14)
NPV
0 1 2 3 4 5 6 7 8 9 10
–200,00 NPV (kd=0,12)
NPV (kd=0,1)
–400,00 NPV (kd=0,08)
NPV (kd=0,06)
–600,00
–800,00
–1000,00
L
3. β ¼ 0.14
increases at credit rate kd ¼ 0.06, kd ¼ 0.08, kd ¼ 0.1, and kd ¼ 0.12. The cutoff
credit rate kd* value, separating the range of increasing NPV(L) from range of
decreasing NPV(L ) for investment profitability coefficient β ¼ 0.14, is equal to
0.14. At higher credit rate kd values, NPV(L ) represents decreasing function.
NPV(L) at β=0,14
1000,00
800,00
600,00
400,00 NPV (kd=0,18)

NPV (kd=0,16)
200,00 NPV (kd=0,14)
NPV
NPV (kd=0,12)
0,00
0 1 2 3 4 5 6 7 8 9 10 NPV (kd=0,1)
–200,00 NPV (kd=0,08)
NPV (kd=0,06)
–400,00
–600,00
–800,00
L
One can see that the cutoff credit rate kd* values separating the range of increas-
ing NPV(L ) from range of decreasing NPV(L ) strongly correlate with investment
profitability coefficient β and practically linearly depend on it.
For long-term projects (Modigliani–Miller limit), it was found that the cutoff
credit rate values kd* are proportional to investment profitability coefficients β: it
turns out that for equity capital cost k0 ¼ 0.2, the cutoff credit rate values kd*
separating the range of increasing NPV(L ) from range of decreasing NPV(L) are
approximately equal to investment profitability coefficient β; for investment profit-
ability coefficient β ¼ 0.1, kd* is equal to 0.1; for β ¼ 0.12 kd* is equal to 0.12; and
for investment profitability coefficient β ¼ 0.14 kd* is equal to 0.14. The slope of the
curve NPV(L) increases with investment profitability coefficient β for the same
value of credit rate kd.

on the Level of Debt Financing L for the Value
Let us consider also the case of equity capital cost k0 ¼ 0.28 and debt capital cost
kd ¼ 6%, 8%, 10%, 12%, 14%, 16%, 18%, 20%, 22%, and 24%.
It is seen from Fig. 20.4 that the cutoff credit rate kd* value separating the range of
increasing NPV(L) from range of decreasing NPV(L ) is equal to 10%.
It is seen from Fig. 20.5 that the cutoff credit rate value kd*, separating the range
of increasing NPV(L ) from range of decreasing NPV(L ), is equal to 20%.
value k0 ¼ 28% and for different debt capital costs kd ¼ 6%, 8%, 10%, 12%, 14%, 16%, 18%, 20%,
22%, and 24%; S ¼ 250; tax on profit rate t ¼ 0.2; and investment profitability coefficient β ¼ 0.1
value k0 ¼ 28% and for different debt capital costs kd ¼ 6%, 8%, 10%, 12%, 14%, 16%, 18%, 20%,
22%, and 24%; S ¼ 250; tax on profit rate t ¼ 0.2; and investment profitability coefficient β ¼ 0.2
From Figs. 20.4 and 20.5, it follows that for β ¼ 0.1, kd* is equal to 0.1, and for
investment profitability coefficient β ¼ 0.2, kd* is equal to 0.2.
We could come to a conclusion that in perpetuity limit for both cases for the
equity values k0 ¼ 20% and k0 ¼ 28%, it turns out that the cutoff credit rate kd*
values are equal to investment profitability coefficient β (and does not depend on the
equity values k0).
As we will see below, this statement is not valid for the projects of arbitrary
durations.
20.4 Projects of Finite (Arbitrary) Duration
Let us consider now the projects of arbitrary durations. We will study the depen-
dence of the efficiency of investments on the level of debt financing L for the same
values of equity costs k0 from 6% to 32%, for different debt capital costs kd and
different investment profitability coefficient β values, as well as for different project
durations.
For arbitrary duration project calculations, we use formula (20.5) for NPV

Lk d ð1 t Þ 1 L
NPV ¼ S 1 þ 1 þ

þ 1 :
WACC ð1 þ WACCÞn
and BFO formula (20.10) for WACC
¼ :

Below we represent the results of calculations for equity costs k0 ¼ 0.2; debt capital
costs kd ¼ 0.18, 0.16, 0.14, 0.12, 0.10, 0.08, and 0.06; S ¼ 250; tax on profit rate
t ¼ 0.2; and project duration n ¼ 5. In the next part, we will compare the results for
project durations n ¼ 5 and n ¼ 3.
For arbitrary duration project calculations, we use formula (20.5) for NPV and
BFO formula for WACC (20.10).
Results are shown in Tables 20.4, 20.5, and 20.6 and Figs. 20.4, 20.5, and 20.6.
20.4 Projects of Finite (Arbitrary) Duration 425
S ¼ 250; tax on profit rate t ¼ 0.2; β ¼ 0.325; and project duration n ¼ 5
0 55.62 55.62 55.62 55.62 55.62 55.62 55.62
1 64.27 51.88 39.78 27.84 16.10 4.63 6.60
2 84.87 58.97 33.37 8.12 16.70 41.06 64.88
3 109.00 69.04 29.55 9.40 47.74 85.35 122.14
4 134.55 80.39 26.81 26.01 78.04 129.06 178.95
5 160.82 92.33 24.61 42.16 107.96 172.47 235.56
6 187.68 104.63 22.73 58.04 137.67 215.71 292.05
7 214.48 117.19 21.05 73.87 167.24 258.85 348.47
8 241.83 129.90 19.51 89.50 196.72 301.91 404.83
9 269.07 142.72 18.06 105.05 226.13 344.92 461.15
10 296.16 155.62 16.68 120.54 255.50 387.89 517.45
0 43.66 43.66 43.66 43.66 43.66 43.66 43.66
1 38.96 26.63 14.64 2.83 8.77 20.08 31.15
2 46.07 20.39 4.97 29.97 54.50 78.55 102.02
3 56.74 17.11 22.02 60.58 98.47 135.61 171.89
4 68.82 15.10 37.99 90.29 141.71 192.09 241.28
5 81.62 13.68 53.42 119.54 184.58 248.28 310.49
6 94.98 12.63 68.53 148.51 227.22 304.31 379.58
7 108.32 11.83 83.45 177.41 269.74 360.22 448.59
8 122.17 11.18 98.22 206.13 312.16 416.07 517.55
9 135.93 10.64 112.91 234.77 354.52 471.86 586.48
10 149.58 10.18 127.53 263.36 396.83 527.61 655.38
0 31.70 31.70 31.70 31.70 31.70 31.70 31.70
1 13.65 1.39 10.49 22.18 33.65 44.80 55.69
2 7.27 18.20 43.32 68.06 92.30 116.03 139.16
3 4.48 34.82 73.59 111.76 149.21 185.87 221.64
4 3.08 50.20 102.79 154.56 205.39 255.13 303.62
5 2.41 64.96 131.45 196.91 261.19 324.10 385.43
6 2.27 79.37 159.80 238.99 316.78 392.90 467.11
7 2.17 93.53 187.94 280.94 372.24 461.60 548.72
8 2.50 107.54 215.96 322.76 427.60 530.22 630.28
9 2.79 121.44 243.87 364.50 482.91 598.80 711.81
10 3.01 135.26 271.73 406.18 538.16 667.33 793.30
NPV(L) at β=0,325
600,00
500,00
400,00
300,00
NPV (kd=0,18)
200,00 NPV (kd=0,16)
NPV (kd=0,14)
NPV
100,00
NPV (kd=0,12)
0,00 NPV (kd=0,1)
0 1 2 3 4 5 6 7 8 9 10 NPV (kd=0,08)
–100,00
NPV (kd=0,06)
–200,00
–300,00
–400,00
L
S ¼ 250; tax on profit rate t ¼ 0.2; investment profitability coefficient β ¼ 0.325; and project
duration n ¼ 5
1. β ¼ 0.325
increases at credit rate kd ¼ 0.06, kd ¼ 0.08, kd ¼ 0.1, and kd ¼ 0.12. The cutoff
credit rate value kd*, separating the range of increasing NPV(L ) from the range of
0.14. At higher credit rates kd values, NPV(L ) represents decreasing function.
2. β ¼ 0.345
increases at credit rates kd ¼ 0.06, kd ¼ 0.08, kd ¼ 0.1, kd ¼ 0.12, and kd ¼ 0.14. The
cutoff credit rate value kd*, separating the range of increasing NPV(L ) from range of
0.16. At higher credit rates kd values, NPV(L ) represents decreasing function.
3. β ¼ 0.365
increases at credit rate kd ¼ 0.06, kd ¼ 0.08, kd ¼ 0.1, kd ¼ 0.12, kd ¼ 0.14, and
kd ¼ 0.16. The cutoff credit rate value kd*, separating the range of increasing NPV
(L ) from the range of decreasing NPV(L ) for investment profitability coefficient
β ¼ 0.365, is equal to 0.18. At higher credit rates kd values, NPV(L) represents
decreasing function.
NPV(L) at β=0,345
700,00
600,00
500,00
NPV (kd=0,18)
400,00
NPV (kd=0,16)
300,00 NPV (kd=0,14)
NPV
200,00 NPV (kd=0,12)

NPV (kd=0,1)
100,00 NPV (kd=0,08)
0,00 NPV (kd=0,06)
0 1 2 3 4 5 6 7 8 9 10
–100,00
–200,00
L
duration n ¼ 5
NPV(L) at β=0,365
900,00
800,00
700,00
600,00 NPV (kd=0,18)
500,00 NPV (kd=0,16)
NPV (kd=0,14)
NPV
400,00
NPV (kd=0,12)
300,00 NPV (kd=0,1)
200,00 NPV (kd=0,08)
NPV (kd=0,06)
100,00
0,00
0 1 2 3 4 5 6 7 8 9 10
–100,00
L
duration n ¼ 5
One can see that the cutoff credit rate values kd*, separating the range of
increasing NPV(L ) from the range of decreasing NPV(L ), strongly correlate with
investment profitability coefficient β and practically linearly depend on it: kd*
linearly increases with profitability coefficient β.
For arbitrary duration projects, results are as follows. The efficiency of invest-
ments strongly depends on project duration and increases with duration. One can see
that the slope of the curve NPV(L ) at project duration n ¼ 5 is always higher than for
project duration n ¼ 3. The efficiency of investments increases with project duration

and is less than for long-term (perpetuity) projects. Transition to increasing NPV(L )
behavior for finite duration projects requires much higher values of investment
profitability coefficient β than in the case of long-term (perpetuity) projects, where
kd* is approximately equal to β: for 5-year projects, the cutoff credit rate value kd*
for investment profitability coefficient β ¼ 0.325 is equal to 0.14, for investment
profitability coefficient β ¼ 0.345 is equal to 0.16, and for investment profitability
coefficient β ¼ 0.365 is equal to 0.18. Thus, for finite duration projects as well as for
the long-term projects, cutoff credit rate values kd* turn out to be proportional to
investment profitability coefficients β, but investment profitability coefficients β are
approximately twice higher than kd*.

Below at Figs. 20.9, 20.10, 20.11, and 20.12, we present the results of calculations of
the dependence of the Net Present Value, NPV, on the leverage level L for the equity
value k0 ¼ 28% and for different debt capital costs kd ¼ 0.24, 0.22, 0.20, 0.18, 0.16,
0.14, 0.12, 0.10, 0.08, and 0.06; S ¼ 250; tax on profit rate t ¼ 0.2; investment
profitability coefficient β ¼ 0.1; and project durations n ¼ 3 and n ¼ 5.
From Figs. 20.9, 20.10, 20.11, and 20.12, one can make the following
conclusions:
n=3, β=0,1
0,00
1 2 3 4 5 6 7 8 9 10
–500,00
NPV (kd=0,24)
NPV (kd=0,22)
–1000,00 NPV (kd=0,20)
NPV (kd=0,18)
NPV
NPV (kd=0,16)
–1500,00 NPV (kd=0,14)
NPV (kd=0,12)
NPV (kd=0,10)
–2000,00
NPV (kd=0,08)
NPV (kd=0,06)
–2500,00
L
value k0 ¼ 28% and for different debt capital costs kd ¼ 0.24, 0.22, 0.20, 0.18, 0.16, 0.14, 0.12,
0.10, 0.08, and 0.06; S ¼ 250; tax on profit rate t ¼ 0.2; investment profitability coefficient β ¼ 0.1;
and project duration n ¼ 3
n=3, β=0,2
0,00
1 2 3 4 5 6 7 8 9 10
–200,00
NPV (kd=0,24)
–400,00
NPV (kd=0,22)
–600,00
NPV (kd=0,20)
–800,00
NPV (kd=0,18)
NPV
–1000,00 NPV (kd=0,16)

–1200,00 NPV (kd=0,14)
–1400,00 NPV (kd=0,12)
–1600,00 NPV (kd=0,10)
–1800,00 NPV (kd=0,08)
–2000,00 NPV (kd=0,06)

L
n=5, β=0,1
0,00
1 2 3 4 5 6 7 8 9 10
NPV (kd=0,24)
–500,00
NPV (kd=0,22)
NPV (kd=0,20)
–1000,00 NPV (kd=0,18)

NPV (kd=0,16)
NPV
NPV (kd=0,14)
–1500,00 NPV (kd=0,12)
NPV (kd=0,10)
NPV (kd=0,08)
–2000,00 NPV (kd=0,06)
–2500,00
L
1. NPV decreases with debt capital cost kd.

2. NPV increases with investment profitability coefficient β as well as with project
duration.
n=5, β=0,2
0,00
1 2 3 4 5 6 7 8 9 10
–200,00
NPV (kd=0,24)
–400,00
NPV (kd=0,22)
NPV (kd=0,20)
–600,00
NPV (kd=0,18)
NPV
–800,00 NPV (kd=0,16)

NPV (kd=0,14)
–1000,00 NPV (kd=0,12)
NPV (kd=0,10)
–1200,00
NPV (kd=0,08)
NPV (kd=0,06)
–1400,00
–1600,00
L
3. The cutoff value kd* has been reached at Figs. 20.9, 20.10, 20.11, and 20.12 only
at profitability coefficient β ¼ 0.2 for a 5-year project and is equal to 6%; it will
increase with investment profitability coefficient β. Bigger values of β, and/or
longer durations n, and/or bigger values of equity capital S, are required in order
to demonstrate the presence of a cutoff value kd* for particular project.
20.5 The Dependence of the Net Present Value, NPV,

on the Leverage Level l for Projects of Different
Durations
We consider the case of equity cost (at L ¼ 0) k0 ¼ 14% and fixed value of debt cost
kd ¼ 0.04, 0.06, 0.08, 0.1, and 0.12 and compare the results for projects of different
durations: n ¼ 3 years and n ¼ 5 years (Tables 20.7, 20.8, 20.9, and 20.10 and
Figs. 20.13 and 20.14).
20.5 The Dependence of the Net Present Value, NPV, on the Leverage Level. . . 431
Table 20.7 The dependence of the Net Present Value, NPV, on the leverage level L for the equity
cost value k0 ¼ 14% and for debt capital cost kd ¼ 0.04; S ¼ 250; tax on profit rate t ¼ 0.2;
investment profitability coefficient β ¼ 0.1; and project duration n ¼ 3
S L WACC (%) k0 kd wd t n β ke NPV
250 0 14.00 0.14 0.04 0.00 0.2 3 0.1 0.14 203.57
250 1 13.34 0.14 0.04 0.50 0.2 3 0.1 0.23 346.60
250 2 13.11 0.14 0.04 0.67 0.2 3 0.1 0.33 491.78
250 3 13.00 0.14 0.04 0.75 0.2 3 0.1 0.42 637.53
250 4 12.94 0.14 0.04 0.80 0.2 3 0.1 0.52 783.49
250 5 12.89 0.14 0.04 0.83 0.2 3 0.1 0.61 929.57
250 6 12.86 0.14 0.04 0.86 0.2 3 0.1 0.71 1075.71
250 7 12.84 0.14 0.04 0.88 0.2 3 0.1 0.80 1221.89
250 8 12.82 0.14 0.04 0.89 0.2 3 0.1 0.90 1368.10
250 9 12.80 0.14 0.04 0.90 0.2 3 0.1 0.99 1514.33
250 10 12.79 0.14 0.04 0.91 0.2 3 0.1 1.09 1660.57
250 0 14.00 0.14 0.04 0.00 0.2 5 0.1 0.14 181.34
250 1 13.26 0.14 0.04 0.50 0.2 5 0.1 0.23 272.31
250 2 13.01 0.14 0.04 0.67 0.2 5 0.1 0.33 366.58
250 3 12.88 0.14 0.04 0.75 0.2 5 0.1 0.42 461.70
250 4 12.80 0.14 0.04 0.80 0.2 5 0.1 0.51 557.17
250 5 12.75 0.14 0.04 0.83 0.2 5 0.1 0.61 652.81
250 6 12.72 0.14 0.04 0.86 0.2 5 0.1 0.70 748.55
250 7 12.69 0.14 0.04 0.88 0.2 5 0.1 0.79 844.36
250 8 12.67 0.14 0.04 0.89 0.2 5 0.1 0.88 940.21
250 9 12.65 0.14 0.04 0.90 0.2 5 0.1 0.98 1036.09
250 10 12.64 0.14 0.04 0.91 0.2 5 0.1 1.07 1131.99
250 0 14.00 0.14 0.04 0.00 0.2 3 0.2 0.14 157.14
250 1 13.34 0.14 0.04 0.50 0.2 3 0.2 0.23 252.69
250 2 13.11 0.14 0.04 0.67 0.2 3 0.2 0.33 350.39
250 3 13.00 0.14 0.04 0.75 0.2 3 0.2 0.42 448.64
250 4 12.94 0.14 0.04 0.80 0.2 3 0.2 0.52 547.12
250 5 12.89 0.14 0.04 0.83 0.2 3 0.2 0.61 645.71
250 6 12.86 0.14 0.04 0.86 0.2 3 0.2 0.71 744.36
250 7 12.84 0.14 0.04 0.88 0.2 3 0.2 0.80 843.05
250 8 12.82 0.14 0.04 0.89 0.2 3 0.2 0.90 941.77
250 9 12.80 0.14 0.04 0.90 0.2 3 0.2 0.99 1040.51
250 10 12.79 0.14 0.04 0.91 0.2 3 0.2 1.09 1139.26
250 0 14.00 0.14 0.04 0.00 0.2 5 0.2 0.14 112.68
250 1 13.26 0.14 0.04 0.50 0.2 5 0.2 0.23 132.50
250 2 13.01 0.14 0.04 0.67 0.2 5 0.2 0.33 155.57
250 3 12.88 0.14 0.04 0.75 0.2 5 0.2 0.42 179.49
250 4 12.80 0.14 0.04 0.80 0.2 5 0.2 0.51 203.76
250 5 12.75 0.14 0.04 0.83 0.2 5 0.2 0.61 228.20
250 6 12.72 0.14 0.04 0.86 0.2 5 0.2 0.70 252.73
250 7 12.69 0.14 0.04 0.88 0.2 5 0.2 0.79 277.33
250 8 12.67 0.14 0.04 0.89 0.2 5 0.2 0.88 301.97
250 9 12.65 0.14 0.04 0.90 0.2 5 0.2 0.98 326.65
250 10 12.64 0.14 0.04 0.91 0.2 5 0.2 1.07 351.34
NPV(L), kd=0,04, β=0,1

0,00
–200,00 0 1 2 3 4 5 6 7 8 9 10
–400,00
–600,00
–800,00
NPV
–1000,00
–1200,00
–1400,00
–1600,00
–1800,00
L
NPV(n=3) NPV(n=5)
investment profitability coefficient β ¼ 0.1; and two project durations n ¼ 3 and n ¼ 5
20.5 The Dependence of the Net Present Value, NPV, on the Leverage Level. . . 433
NPV(L), kd=0,04, β=0,2

0,00
0 1 2 3 4 5 6 7 8 9 10
–200,00
–400,00
NPV
–600,00
–800,00
–1000,00
–1200,00
L
NPV(n=3) NPV(n=5)
investment profitability coefficient β ¼ 0.2; and two project durations n ¼ 3 and n ¼ 5
kd ¼ 0.1
One can see that at fixed credit rates k0, NPV increases with project duration. The
(negative) slope of NPV(L ) curves decreases with project duration (Tables 20.11,
20.12, 20.13, and 20.14 and Figs. 20.15 and 20.16).
cost value k0 ¼ 14% and for debt capital cost kd ¼ 0.1; S ¼ 250; tax on profit rate t ¼ 0.2; investment
profitability coefficient β ¼ 0.2; and project duration n ¼ 3
250 0 14.00 0.14 0.10 0.00 0.2 3 0.1 0.14 203.57
250 1 12.51 0.14 0.10 0.50 0.2 3 0.1 0.17 377.91
250 2 12.01 0.14 0.10 0.67 0.2 3 0.1 0.20 557.74
250 3 11.76 0.14 0.10 0.75 0.2 3 0.1 0.23 739.00
250 4 11.61 0.14 0.10 0.80 0.2 3 0.1 0.26 920.85
250 5 11.51 0.14 0.10 0.83 0.2 3 0.1 0.29 1103.00
250 6 11.44 0.14 0.10 0.86 0.2 3 0.1 0.32 1285.31
250 7 11.39 0.14 0.10 0.88 0.2 3 0.1 0.35 1467.73
250 8 11.35 0.14 0.10 0.89 0.2 3 0.1 0.38 1650.23
250 9 11.31 0.14 0.10 0.90 0.2 3 0.1 0.41 1832.77
250 10 11.28 0.14 0.10 0.91 0.2 3 0.1 0.44 2015.35
250 0 14.00 0.14 0.10 0.00 0.2 5 0.1 0.14 181.34
250 1 12.41 0.14 0.10 0.50 0.2 5 0.1 0.17 317.91
250 2 11.88 0.14 0.10 0.67 0.2 5 0.1 0.20 462.97
250 3 11.61 0.14 0.10 0.75 0.2 5 0.1 0.22 610.30
250 4 11.45 0.14 0.10 0.80 0.2 5 0.1 0.25 758.57
250 5 11.34 0.14 0.10 0.83 0.2 5 0.1 0.28 907.31
250 6 11.26 0.14 0.10 0.86 0.2 5 0.1 0.31 1056.33
250 7 11.20 0.14 0.10 0.88 0.2 5 0.1 0.34 1205.52
250 8 11.16 0.14 0.10 0.89 0.2 5 0.1 0.36 1354.83
250 9 11.12 0.14 0.10 0.90 0.2 5 0.1 0.39 1504.22
250 10 11.09 0.14 0.10 0.91 0.2 5 0.1 0.42 1653.67
250 0 14.00 0.14 0.10 0.00 0.2 3 0.2 0.14 157.14
250 1 12.51 0.14 0.10 0.50 0.2 3 0.2 0.17 282.68
250 2 12.01 0.14 0.10 0.67 0.2 3 0.2 0.20 413.66
250 3 11.76 0.14 0.10 0.75 0.2 3 0.2 0.23 546.07
250 4 11.61 0.14 0.10 0.80 0.2 3 0.2 0.26 679.06
250 5 11.51 0.14 0.10 0.83 0.2 3 0.2 0.29 812.35
250 6 11.44 0.14 0.10 0.86 0.2 3 0.2 0.32 945.80
250 7 11.39 0.14 0.10 0.88 0.2 3 0.2 0.35 1079.36
250 8 11.35 0.14 0.10 0.89 0.2 3 0.2 0.38 1212.99
250 9 11.31 0.14 0.10 0.90 0.2 3 0.2 0.41 1346.67
250 10 11.28 0.14 0.10 0.91 0.2 3 0.2 0.44 1480.38
250 0 14.00 0.14 0.10 0.00 0.2 5 0.2 0.14 112.68
250 1 12.41 0.14 0.10 0.50 0.2 5 0.2 0.17 175.18
250 2 11.88 0.14 0.10 0.67 0.2 5 0.2 0.20 246.02
250 3 11.61 0.14 0.10 0.75 0.2 5 0.2 0.22 319.09
250 4 11.45 0.14 0.10 0.80 0.2 5 0.2 0.25 393.09
250 5 11.34 0.14 0.10 0.83 0.2 5 0.2 0.28 467.55
250 6 11.26 0.14 0.10 0.86 0.2 5 0.2 0.31 542.29
250 7 11.20 0.14 0.10 0.88 0.2 5 0.2 0.34 617.20
250 8 11.16 0.14 0.10 0.89 0.2 5 0.2 0.36 692.22
250 9 11.12 0.14 0.10 0.90 0.2 5 0.2 0.39 767.32
250 10 11.09 0.14 0.10 0.91 0.2 5 0.2 0.42 842.47
NPV(L), kd=0,1, β=0,1

0,00
0 1 2 3 4 5 6 7 8 9 10
–500,00
–1000,00
NPV
–1500,00
–2000,00
–2500,00
L
NPV(n=3) NPV(n=5)
profitability coefficient β ¼ 0.1; and two project durations n ¼ 3 and n ¼ 5
NPV(L), kd=0,1, β=0,2

0,00
0 1 2 3 4 5 6 7 8 9 10
–200,00
–400,00
–600,00
NPV
–800,00
–1000,00
–1200,00
–1400,00
–1600,00
L
NPV(n=3) NPV(n=5)
profitability coefficient β ¼ 0.2; and two project durations n ¼ 3 and n ¼ 5
20.6 Conclusions
We study the role of the Central Bank and commercial banks in creating and
maintaining a favorable investment climate in the country. Within the framework
of modern investment models created by the authors, the dependence of the
efficiency of investments on the level of debt financing within a wide range of values
of equity capital costs and debt capital costs under different project terms (long-term
projects as well as projects of arbitrary duration) and different investment profitabil-
ity coefficients β is investigated. The effectiveness of investments is determined by
the Net Present Value (NPV). The study is conducted within the framework of
investment models with debt repayment at the end of the project term.
decreasing depending on profitability coefficient β and credit rate value kd. The
cutoff credit rate values kd* separating the range of increasing NPV(L) from range of
decreasing NPV(L ) are determined.
For long-term projects (Modigliani–Miller limit), it was found that the cutoff
credit rate values kd* are proportional to investment profitability coefficients β: it
turns out that for equity capital cost k0 ¼ 0.2, the cutoff credit rate value kd*
separating the range of increasing NPV(L ) from range of decreasing NPV(L ) is
approximately equal to investment profitability coefficient β; for investment profit-
ability coefficient β ¼ 0.1, kd* is equal to 0.1; for β ¼ 0.12, kd* is equal to 0.12; and
for investment profitability coefficient β ¼ 0.14, kd* is equal to 0.14. The slope of the
curve NPV(L) increases with investment profitability coefficient β for the same
value of credit rate kd.
We come to a conclusion that for long-term projects (in perpetuity limit) for both
cases for the equity values k0 ¼ 20% and k0 ¼ 28%, it turns out that the cutoff credit
rate values kd* are equal to investment profitability coefficient β (and does not
depend on the equity values k0). This statement is not valid for the projects of
arbitrary (finite) durations.
For arbitrary duration projects, results are as follows. The efficiency of invest-
ments strongly depends on project duration and increases with duration. One can see
that the slope of the curve NPV(L ) at project duration n ¼ 5 is always higher than for
project duration n ¼ 3. The efficiency of investments increases with project duration
and is less than for long-term (perpetuity) projects. Transition to increasing NPV(L )
behavior for finite duration projects requires much higher values of investment
profitability coefficient β than in case of long-term (perpetuity) projects, where kd*
is approximately equal to β: for example, for equity cost k0 ¼ 0.20 and 5-year
projects, the cutoff credit rate value kd* for investment profitability coefficient
β ¼ 0.325 is equal to 0.14; for investment profitability coefficient β ¼ 0.345, 0.16;
and for investment profitability coefficient β ¼ 0.365, 0.18. Thus, for finite duration
projects as well as for the long-term projects, cutoff credit rate values kd* turn out to
be proportional to investment profitability coefficients β, but investment profitability
coefficients β are approximately twice higher than kd*.
We develop a method of determination of the cutoff credit rate values kd*,
separating the range of increasing NPV(L ) from range of decreasing NPV(L ). We
have found the cutoff credit rate kd* values within a wide range of values of equity
costs k0 and debt capital costs kd under different project terms (long-term projects as
well as projects of arbitrary duration) and different investment profitability coeffi-
cients β. Obtained results will help the Central Bank to keep its key rate at the level,
References 437
which allows commercial banks to keep their credit rates below the cutoff credit rate
values kd* in order to create and maintain a favorable investment climate in the
country.
References
(11):815–824
org/10.1080/23322039.20946150
Brusov P, Filatova T, Orehova N, Eskindarov M (2015) Modern corporate finance, investments and
taxation, monograph, 1st edn. Springer International Publishing, Berlin, 368pp
7:37–62
Econ Rev 53:147–175
1954–1957. Am Econ Rev 56:333–391
Part IV
Ratings and Rating Methodologies
Chapter 21
Rating: New Approach
21.1 Introduction
The Chaps. 21, 22, and 23 suggest a new approach to rating methodology. Chapters
21 and 22 are devoted to rating of nonfinancial issuers, while Chap. 23 is devoted to
long-term project rating. The key factors of a new approach are (1) the adequate use
of discounting 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) (Brusov et al. 2015)
(in Chap. 21 into its perpetuity limit). This on the one hand allows use of 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 discuss also the inter-
play 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 to issue more correct ratings of issuers and makes the
rating methodologies more understandable and transparent.
Rating agencies play a very important role in economics. Their analysis of issuer’s
state, generated credit ratings of issuers help investors make reasonable investment
decision as well as help issuers with good enough ratings get credits on lower rates, etc.
But from time to time, we listen about scandals that involved rating agencies and
their credit ratings: let us just remind the situation with sovereign rating of the USA
in 2011 and of the Russia in 2015.
Were these ratings an objective? And how objective could be issued credit ratings
in principal?
To answer this question, we need to understand how rating agencies
(RA) consider, evaluate, and analyze. But this is the secret behind the seven seals:
rating agencies stand to the death, but did not reveal their secrets, even under the
threat of multibillion-dollar sanctions.
Thus, rating agencies represent some “black boxes,” about which information on
the methods of work is almost completely absent.

https://doi.org/10.1007/978-3-319-99686-8_21
442 21 Rating: New Approach
21.2 The Closeness of the Rating Agencies
The closeness of the rating agencies is caused by multiple causes.

1. The desire to preserve their “know-how.” Rating agencies get big enough money
for generated ratings (mostly from issuers) to replicate its methodology.
2. On the other hand, closeness of rating agencies is caused by the desire to avoid
public discussion of the ratings with anyone, including the issuer. It is a very
convenient position—rating agency “a priori” removes himself from beneath any
criticism of generated ratings.
3. The absence of any external control and external analysis of the methodologies
resulted in the fact that shortcomings of methodologies are not subjected to
serious critical analysis and stored long enough.
The illustration of the closeness of rating agencies is the behavior of the S&P
(Standard & Poor’s) Director after declining the sovereign rating of the USA, who
left his position but has not opened the methodology used.
But even in this situation, it is still possible some analysis of the activities and
findings of the rating agencies, based on knowledge and understanding of existing
methods of evaluation. Rating agencies cannot use methods other than developed up
to now by leading economists and financiers.
21.3 The Use of Discounting in the Rating
One of the major flaws of all existing rating methodologies is a failure or a very narrow
use of discounting. But even in those rare cases where it is used, it is not quite correct,
since the discount rate when discounting financial flows is chosen incorrectly.
The need to take into account the time factor in terms of discounting is obvious,
because it is associated with the time value of money. The financial part of the rating
is based on a comparison of generated income with the value of the debt and the
interest payable. Because income and disbursement of debt and interest are separated
in time, the use of discounting when comparing revenues with the value of debt and
interest is absolutely necessary for assigning credit ratings for issuers.
This raises the question about the value of discount rate. This question has always
been one of the major and extremely difficult in many areas of finance: corporate
finance and investment; it is particularly important in business valuation, where a slight
change in the discount rate leads to a significant change in the assessment of company
capitalization that is used by unscrupulous appraisers for artificial bankruptcy of the
company. And the correct valuation of discount rate is extremely essential not only in in
business valuation, but as well in ratings.
21.5 Models 443
21.4 Incorporation of Parameters, Used in Ratings, into

Perpetuity Limit of Modern Theory of Capital
Structure by Brusov–Filatova–Orekhova
In the quantification of the creditworthiness of the issuers, the crucial role belongs to
the so-called financial “ratios,” which constitute direct and inverse ratios of various
generated cash flows to debt values and interest ones. We could mention such ratios
as DCF/Debt, FFO/Debt, CFO/Debt, FOCF/Debt, FFO/cash interest, EBITDA/
interest, Interests/EBITDA, Debt/EBITDA, and some others.
We incorporate these rating parameters (financial “ratios”) into the modern theory of
capital structure—BFO theory (Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b,
2018a, b, c; Brusov and Filatova 2011; Filatova et al. 2008) (for beginning into its
perpetuity limit) (Brusov et al. 2018d; Modigliani and Miller 1966). The importance of
such incorporation, which has been done by us for the first time, is in using this theory as
a powerful tool when discounting financial flows using the correct discounting rate in
rating. Only this theory allows to valuate adequately the weighted average cost of capital
(WACC) and equity cost of capital ke used when discounting financial flows.
The use of the tools of well-developed theories in rating opens completely new
horizons in the rating industry, which could go from mainly the use of qualitative
methods of the evaluation of the creditworthiness of issuers to predominantly
quantitative evaluation methods that will certainly enhance the quality and correct-
ness of the rating.
Currently, rating agencies just directly use financial ratios, while the new meth-
odology will allow (knowing the values of these “relations” (and parameter k0)) to
determine the correct values of discount rates (WACC and ke) that should be used
when discounting the various financial flows, both in terms of their timing and
forecasting.
This has required the modification of the BFO theory (and its perpetuity limit—
Modigliani–Miller theory), as used in financial management the concept of “lever-
age” as the ratio of debt value to the equity value substantially differs from the
concept of “leverage” in the rating, where it is understood as the direct and inverse
ratio of the debt value to the generated cash flow values (income, profit, etc.). The
authors introduced some additional ratios, allowing to more fully characterize the
issuer’s ability to repay debts and to pay interest thereon.
Thus, the bridge is building between the discount rates (WACC, ke), used when
discounting financial flows, and “ratios” in the rating methodology. The algorithm
for finding the discount rates for the given ratio values is developed.
21.5 Models
Two kinds of models of the evaluation of the creditworthiness of issuers, accounting

the discounting financial flows, could be used in rating: one-period model and multi-
period model.
Fig. 21.1 One-period CF kdD D

model
t t1 t2
21.5.1 One-Period Model
One-period model is described by the following formula (see Fig. 21.1):
CFð1 þ iÞt2 t Dþ kd Dð1 þ iÞt2 t1

ð21:1Þ
CFð1 þ iÞt2 t D 1 þ k d ð1 þ iÞt2 t1
Here CF is the value of income for period; D is the debt value; t, t1, t2 the
moments of income, payment of interest, and payment of debt consequently; i is the
discount rate; kd is the credit rate; and kdD is the interest on credit.
21.5.2 Multi-period Model
One-period model of the evaluation of the creditworthiness of issuers, accounting

the discounting financial flows, could be generalized for more interesting multi-
period case.
Multi-period model is described by the following formula:
X t t X h t t i
CF j 1 þ i j 2 j j D j 1 þ kdj 1 þ i j 2 j 1 j ð21:2Þ
j j
Here CFj is the income for j-st period; Dj is the debt value in j-st period; tj, t1j, t2j is
the moments of income, payment of interests, and payment of debt consequently in
j-st period; ij is the discount rate in j-st period; and kdj is the credit rate in j-st period.
There are several options to work with these models:
1. One can check the creditworthiness of the issuer, knowing parameters CFj, Dj, tj,
t1j, t2j, kdj and defining discount rate i by the method described below.
2. When the preset Dj, tj, t1j, t2j, kdj, one can determine which income CFj the issuer
would require to ensure its creditworthiness.
3. When the preset Dj, tj, t1j, t2j, kdj, one can define an acceptable level of debt
financing (including the credit value Dj and credit rates kdj) when the issuer
retains its creditworthiness.
21.6 Theory of Incorporation of Parameters, Used in Ratings, into. . . 445
21.6 Theory of Incorporation of Parameters, Used

in Ratings, into Perpetuity Limit of Modern Theory
of Capital Structure by Brusov–Filatova–Orekhova
For the first time, we incorporate below the parameters, used in ratings, into perpetuity
limit of modern theory of capital structure by Brusov–Filatova–Orekhova (BFO theory).
We’ll consider two kinds of ratios: coverage ratios and leverage ratios.
Let us start from the coverage ratios.
21.6.1 Coverage Ratios
We will consider three kinds of coverage ratios: coverage ratios of debt, coverage
ratios of interest on the credit, and coverage ratios of debt and interest on the credit.
21.6.1.1 Coverage Ratios of Debt
Here
i1 ¼ CF=D ð21:3Þ
Modigliani–Miller theorem for case with corporate taxes (Мodigliani and Мiller
1958, 1963) tells that capitalization of leveraged company, VL, is equal to the
capitalization of unleveraged company, V0, plus tax shield for perpetuity time, Dt:
V L ¼ V 0 þ Dt: ð21:4Þ
Substituting the expressions for both capitalizations, one has
CF CF
¼ þ Dt
WACC k0
Dividing both parts by D, one gets
i1 i1
¼ þt
WACC k0 ð21:5Þ
i1 k 0
WACC ¼
i1 þ tk 0
This ratio (i1) can be used to assess of the following parameters used in rating,
DCF/Debt, FFO/Debt, CFO/Debt, FOCF/Debt, and some others. We will use the last
formula to build a curve of dependence WACC(i1).
21.6.1.2 Coverage Ratios of Interest on the Credit
Here
i2 ¼ CF=k d D ð21:6Þ
Using the Modigliani–Miller theorem for case with corporate taxes
V L ¼ V 0 þ Dt,
we derive the expression for WACC(i2):
CF CF
¼ þ Dt
WACC k0
i2 i2 i2
¼ þ ð21:7Þ
WACC k 0 kd
i2 k 0 k d
WACC ¼
i2 kd þ tk 0
This ratio (i2) can be used to assess of the following parameters, used in rating,
FFO/cashinterest, EBITDA/interest, and some others. We will use the last formula
to build a curve of dependence WACC(i2).
21.6.1.3 Coverage Ratios of Debt and Interest on the Credit (New

Ratios)
Let us consider the coverage ratios of debt and interest on the credit simultaneously:
this is a new ratio, introduced by us for the first time here.
Here
CF
i3 ¼ ð21:8Þ
D ð1 þ k d Þ
Using the above the Modigliani–Miller theorem for case with corporate taxes
V L ¼ V 0 þ Dt,
one gets the expression for WACC(i3):
CF CF
¼ þ Dt
WACC k0
i3 i3 t
¼ þ ð21:9Þ
WACC k0 1 þ kd
i 3 k 0 ð1 þ k d Þ
WACC ¼
i3 ð1 þ k d Þ þ tk 0
This ratio (i3) can be used to assess the following parameters used in rating,
FFO/Debt + interest, EBITDA/Debt + interest, and some others. We will use last
formula to build a curve of dependence WACC(i3).
Let us analyze the dependence of the company’s weighted average cost of capital
(WACC) on the coverage ratios on debt i1, on interest on the credit i2, and on
coverage ratios on debt and interest on the credit with the following data: k0 ¼ 12%;
kd ¼ 6%; t ¼ 20%; ij run from 0 up to 10.
The dependence of the company’s weighted average cost of capital (WACC) on
the coverage ratio on interest on the credit i2 is presented at Fig. 21.3.
the coverage ratio on debt and interest on the credit i2 is presented at Fig. 21.4.
the coverage ratio on debt i1, on interest on the credit i2, and on debt and interest on
the credit i3 is presented at Fig. 21.5.
It is seen from the Figs. 21.2, 21.3, 21.4, and 21.5 that WACC(ij) is an increasing
function on ij with saturation around ij value of order 1 for ratios i1 and i3 and of order
4 or 5 for ratios i2. At saturation WACC reaches the value k0 (equity value at zero
leverage level). This means that for high values of ij, one can choose k0 as a discount
rate with a good accuracy. Thus, the role of parameter k0 increases drastically. The
method of determination of parameter k0 has been developed by Anastasiya Brusova
(2011). So, parameter k0 is the discount rate for limit case of high values of ij (see
however below for more detailed consideration).
Fig. 21.2 The dependence WACC(i1)

of the company’s weighted 0.14
average cost of capital 0.12
(WACC) on the coverage 0.1
ratio on debt i1 0.08
WACC
0.06
0.04
0.02
0
0 2 4 6 8 10 12
i1
Fig. 21.3 The dependence WACC(i2)

0.08
WACC
ratio on interest on the

credit i2 0.06
0.04
0.02
0
0 2 4 6 8 10 12
i2
WACC(i3)
0.14
0.12
0.1
0.08
WACC
0.06
0.04
0.02
0
0 2 4 6 8 10 12
i3
Fig. 21.4 The dependence of the company’s weighted average cost of capital (WACC) on the
coverage ratio on debt and interest on the credit i3
WACC(i)
0.14
0.12
0.1
0.08
WACC
0.06
0.04
0.02
0
0 2 4 6 8 10 12
I
WACC 1 WACC 2 WACC 3
Fig. 21.5 The dependence of company’s weighted average cost of capital (WACC) on the
coverage ratio on debt i1, on interest on the credit i2, and on debt and interest on the credit i3
It is clear from the Figs. 21.2, 21.3, 21.4, and 21.5 that the case of low values of ij
requires more detailed consideration. Let us consider the situation with low values of
ij which seems to be the case of the most interest.
21.6.2 More Detailed Consideration
Below we consider the case of low values of ij with more details. ij will vary from
zero up to 1 with all other parameters to be the same (Fig. 21.6, 21.7, 21.8, and 21.9).
More detailed consideration leads us to the following conclusions:
WACC(i1)
0.1400
0.1200
0.1000
0.0800
0.0600 WACC(i1)
0.0400
0.0200
0.0000
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
WACC(i2)
0.0900
0.0800
0.0700
0.0600
0.0500
0.0400 WACC(i2)
0.0300
0.0200
0.0100
0.0000
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
1. In the case of coverage ratio on debt and interest on the credit i3, WACC goes to
saturation very fast: with accuracy of 20% at i3 ¼ 0.15 and with accuracy of 5% at
i3 ¼ 0.5.
2. In the case of coverage ratio on debt i1, WACC practically linearly increases with
parameter i1 and goes to saturation at i1 ¼ 0.1.
3. In the case of coverage ratio on interest on the credit i2, WACC increases with
parameter i2 much more slowly than in the two previous cases and goes to
saturation at high values of i2: with accuracy of 10% at i2 ¼ 4.
WACC(i3)
0.1400
0.1200
0.1000
0.0800
0.0600 WACC(i3)
0.0400
0.0200
0.0000
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
0.1400
0.1200
0.1000
0.0800
WACC(i1)
WACC(i2)
0.0600
WACC(i3)
0.0400
0.0200
0.0000
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
coverage ratio on debt i1, on interest on the credit i2, and on debt and interest on the credit i3
21.6.3 Leverage Ratios
Let us consider now the leverage ratios. We will consider three kinds of leverage
ratios: leverage ratios of debt, leverage ratios of interest on the credit, and leverage
ratios of debt and interest on the credit.
21.6.3.1 Leverage Ratios for Debt
Here
l1 ¼ D=CF ð21:10Þ
As above for coverage ratios, we use the Modigliani–Miller theorem for case with
corporate taxes
V L ¼ V 0 þ Dt,
we derive the expression for WACC(l1):
CF CF
¼ þ Dt
WACC k0
1 1
¼ þ l1 t ð21:11Þ
WACC k0
k0
WACC ¼
1 þ tl1 k 0
This ratio (l1) can be used to assess of the following parameters used in rating,
Debt/EBITDA and some others. We will use the last formula to build a curve of
dependence WACC(l1).
21.6.3.2 Leverage Ratios for Interest on Credit
Here
l2 ¼ kd D=CF ð21:12Þ
We use again the Modigliani–Miller theorem for case with corporate taxes:
V L ¼ V 0 þ Dt:
We derive the expression for WACC(l2):
CF CF
¼ þ Dt
WACC k0
1 1 l2 t
¼ þ ð21:13Þ
WACC k 0 kd
k0 kd
WACC ¼
k d þ tl2 k0
This ratio (l2) can be used to assess of the following parameters used in rating,
Interests/EBITDA and some others. We will use the last formula to build a curve of
dependence WACC(l2).
21.6.3.3 Leverage Ratios for Debt and Interest on Credit
Here
l3 ¼ Dð1 þ k d Þ=CF ð21:14Þ
Using the Modigliani–Miller theorem for case with corporate taxes
V L ¼ V 0 þ Dt,
we derive the expression for WACC(l3):
CF CF
¼ þ Dt
WACC k0
1 1 l3 t
¼ þ ð21:15Þ
WACC k 0 1 þ kd
k 0 ð1 þ k d Þ
WACC ¼
1 þ k d þ tl3 k0
This ratio (l3) can be used to assess the following parameters used in rating,
Debt + interest /FFO, Debt + interest / EBIT, Debt + interest/EBITDA(R), and some
others. We will use the last formula to build a curve of dependence WACC(l3).
Let us analyze the dependence of the company’s weighted average cost of capital
(WACC) on the leverage ratios with the following data: k0 ¼ 12%; kd ¼ 6%;
t ¼ 20%; li runs from 0 up to 10.
the leverage ratio on debt l1 is presented at Fig. 21.10.
Fig. 21.10 The dependence WACC (l1)

(WACC) on the leverage 0.1
0.08
WACC
ratio on debt l1
0.06
0.04
0.02
0
0 2 4 6 8 10 12
l1
21.7 Equity Cost 453
Fig. 21.11 The dependence WACC (l2)

WACC
ratio on interest on credit l2 0.08
0.06
0.04
0.02
0
0 2 4 6 8 10 12
l2
Fig. 21.12 The dependence WACC(l3)

WACC
ratio on debt and interest on 0.08

credit l3 0.06
0.04
0.02
0
0 2 4 6 8 10 12
l3

the leverage ratio on interest on credit l2 is presented at Fig. 21.11.
the leverage ratio on debt and interest on credit l3 is presented at Fig. 21.12.
the leverage ratio on debt, l1; on interest on credit, l2; and on debt and interest on
credit, l3, simultaneously is presented at Fig. 21.13.
Analysis of the dependences of the company’s weighted average cost of capital
(WACC) on the leverage ratio on debt, l1, on interest on credit, l2, and on debt and
interest on credit, l3, shows the following: for all leverage ratios, weighted average
cost of capital (WACC) decreases with leverage ratios. For leverage ratio on debt l1
and leverage ratio on debt and interest on credit l3, WACC decreases very similar
and practically linearly from k0 ¼ 12% at l1,3 ¼ 0 up to 9.7% at l1,3 ¼ 10. For
leverage ratio on interest on credit l2, WACC decreases nonlinearly and much faster
from k0 ¼ 12% at l2 ¼ 0 up to 2.4% at l2 ¼ 10.
21.7 Equity Cost
Equity cost plays a very important role in economy and finance because it is the
essence of the dividend policy of companies, which should be accounted in rating. A
modern approach to the dividend policy of companies, based on the real value of
WACC (l)
0.14
0.12
0.1
WACC
0.08
0.06
0.04
0.02
0
0 2 4 6 8 10 12
l
WACC1 WACC2 WACC3
leverage ratio on debt, l1, on interest on credit, l2, and on debt and on interest on credit, l3,
simultaneously
their equity capital cost, compared to its efficiency of planned investment is

suggested in the article (Brusov et al. 2012). This allows return to the economic
essence of dividends, as the payment to shareholders for the use of equity capital.
Equity cost ke determines the economically reasonable dividend value. Rating
agencies will be able to compare payable dividend value with economically reason-
able dividend level and make conclusion about the adequacy of the dividend policy
of companies and its influence on company’s credit rating.
For finding the dependence of equity cost ke on coverage ratios and leverage
ratios, we consider consistently the dependence of equity cost ke on ratios i1, i2, i3, l1,
l2, and l3, using the following formula, which couples weighted average cost of
capital WACC (calculated by us above: see Tables 21.1, 21.2, 21.3, 21.4, 21.5, 21.6,
21.7, 21.8, and 21.9) and equity cost ke:
k e ¼ WACCð1 þ LÞ Lkd ð1 t Þ: ð21:16Þ
The Dependence of Equity Cost ke on Coverage Ratios i1, i2, and i3

Let us study the dependence of equity cost ke on coverage ratios i1, i2, and i3 for the
same set of parameters as used above and for leverage levels L ¼ 1 and L ¼ 2
(Table 21.10, 21.11, and 21.12).
1) L ¼ 1
2) L ¼ 2
We could make some conclusions, based on Tables 21.13, 21.14, and 21.15 and
Figs. 21.14, 21.15, and 21.16. In all three cases, equity cost ke increases with
coverage ratios and goes to saturation at high values of coverage ratios. Saturation
values increase with leverage level from 19% at L ¼ 1 up to value above 26% at
L ¼ 2. Note that for coverage ratios i1 and i2, the saturation takes place at values i1,2
of order unit, while for coverage ratio i3, the saturation takes place at much higher i3
values of order 6 or 7.
Table 21.1 The dependence t i1 k0 kd WACC

of the company’s weighted
0.2 0 0.12 0.06 0
average cost of capital
(WACC) on the coverage ratio 0.2 1 0.12 0.06 0.1171875
on debt i1 0.2 2 0.12 0.06 0.1185771
0.2 3 0.12 0.06 0.1190476
0.2 4 0.12 0.06 0.1192843
0.2 5 0.12 0.06 0.1194268
0.2 6 0.12 0.06 0.1195219
0.2 7 0.12 0.06 0.11959
0.2 8 0.12 0.06 0.1196411
0.2 9 0.12 0.06 0.1196809
0.2 10 0.12 0.06 0.1197127

0.2 0 0.12 0.06 0
on debt i2 0.2 2 0.12 0.06 0.1
0.2 3 0.12 0.06 0.105882
0.2 4 0.12 0.06 0.109091
0.2 5 0.12 0.06 0.111111
0.2 6 0.12 0.06 0.1125
0.2 7 0.12 0.06 0.113514
0.2 8 0.12 0.06 0.114286
0.2 9 0.12 0.06 0.114894
0.2 10 0.12 0.06 0.115385

of company’s weighted
0.2 0 0.12 0.06 0
on debt i3 0.2 2 0.12 0.06 0.1186567
0.2 3 0.12 0.06 0.1191011
0.2 4 0.12 0.06 0.1193246
0.2 5 0.12 0.06 0.1194591
0.2 6 0.12 0.06 0.1195489
0.2 7 0.12 0.06 0.1196131
0.2 8 0.12 0.06 0.1196613
0.2 9 0.12 0.06 0.1196989
0.2 10 0.12 0.06 0.1197289
Equity cost ke should be used as discount rate for unleveraged (financially

independent) companies. For coverage ratios i1 and i2, saturation values of equity
cost ke could be used as discount rate above unit, while for coverage ratio i3,
saturation values of equity cost ke could be used as discount rate at i3 value above
6 or 7.
Table 21.4 The dependence i1 k0 kd t WACC(i1)

0 0.12 0.06 0.2 0.0000
(WACC) on the coverage ratio 0.1 0.12 0.06 0.2 0.0117
on debt i1 0.2 0.12 0.06 0.2 0.0234
0.3 0.12 0.06 0.2 0.0352
0.4 0.12 0.06 0.2 0.0469
0.5 0.12 0.06 0.2 0.0586
0.6 0.12 0.06 0.2 0.0703
0.7 0.12 0.06 0.2 0.0820
0.8 0.12 0.06 0.2 0.0938
0.9 0.12 0.06 0.2 0.1055
1 0.12 0.06 0.2 0.1172

0 0.12 0.06 0.2 0.0000
on debt i1 0.2 0.12 0.06 0.2 0.0400
0.3 0.12 0.06 0.2 0.0514
0.4 0.12 0.06 0.2 0.0600
0.5 0.12 0.06 0.2 0.0667
0.6 0.12 0.06 0.2 0.0720
0.7 0.12 0.06 0.2 0.0764
0.8 0.12 0.06 0.2 0.0800
0.9 0.12 0.06 0.2 0.0831
1 0.12 0.06 0.2 0.0857

0 0.12 0.06 0.2 0.0000
on debt i3 0.2 0.12 0.06 0.2 0.1078
0.3 0.12 0.06 0.2 0.1116
0.4 0.12 0.06 0.2 0.1136
0.5 0.12 0.06 0.2 0.1148
0.6 0.12 0.06 0.2 0.1156
0.7 0.12 0.06 0.2 0.1162
0.8 0.12 0.06 0.2 0.1167
0.9 0.12 0.06 0.2 0.1171
1 0.12 0.06 0.2 0.1173
Table 21.7 The dependence t l1 k0 kd WACC

0.2 0 0.12 0.06 0.12
on debt l1 0.2 2 0.12 0.06 0.114504
0.2 3 0.12 0.06 0.11194
0.2 4 0.12 0.06 0.109489
0.2 5 0.12 0.06 0.107143
0.2 6 0.12 0.06 0.104895
0.2 7 0.12 0.06 0.10274
0.2 8 0.12 0.06 0.100671
0.2 9 0.12 0.06 0.098684
0.2 10 0.12 0.06 0.096774

0.2 0 0.12 0.06 0.12
on debt l2 0.2 2 0.12 0.06 0.066667
0.2 3 0.12 0.06 0.054545
0.2 4 0.12 0.06 0.046154
0.2 5 0.12 0.06 0.04
0.2 6 0.12 0.06 0.035294
0.2 7 0.12 0.06 0.031579
0.2 8 0.12 0.06 0.028571
0.2 9 0.12 0.06 0.026087
0.2 10 0.12 0.06 0.024

0.2 0 0.12 0.06 0.12
on debt l3 0.2 2 0.12 0.06 0.114819
0.2 3 0.12 0.06 0.112393
0.2 4 0.12 0.06 0.110068
0.2 5 0.12 0.06 0.107836
0.2 6 0.12 0.06 0.105693
0.2 7 0.12 0.06 0.103634
0.2 8 0.12 0.06 0.101654
0.2 9 0.12 0.06 0.099747
0.2 10 0.12 0.06 0.097911
Table 21.10 The dependence L i1 WACC(i1) kd t ke

of equity cost ke on coverage
1 0 0.00000 0.06 0.2 0.0480
ratio i1 at leverage level L ¼ 1
1 1 0.11719 0.06 0.2 0.1864
1 2 0.11858 0.06 0.2 0.1892
1 3 0.11905 0.06 0.2 0.1901
1 4 0.11928 0.06 0.2 0.1906
1 5 0.11943 0.06 0.2 0.1909
1 6 0.11952 0.06 0.2 0.1910
1 7 0.11959 0.06 0.2 0.1912
1 8 0.11964 0.06 0.2 0.1913
1 9 0.11968 0.06 0.2 0.1914
1 10 0.11971 0.06 0.2 0.1914

2 0 0.00000 0.06 0.2 0.0960
2 1 0.11719 0.06 0.2 0.2556
2 2 0.11858 0.06 0.2 0.2597
2 3 0.11905 0.06 0.2 0.2611
2 4 0.11928 0.06 0.2 0.2619
2 5 0.11943 0.06 0.2 0.2623
2 6 0.11952 0.06 0.2 0.2626
2 7 0.11959 0.06 0.2 0.2628
2 8 0.11964 0.06 0.2 0.2629
2 9 0.11968 0.06 0.2 0.2630
2 10 0.11971 0.06 0.2 0.2631

1 0 0.00000 0.06 0.2 0.0480
1 1 0.11734 0.06 0.2 0.1867
1 2 0.11866 0.06 0.2 0.1893
1 3 0.11910 0.06 0.2 0.1902
1 4 0.11932 0.06 0.2 0.1906
1 5 0.11946 0.06 0.2 0.1909
1 6 0.11955 0.06 0.2 0.1911
1 7 0.11961 0.06 0.2 0.1912
1 8 0.11966 0.06 0.2 0.1913
1 9 0.11970 0.06 0.2 0.1914
1 10 0.11973 0.06 0.2 0.1915

2 0 0.00000 0.06 0.2 0.0960
2 1 0.11734 0.06 0.2 0.2560
2 2 0.11866 0.06 0.2 0.2600
2 3 0.11910 0.06 0.2 0.2613
2 4 0.11932 0.06 0.2 0.2620
2 5 0.11946 0.06 0.2 0.2624
2 6 0.11955 0.06 0.2 0.2626
2 7 0.11961 0.06 0.2 0.2628
2 8 0.11966 0.06 0.2 0.2630
2 9 0.11970 0.06 0.2 0.2631
2 10 0.11973 0.06 0.2 0.2632

1 0 0.00000 0.06 0.2 0.0480
1 1 0.08571 0.06 0.2 0.1234
1 2 0.10000 0.06 0.2 0.1520
1 3 0.10588 0.06 0.2 0.1638
1 4 0.10909 0.06 0.2 0.1702
1 5 0.11111 0.06 0.2 0.1742
1 6 0.11250 0.06 0.2 0.1770
1 7 0.11351 0.06 0.2 0.1790
1 8 0.11429 0.06 0.2 0.1806
1 9 0.11489 0.06 0.2 0.1818
1 10 0.11538 0.06 0.2 0.1828

2 0 0.00000 0.06 0.2 0.0960
2 1 0.08571 0.06 0.2 0.1611
2 2 0.10000 0.06 0.2 0.2040
2 3 0.10588 0.06 0.2 0.2216
2 4 0.10909 0.06 0.2 0.2313
2 5 0.11111 0.06 0.2 0.2373
2 6 0.11250 0.06 0.2 0.2415
2 7 0.11351 0.06 0.2 0.2445
2 8 0.11429 0.06 0.2 0.2469
2 9 0.11489 0.06 0.2 0.2487
2 10 0.11538 0.06 0.2 0.2502
Ke(i1)
0.3000
0.2500
0.2000
0.1500
0.1000 L=1
0.0500 L=2
0.0000
0 1 2 3 4 5 6 7 8 9 10
-0.0500
-0.1000
-0.1500
Fig. 21.14 The dependence of equity cost ke on coverage ratio i1 at two leverage level values L ¼ 1
and L ¼ 2
Ke(i2)
0.3000
0.2500
0.2000
0.1500
0.1000 L=1
0.0500 L=2
0.0000
0 1 2 3 4 5 6 7 8 9 10
-0.0500
-0.1000
-0.1500
and L ¼ 2
The Dependence of Equity Cost ke on Leverage Ratios l1, l2, and l3

We study below the dependence of equity cost ke on leverage ratios l1, l2, and l3 for
the same set of parameters as used above and for leverage levels L ¼ 1 and L ¼ 2.
The Dependence of Equity Cost ke on Leverage Ratio l1
1) L ¼ 1 (Table 21.16)
2) L ¼ 2 (Table 21.17 and Fig. 21.17)
Ke(i3)
0.3000
0.2500
0.2000
0.1500
0.1000 L=1
0.0500 L=2
0.0000
0 1 2 3 4 5 6 7 8 9 10
-0.0500
-0.1000
-0.1500
and L ¼ 2
Table 21.16 The dependence L l1 WACC(l1) kd t ke

of equity cost ke on leverage
1 0 0.12000 0.06 0.2 0.1920
ratio l1 at leverage level L ¼ 1
1 1 0.11719 0.06 0.2 0.1864
1 2 0.11450 0.06 0.2 0.1810
1 3 0.11194 0.06 0.2 0.1759
1 4 0.10949 0.06 0.2 0.1710
1 5 0.10714 0.06 0.2 0.1663
1 6 0.10490 0.06 0.2 0.1618
1 7 0.10274 0.06 0.2 0.1575
1 8 0.10067 0.06 0.2 0.1533
1 9 0.09868 0.06 0.2 0.1494
1 10 0.09677 0.06 0.2 0.1455

2 0 0.12000 0.06 0.2 0.2640
2 1 0.11719 0.06 0.2 0.2556
2 2 0.11450 0.06 0.2 0.2475
2 3 0.11194 0.06 0.2 0.2398
2 4 0.10949 0.06 0.2 0.2325
2 5 0.10714 0.06 0.2 0.2254
2 6 0.10490 0.06 0.2 0.2187
2 7 0.10274 0.06 0.2 0.2122
2 8 0.10067 0.06 0.2 0.2060
2 9 0.09868 0.06 0.2 0.2001
2 10 0.09677 0.06 0.2 0.1943
Ke(I1)
0.3000
0.2500
0.2000
0.1500 L=1
L=2
0.1000
0.0500
0.0000
0 1 2 3 4 5 6 7 8 9 10
Fig. 21.17 The dependence of equity cost ke on leverage ratio l1 at two leverage level values L ¼ 1
and L ¼ 2

1 0 0.12000 0.06 0.2 0.1920
1 1 0.08571 0.06 0.2 0.1234
1 2 0.06667 0.06 0.2 0.0853
1 3 0.05455 0.06 0.2 0.0611
1 4 0.04615 0.06 0.2 0.0443
1 5 0.04000 0.06 0.2 0.0320
1 6 0.03529 0.06 0.2 0.0226
1 7 0.03158 0.06 0.2 0.0152
1 8 0.02857 0.06 0.2 0.0091
1 9 0.02609 0.06 0.2 0.0042
1 10 0.02400 0.06 0.2 0.0000
The Dependence of Equity Cost ke on Leverage Ratios l2

1) L ¼ 1 (Table 21.18)
2) L ¼ 2 (Table 21.19 and Fig. 21.18)
The Dependence of Equity Cost ke on Leverage Ratios l3
1) L ¼ 1 (Table 21.20)
2) L ¼ 2 (Table 21.21 and Fig. 21.19)

2 0 0.12000 0.06 0.2 0.2640
2 1 0.08571 0.06 0.2 0.1611
2 2 0.06667 0.06 0.2 0.1040
2 3 0.05455 0.06 0.2 0.0676
2 4 0.04615 0.06 0.2 0.0425
2 5 0.04000 0.06 0.2 0.0240
2 6 0.03529 0.06 0.2 0.0099
2 7 0.03158 0.06 0.2 0.0013
2 8 0.02857 0.06 0.2 0.0103
2 9 0.02609 0.06 0.2 0.0177
2 10 0.02400 0.06 0.2 0.0240
Ke(I2)
0.3000
0.2500
0.2000
0.1500 L=1
0.1000 L=2
0.0500
0.0000
0 1 2 3 4 5 6 7 8 9 10
-0.0500
and L ¼ 2

1 0 0.12000 0.06 0.2 0.1920
1 1 0.11735 0.06 0.2 0.1867
1 2 0.11482 0.06 0.2 0.1816
1 3 0.11239 0.06 0.2 0.1768
1 4 0.11007 0.06 0.2 0.1721
1 5 0.10784 0.06 0.2 0.1677
1 6 0.10569 0.06 0.2 0.1634
1 7 0.10363 0.06 0.2 0.1593
1 8 0.10165 0.06 0.2 0.1553
1 9 0.09975 0.06 0.2 0.1515
1 10 0.09791 0.06 0.2 0.1478

2 0 0.12000 0.06 0.2 0.2640
2 1 0.11735 0.06 0.2 0.2561
2 2 0.11482 0.06 0.2 0.2485
2 3 0.11239 0.06 0.2 0.2412
2 4 0.11007 0.06 0.2 0.2342
2 5 0.10784 0.06 0.2 0.2275
2 6 0.10569 0.06 0.2 0.2211
2 7 0.10363 0.06 0.2 0.2149
2 8 0.10165 0.06 0.2 0.2090
2 9 0.09975 0.06 0.2 0.2032
2 10 0.09791 0.06 0.2 0.1977
Ke(I3)
0.3000
0.2500
0.2000
0.1500 L=1
L=2
0.1000
0.0500
0.0000
0 1 2 3 4 5 6 7 8 9 10
and L ¼ 2
21.8 How to Evaluate the Discount Rate?
Let us discuss now the algorithm of valuation of the discount rate, if we know one or
a few ratios (coverage or leverage ones). The developed above method allows
estimate discount rate with the best accuracy characteristic for used theory of capital
structure (perpetuity limit).
21.9 Influence of Leverage Level 465
21.8.1 Using One Ratio
If one knows one ratio (coverage or leverage one), the algorithm of valuation of the
discount rate is as follows:
– Determination of the parameter k0.
– Knowing k0, kd, and t, one builds the curve of dependence WACC(i) or WACC
(l).
– Then, using the known value of coverage ratio (i0) or leverage ratio (l0), one finds
the value WACC(i0) or WACC(l0), which represents the discount rate.
21.8.2 Using a Few Ratios
If we know say m values of coverage ratios (ij) and n values of leverage ratios (lk),
– We find by the above algorithm m values of WACC(ij) and n values of WACC(lk)
first.
– Then we find the average value of WACC by the following formula:
" #
1 X
m X n
WACCav ¼ WACC i j þ WACCðlk Þ :
m þ n j¼1 k¼1
This found value WACCav should be used when discounting the financial flows
in rating.
21.9 Influence of Leverage Level
We discuss also the interplay between rating ratios and leverage level which can be
quite important in rating.
21.9.1 The Dependence of Equity Cost ke on Leverage Level

at Two Coverage Ratio Values ij ¼ 1 and ij ¼ 2
1) i1 ¼ 1
2) i1 ¼ 2
1) i2 ¼ 1
2) i2 ¼ 2
1) i3 ¼ 1
2) i3 ¼ 2
It is seen from Tables 21.22, 21.23, 21.24, 21.25, 21.26, and 21.27 and
Figs. 21.20, 21.21, and 21.22 that equity cost ke increases practically linearly with
leverage level for all coverage ratios i1, i2, and i3. For each of the two coverage ratios
i1 and i2, curves ke (L) for two values of ij (1 and 2) practically coincide. For
coverage ratio i3, curves ke (L) for value of i3 ¼ 2 lie above one for i3 ¼ 1, and
angle of inclination for value of i3 ¼ 2 is bigger.
Table 21.22 The dependence L WACC(i1 ¼ 1) kd t ke

0 0.11719 0.06 0.2 0.1172
level L at coverage ratio i1 ¼ 1
1 0.11719 0.06 0.2 0.1864
2 0.11719 0.06 0.2 0.2556
3 0.11719 0.06 0.2 0.3248
4 0.11719 0.06 0.2 0.3939
5 0.11719 0.06 0.2 0.4631
6 0.11719 0.06 0.2 0.5323
7 0.11719 0.06 0.2 0.6015
8 0.11719 0.06 0.2 0.6707
9 0.11719 0.06 0.2 0.7399
10 0.11719 0.06 0.2 0.8091

0 0.11858 0.06 0.2 0.1186
1 0.11858 0.06 0.2 0.1892
2 0.11858 0.06 0.2 0.2597
3 0.11858 0.06 0.2 0.3303
4 0.11858 0.06 0.2 0.4009
5 0.11858 0.06 0.2 0.4715
6 0.11858 0.06 0.2 0.5420
7 0.11858 0.06 0.2 0.6126
8 0.11858 0.06 0.2 0.6832
9 0.11858 0.06 0.2 0.7538
10 0.11858 0.06 0.2 0.8243

0 0.11734 0.06 0.2 0.1173
1 0.11734 0.06 0.2 0.1867
2 0.11734 0.06 0.2 0.2560
3 0.11734 0.06 0.2 0.3254
4 0.11734 0.06 0.2 0.3947
5 0.11734 0.06 0.2 0.4641
6 0.11734 0.06 0.2 0.5334
7 0.11734 0.06 0.2 0.6027
8 0.11734 0.06 0.2 0.6721
9 0.11734 0.06 0.2 0.7414
10 0.11734 0.06 0.2 0.8108
21.9 Influence of Leverage Level 467

0 0.11866 0.06 0.2 0.1187
1 0.11866 0.06 0.2 0.1893
2 0.11866 0.06 0.2 0.2600
3 0.11866 0.06 0.2 0.3306
4 0.11866 0.06 0.2 0.4013
5 0.11866 0.06 0.2 0.4719
6 0.11866 0.06 0.2 0.5426
7 0.11866 0.06 0.2 0.6133
8 0.11866 0.06 0.2 0.6839
9 0.11866 0.06 0.2 0.7546
10 0.11866 0.06 0.2 0.8252

0 0.08571 0.06 0.2 0.0857
1 0.08571 0.06 0.2 0.1234
2 0.08571 0.06 0.2 0.1611
3 0.08571 0.06 0.2 0.1989
4 0.08571 0.06 0.2 0.2366
5 0.08571 0.06 0.2 0.2743
6 0.08571 0.06 0.2 0.3120
7 0.08571 0.06 0.2 0.3497
8 0.08571 0.06 0.2 0.3874
9 0.08571 0.06 0.2 0.4251
10 0.08571 0.06 0.2 0.4629

0 0.10000 0.06 0.2 0.1000
1 0.10000 0.06 0.2 0.1520
2 0.10000 0.06 0.2 0.2040
3 0.10000 0.06 0.2 0.2560
4 0.10000 0.06 0.2 0.3080
5 0.10000 0.06 0.2 0.3600
6 0.10000 0.06 0.2 0.4120
7 0.10000 0.06 0.2 0.4640
8 0.10000 0.06 0.2 0.5160
9 0.10000 0.06 0.2 0.5680
10 0.10000 0.06 0.2 0.6200
Ke(L)
0.7800
0.6800
0.5800
0.4800 i1=1
0.3800 i1=2
0.2800
0.1800
0.0800
0 1 2 3 4 5 6 7 8 9 10
Fig. 21.20 The dependence of equity cost ke on leverage level at two coverage ratio values i1 ¼ 1
and i1 ¼ 2
Ke(L)
0.9000
0.8000
0.7000
0.6000
0.5000
0.4000 i2=1
0.3000 i2=2
0.2000
0.1000
0.0000
0 1 2 3 4 5 6 7 8 9 10
and i2 ¼ 2.
21.10 The Dependence of Equity Cost ke on Leverage Level

at Two Leverage Ratio Values lj ¼ 1 and lj ¼ 2
Let us now study the dependence of equity cost ke on leverage level at two leverage
ratio values lj ¼ 1 and lj ¼ 2 for leverage ratios l1, l2, and l3.
1) l1 ¼ 1
2) l1 ¼ 2
1) l2 ¼ 1
2) l2 ¼ 2
1) l3 ¼ 1
2) l3 ¼ 2
It is seen from Tables 21.28, 21.29, 21.30, 21.31, 21.32, and 21.33 and
Figs. 21.23, 21.24, and 21.25 that equity cost ke increases practically linearly with
21.10 The Dependence of Equity Cost ke on. . . 469
Ke(L)
0.7000
0.6000
0.5000
0.4000
i3=1
0.3000 i3=2
0.2000
0.1000
0.0000
0 1 2 3 4 5 6 7 8 9 10
and i3 ¼ 2
Table 21.28 The dependence L WACC(l1 ¼ 1) kd t ke

0 0.11719 0.06 0.2 0.1172
level L at leverage ratio l1 ¼ 1
1 0.11719 0.06 0.2 0.1864
2 0.11719 0.06 0.2 0.2556
3 0.11719 0.06 0.2 0.3248
4 0.11719 0.06 0.2 0.3939
5 0.11719 0.06 0.2 0.4631
6 0.11719 0.06 0.2 0.5323
7 0.11719 0.06 0.2 0.6015
8 0.11719 0.06 0.2 0.6707
9 0.11719 0.06 0.2 0.7399
10 0.11719 0.06 0.2 0.8091

0 0.11450 0.06 0.2 0.1145
1 0.11450 0.06 0.2 0.1810
2 0.11450 0.06 0.2 0.2475
3 0.11450 0.06 0.2 0.3140
4 0.11450 0.06 0.2 0.3805
5 0.11450 0.06 0.2 0.4470
6 0.11450 0.06 0.2 0.5135
7 0.11450 0.06 0.2 0.5800
8 0.11450 0.06 0.2 0.6465
9 0.11450 0.06 0.2 0.7130
10 0.11450 0.06 0.2 0.7795

0 0.08571 0.06 0.2 0.0857
1 0.08571 0.06 0.2 0.1234
2 0.08571 0.06 0.2 0.1611
3 0.08571 0.06 0.2 0.1989
4 0.08571 0.06 0.2 0.2366
5 0.08571 0.06 0.2 0.2743
6 0.08571 0.06 0.2 0.3120
7 0.08571 0.06 0.2 0.3497
8 0.08571 0.06 0.2 0.3874
9 0.08571 0.06 0.2 0.4251
10 0.08571 0.06 0.2 0.4629

0 0.06667 0.06 0.2 0.0667
1 0.06667 0.06 0.2 0.0853
2 0.06667 0.06 0.2 0.1040
3 0.06667 0.06 0.2 0.1227
4 0.06667 0.06 0.2 0.1413
5 0.06667 0.06 0.2 0.1600
6 0.06667 0.06 0.2 0.1787
7 0.06667 0.06 0.2 0.1973
8 0.06667 0.06 0.2 0.2160
9 0.06667 0.06 0.2 0.2347
10 0.06667 0.06 0.2 0.2533

0 0.11735 0.06 0.2 0.1174
1 0.11735 0.06 0.2 0.1867
2 0.11735 0.06 0.2 0.2561
3 0.11735 0.06 0.2 0.3254
4 0.11735 0.06 0.2 0.3948
5 0.11735 0.06 0.2 0.4641
6 0.11735 0.06 0.2 0.5335
7 0.11735 0.06 0.2 0.6028
8 0.11735 0.06 0.2 0.6722
9 0.11735 0.06 0.2 0.7415
10 0.11735 0.06 0.2 0.8109
21.10 The Dependence of Equity Cost ke on. . . 471

0 0.11482 0.06 0.2 0.1148
1 0.11482 0.06 0.2 0.1816
2 0.11482 0.06 0.2 0.2485
3 0.11482 0.06 0.2 0.3153
4 0.11482 0.06 0.2 0.3821
5 0.11482 0.06 0.2 0.4489
6 0.11482 0.06 0.2 0.5157
7 0.11482 0.06 0.2 0.5826
8 0.11482 0.06 0.2 0.6494
9 0.11482 0.06 0.2 0.7162
10 0.11482 0.06 0.2 0.7830
Ke(L)
0.9000
0.8000
0.7000
0.6000
0.5000
L1=1
0.4000
L1=2
0.3000
0.2000
0.1000
0.0000
0 1 2 3 4 5 6 7 8 9 10
Fig. 21.23 The dependence of equity cost ke on leverage level at two leverage ratio values l1 ¼ 1
and l1 ¼ 2
leverage level for all leverage ratios l1, l2, and l3. For each of two leverage ratios l1,
l3, curves ke (L ) for two values of lj (1 and 2) practically coincide. For leverage ratio
l2, curves ke (L ) for value of l3 ¼ 1 lie above one for l3 ¼ 2, and angle of inclination
for value of l3 ¼ 1 is bigger.
Ke(L)
0.5000
0.4500
0.4000
0.3500
0.3000
0.2500 L2=1
0.2000 L2=2
0.1500
0.1000
0.0500
0.0000
0 1 2 3 4 5 6 7 8 9 10
and l2 ¼ 2
Ke(L)
0.9000
0.8000
0.7000
0.6000
0.5000
L3=1
0.4000
L3=2
0.3000
0.2000
0.1000
0.0000
0 1 2 3 4 5 6 7 8 9 10
and l3 ¼ 2
21.11 Conclusion
The Chaps. 21, 22, and 23 suggest a new approach to rating methodology. This
chapter and the next one (Chap. 22) are devoted to rating of nonfinancial issuers,
while Chap. 23 is devoted to long-term project rating. The key factors of a new
approach are (1) the adequate use of discounting financial flows virtually not used in
existing rating methodologies and (2) the incorporation of rating parameters (finan-
cial “ratios”) into the modern theory of capital structure BFO (and its perpetuity
References 473
limit). This on the one hand allows use of the powerful tool of this theory in the
rating, and on the other hand, it ensures the correct discount rates when discounting
financial flows. Two models for accounting of discounting financial flows—one-
period and multi-period are discussed. An algorithm of valuation of correct discount
rate, accounting rating ratios is suggested. We discuss also the interplay between
rating ratios and leverage level which can be quite important in rating. All above
creates a new base for rating methodologies.
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Chapter 22
Rating Methodology: New Look and New
Horizons
22.1 Introduction
In a previous chapter, we have offered fundamentally new approach to rating

methodology, which includes adequate application of discounting of financial
flows virtually not used in existing rating methodologies. The incorporation of rating
parameters (financial “ratios”) into the perpetuity limit of modern theory of capital
structure by Brusov–Filatova–Orekhova (BFO) theory has been done: it required a
modification of perpetuity limit of BFO theory for rating needs. Two models
(one-period and multi-period) for accounting of discounting of financial flows
were discussed. An algorithm of valuation of discount rate, accounting rating ratios,
has been suggested. We discussed also the interplay between rating ratios and
leverage level which can be quite important in rating.
As we discussed in a number of works (Brusov and Filatova 2011; Brusov et al.
2011a, b, c, 2012a, b, 2013a, b, 2014a, b, 2015, 2018a, b, c, d; Brusova 2011;
Filatova et al. 2008), perpetuity limit of BFO theory (Modigliani and Miller 1958,
1963, 1966)—Modigliani–Miller theory—underestimated the assessment of the
attracting capital cost and therefore overestimated the assessment of the capitaliza-
tion of the company. Besides the time factor, which is very important, does not exist
in the perpetuity limit. And therefore in this limit, there is no concept of the age of the
company, and their lifetime is infinite (perpetuity).
In the present chapter, the generalization of the developed by us approach for the
case of modern theory of capital structure and capital cost by Brusov–Filatova–
Orekhova (BFO theory) for companies and corporations of arbitrary age, i.e., for
general case of BFO theory, has been done (Brusov et al. 2018c).
This has required the modification of the BFO theory for the rating needs (much
more complicated than it was done in case of perpetuity limit—Modigliani–Miller
theory), as the concept of “leverage” as the ratio of debt value to the equity value,
used in financial management substantially differs from the concept of “leverage”,
used in the rating, where it is understood as the direct and inverse ratio of the debt

https://doi.org/10.1007/978-3-319-99686-8_22
476 22 Rating Methodology: New Look and New Horizons
value to the generated cash flow values (income, profit, etc.). We introduce here
some additional ratios, allowing to more fully characterize the issuer’s ability to
repay debts and to pay interest thereon.
As we mentioned in the previous chapter, the bridge is building between the
discount rates (WACC, ke) used when discounting of financial flows, and “ratios” in
the rating methodology. The algorithm for finding the discount rates for given ratio
values is developed.
Application of BFO theory modified for rating purposes allows to adequately
produce the discounting of financial flows by using the correct discount rates taken
into account when discounting the magnitude of rating ratios and take into account
the time factor missing in perpetuity limit and being the vital, i.e., to take into account
the company age (in BFO-I theory) or the company lifetime (in the BFO-II theory).
22.2 The Analysis of Methodological and Systemic

Deficiencies in the Existing Credit Rating
of Nonfinancial Issuers
The analysis of methodological and systemic deficiencies in the existing credit rating
of nonfinancial issuers has been conducted by us. We have analyzed the methodol-
ogy of the big three (Standard & Poor’s, Fitch and Moody’s) and Russian national
rating agency.
22.2.1 The Closeness of the Rating Agencies
The closeness of the rating agencies has been discussed by us in a previous paper
(Brusov et al. 2018a, c, d) and is caused by multiple causes.
1. The desire to preserve their “know-how.” Rating agencies get big enough money
for generated ratings (mostly from issuers) to replicate its methodology.
2. The desire to avoid public discussion of the ratings with anyone, including the
issuer. It is very convenient position—rating agency “a priori” removes himself
from beneath any criticism of generated ratings.
3. The absence of any external control and external analysis of the methodologies is
resulted in the fact that shortcomings of methodologies are not subjected to
serious critical analysis and stored long enough.
22.2.2 Discounting
One of the major flaws of all existing rating methodologies is a failure or a very
narrow use of discounting. But even in those rare cases where it is used, it is not quite
22.2 The Analysis of Methodological and Systemic Deficiencies in the. . . 477
correct, since the discount rate when discounting financial flows is chosen
incorrectly.
The need to take into account the time factor in terms of discounting is obvious,
because it is associated with the time value of money. The financial part of the rating
is based on a comparison of generated income with the value of the debt and the
interest payable. Because income and disbursement of debt and interest are separated
in time, the use of discounting when comparing revenues with the value of debt and
interest is absolutely necessary for assigning credit ratings for issuers.
1. In existing rating methodologies, despite their breadth and detail, there are a lot of
shortcomings. One of the major flaws of all existing rating methodologies, as
mentioned in our previous paper, is a failure or a very narrow use of discounting.
But even in those rare cases where it is used, it is not quite correct, since the
discount rate when discounting financial flows is chosen incorrectly.
The need to take into account the time factor in terms of discounting is
obvious, because it is associated with the time value of money. The financial
part of the rating is based on a comparison of generated income with the value of
the debt and the interest payable. Because income and disbursement of debt and
interest are separated in time, the use of discounting when comparing revenues
with the value of debt and interest is absolutely necessary for assigning credit
ratings for issuers.
This raises the question about the discount rate. This question has always been
one of the major and extremely difficult in many areas of finance: corporate
finance and investment; it is particularly important in business valuation, where a
slight change in the discount rate leads to significant changes in estimates of
capitalization of the company, which is used by unscrupulous appraisers for
artificial bankruptcy of companies. As well it is essential in rating, and when
assigning a rating to an issuer, and forecasting.
Therefore, as soon as we are talking about financial flows, it is necessary to
account discounting; otherwise the time value of money does not take into
account, i.e., any analysis of financial flows should take account of discounting.
2. When we talk about using the rating reports for the three or five (GAAP) years,
assuming the behavior indicators beyond that period, “a flat” discounting must be
taken into account.
22.2.3 Dividend Policy of the Company
1. Dividend policy of the company must take into account (and account) when
rating, because the financial policy is taken into account in rating. However, the
existing methodologies for ranking estimate only the stability of the dividend
policy and do not estimate its reasonableness, how reasonable is the value of
dividend payouts and how do they relate to the economically reasonable dividend
values.
2. The reasonableness of dividend policy, its score, is determined by comparing the
values of paid dividends with their economically reasonable value, which is the
cost of equity capital ke of the company. The calculation of ke is a rather
difficult task.
BFO theory allows you to make the correct assessment of the value of the
equity capital cost of the company, and thus to compare values of the paid by
the company dividend to their economically reasonable value, it allows you to
assess the reasonableness of dividend policy, which is clearly linked to the
creditworthiness of the issuer.
3. For example, one of the varieties “cash flow,” taking into account the amount of
paid dividends [discretionary cash flow (DCF) S&P], should be compared with
the “economically reasonable dividend values, and this will affect the rating.”
22.2.4 Leverage Level
1. Currently the rating agencies take into account the leverage level only from the
perspective of assessing of financial stability and risk of bankruptcy. In fact the
leverage level significantly affects the main financial indicators of the company’s
activity: the cost of equity capital, WACC, in other words, the cost of attracting of
capital, as well as the capitalization of the company. The failure of this effect in
the analysis of financial reports leads to incorrect conclusions based on it.
Evaluation (by the BFO method) of the influence of the debt financing level on
the effectiveness of investment projects for different values of capital costs can be
used in the rating of investment projects and investment programs of companies.
22.2.5 Taxation
1. Taxation affects the rating of the issuers. Evaluation (by the BFO method) of the
influence of taxation (tax on profit organization rate) on the financial performance
of the company and on the effectiveness of investment projects can be used when
rating companies and their investment programs and investment projects, as well
as in the context of change of tax on profits of the organization rate for forecast
predictions and in analysis of country risk.
2. Evaluation (by BFO the method) of the influence of the Central Bank base rate,
credit rates of commercial banks on the effectiveness of investment projects, and
creation of a favorable investment climate in the country can be used to forecast
predictions, as well as in country risk analysis.
22.2 The Analysis of Methodological and Systemic Deficiencies in the. . . 479
22.2.6 Account of the Industrial Specifics of the Issuer
Industrial specifics of the issuer in the existing rating methodologies, especially in

newly established and taking into account the experience of predecessors, are
ignored. So in “The methodology of ACRA for assigning of credit ratings for
non-financial companies on a national scale for the Russian Federation” “own
creditworthiness is determined by taking into account the characteristics of the
industry in which the company operates. To assess the factor of the industry risk
profile, ACRA subdivides the industry into five groups according to their cyclical,
barriers to entry, industry risk statistics, as well as trends and prospects.
The weight of the factor of industry risk profile is determined individually for
each group and varies depending on the level of credit risk. This creates a certain
rating threshold for companies from industries with high-risk and slightly rewards
low-risk industry.”
However, the existing accounting of industry specifics of issuer is clearly insuf-
ficient. Ranking methodologies should better integrate industry peculiarities in the
organization of finance of issuers. In particular, it is very important to define business
needs in working capital, from the size of which financial soundness indicators,
solvency, and creditworthiness depend directly. The latter is the key indicator in
rating.
22.2.7 Neglect of Taking into Account the Particularities

of the Issuer
In existing rating methodologies taking into account the particularities of the issuer,
features of financial reports, and taxation, legal and financial system is neglected in
favor of achieving full comparability of financial reports; they smooth the distinc-
tions (see Moody’s rating methodologies).
22.2.8 Financial Ratios
1. A necessary and sufficient quantity and mix of financial ratios are not determined;
it appears that such questions are even not raised though valuation of the financial
risk, the financial condition of the issuer, largely depends on the quantity and
quality of financial ratios, their correlation, or independence.
2. Some financial ratios define ambiguously the state of the issuer. For example, the
ratio of cash flow/leverage is high at high cash flow value as well as at
low-leverage value. The question is how these two different states of the issuer,
which is attributed to one value of financial risk, is really equally related to
credit risk.
3. As recognized in the ACRA methodology, “in some cases it is possible a formal

hit of individual characteristics of factor/subfactor simultaneously in several
categories of evaluation, particularly for qualitative factors. In this case, the
score is based on expert opinion, taking into account the most important
parameters,”
4. In connection with paragraph 3, it should be noted that the formalization of expert
opinions is one of the most important tasks in improving the rating methodology
and in making a peer review process more objective. There are a few ways to
solve this problem: using results of modern theory of measurement and using of
the formalism of fuzzy sets, fuzzy logic, and others.
5. Tabulate the composition of various risks, for example, CICRA (in S&P meth-
odology) gives 6 6 matrix, which has 36 elements, i.e., generally CICRA
should have 36 different values, but their total number is equal to 6. The question
is how this is justified. The fact that total number is equal exactly to 6 shows that it
is not very justified or there are other considerations, but they must be well
grounded.
Similar examples abound. So in “The ACRA methodology for assigning of
credit ratings for microfinance organizations on a national scale for the Russian
Federation” Table 22.1 “Score of funding and liquidity” provides 5 5 matrix
that has 25 elements, i.e., generally should be 25 different states, but their total
number is equal to 5. The question is whether it is justified. The fact that total
number is equal exactly to 5 shows that it is not very justified.
6. Tabulate of mixes of different ratios in determining the financial risk has been
done not quite correctly:
FFO/ Debt/ CFO/ DCF/

debt EBITDA FFO/cash EBITDA/ debt FOCF/ debt
(%) (x) interest (x) interest (x) (%) debt (%) (%)
Minimal 60+ Less than More than More than More 40+ 25+
1.5 13 15 than 50
Modest 45–60 1.5–2 9–13 10–15 35–50 25–40 15–25
Intermediate 30–45 2–3 6–9 6–10 25–35 15–25 10–15
Significant 20–30 3–4 4–6 3–6 15–25 10–15 5–10
Aggressive 12–20 4–5 2–4 2–3 10–15 5–10 2–5
Highly Less Greater Less than 2 Less than 2 Less Less Less
leveraged than 12 than 5 than 10 than 5 than 2
Table 22.1 Score of funding Liquidity assessment

and liquidity (after ACRA)
Assessment of funding 1 2 3 4 5
1 1 2 2 3 4
2 1 2 3 3 4
3 2 2 3 4 5
4 3 3 3 4 5
5 3 3 4 5 5
22.3 Modification of the BFO Theory for Companies and Corporations of. . . 481
ratios at least not completely correlated but used as fully correlated. So, one can see
that the two lines
Minimal 60+ Less than More than More than More than 40+ 25+
1.5 13 15 50
Modest 45–60 1.5–2 9–13 10–15 35–50 25–40 15–25
do not allow mixing between parameters of lines, although such mixing can occur,
for example,
60+ 1.5–2 More than 13 More than 15 More than 50 40+ 25+
All these points are limiting the applicability of rating agencies methods. They
were introduced by the rating agencies for the purpose of simplifying the procedure
of ranking (with or without understanding), with a view of unification of methods to
different reporting systems and different countries and with the objective of compa-
rability of results.
Mentioned ambiguity of evaluations already occurred when S&P has assigned a
rating to Gazprom.
22.3 Modification of the BFO Theory for Companies

and Corporations of Arbitrary Age for Purposes
of Ranking
We will conduct below the modification of the BFO theory for companies and
corporations of arbitrary age for purposes of ranking, which proved much more
difficult than modification of its (BFO theory) perpetuity limit.
As it turned out, use of the famous formula BFO
½1 ð1 þ WACCÞn ½1 ð1 þ k0 Þn
¼ ð22:1Þ
is not possible, since it no longer includes cash flows CF and debt value D, and the
leverage level L ¼ D/S (in the same sense as it is used in financial management) is
included only through the share of leveraged wd ¼ L/(L þ 1).
For the modification of the general theory of BFO for ranking purposes, one must
return to the initial assumptions under the derivation of the BFO formula.
Modigliani–Miller theorem in case of existing corporate taxes, generalized by us
for the case of finite company age, states that capitalization of leveraged company
(using the debt financing), VL, is equal to the capitalization of non-leveraged
company (which does not use the debt financing) and, V0, increased by the amount
of the tax shield for the finite period of time, TSn,
V L ¼ V 0 þ TSn : ð22:2Þ
where the capitalization of leveraged company
CF
VL ¼ ð1 ð1 þ WACCÞn Þ; ð22:3Þ
WACC
the capitalization of non-leveraged company
CF
V0 ¼ ð1 ð1 þ k0 Þn Þ; ð22:4Þ
k0
and the tax shield for the period of n years
TSn ¼ tDð1 ð1 þ kd Þn Þ: ð22:5Þ
Substituting Eqs. (22.3–22.5) into Eq. (22.2), we obtain Eq. (22.6), which will be
used by us in the future to modify the BFO theory for the needs of the ranking.
CF∗ð1 ð1 þ WACCÞn Þ CF
¼ ∗ð1 ð1 þ k0 Þn Þ þ t∗D∗ð1 ð1 þ k d Þn Þ
WACC k0
ð22:6Þ
Below we fulfill the incorporation of rating parameters (financial “ratios”) into the
modern theory of capital structure [Brusov–Filatova–Orekhova (BFO) theory].
As we noted in a previous paper (Brusov et al. 2018a, c, d), in quantification of
the creditworthiness of the issuers, the crucial role belongs to the so-called financial
“ratios,” which constitute a direct and inverse ratios of various generated cash flows
to debt values and interest ones. We could mention such ratios as DCF/Debt,
FFO/Debt, CFO/Debt, FOCF/Debt, FFO/cashinterest, EBITDA/interest, Interests/
EBITDA, Debt/EBITDA, and some others.
Let us consider two kind of rating ratios: coverage ratios and leverage ratios.
22.4 Coverage Ratios
We start from the coverage ratios and will consider three kinds of coverage ratios:
coverage ratios of debt, coverage ratios of interest on the credit, and coverage ratios
of debt and interest on the credit. Note that the last type of ratios has been introduced
by us for the first time for a more complete valuation of the issuer’s ability to repay
debts and to pay interest thereon.
22.4 Coverage Ratios 483
22.4.1 Coverage Ratios of Debt
Here
i1 ¼ CF=D
Let us consider the coverage ratios of debt first.

Dividing both parts of the formula (22.6) by the value of the debt D, enter the debt
coverage ratio into the general BFO theory
i1 ¼ CF=D ð22:7Þ
i1 ∗ 1 ð1 þ WACCÞn i1 ∗ 1 ð1 þ k0 Þn
¼ þ t∗ð1 ð1 þ kd Þn Þ ð22:8Þ
WACC k0
i1 ∗A ¼ i1 ∗B þ t∗C ð22:9Þ
1 ð1 þ WACCÞn
A¼ ; ð22:10Þ
WACC
1 ð1 þ k0 Þn
B¼ ; ð22:11Þ
k0
C ¼ ð1 ð1 þ kd Þn Þ; ð22:12Þ
DCF/Debt, FFO/Debt, CFO/Debt, FOCF/Debt, and some others. We will use For-
mula (22.8) to study the dependence WACC (i1) and to build a curve of this
dependence.
Let us analyze the dependence of the weighted average cost of capital (WACC)
on debt coverage ratio i1. We consider the case k0 ¼ 8%; kd ¼ 4%; t¼20%; i1 is
changed from 1 up to 10, for two company ages n ¼ 3 and n ¼ 5.
The dependence of company’s weighted average cost of capital (WACC) on the
coverage ratio on debt i1 is shown at Figs. 22.1 and 22.2.
22.4.2 The Coverage Ratio on Interest on the Credit
Let us analyze now the dependence of company’s weighted average cost of capital
(WACC) on the coverage ratio on interest on the credit i2.
Dividing both parts of the formula (22.6) by the value of the interest on the credit
kdD, enter the coverage ratio on interest on the credit i2 into the general BFO theory
Fig. 22.1 The dependence WACC(i1) at n=3

(WACC) on the coverage
ratio on debt i1 at n ¼ 3 0.079
0.078
0.077
0.076
0.075
0 5 10 15

of company’s weighted 0.08
ratio on debt i1 at n ¼ 5 0.079
0.0785
0.078
0.0775
0.077
0.0765
0.076
0 5 10 15
i2 ∗ 1 ð1 þ WACCÞn i2 ∗ 1 ð1 þ k0 Þn t∗ð1 ð1 þ k d Þn Þ

¼ þ
WACC k0 kd
Here
CF
¼ i2
D∗kd
t∗C
i2 ∗A ¼ i2 ∗B þ
kd
The dependences of company’s weighted average cost of capital (WACC) on the

coverage ratio on interest on the credit i2 at company ages n ¼ 3 and n ¼ 5 are shown
at Figs. 22.3 and 22.4.

0.08
0.06
ratio on interest on the credit
i2 at company age n ¼ 3
0.04
0.02
0
0 5 10 15
-0.02
-0.04

0.08
ratio on interest on the credit 0.06
0.04
0.02
0
0 5 10 15
FFO/cashinterest, EBITDA/interest, and some others. We will use the last formula to
build a curve of dependence WACC(i2).

(New Ratios)
Let us now study the dependence of the company’s weighted average cost of capital
(WACC) on the coverage ratios of debt and interest on the credit simultaneously i3:
this is new ratio introduced by us for the first time here for a more complete
description of the issuer’s ability to repay debts and to pay interest thereon.
Dividing both parts of the formula (22.6) by the value of the debt and interest on
the credit (1 þ kd)D, enter the coverage ratio on debt and interest on the credit i3 into
the general BFO theory
CF
¼ i3
D∗ð1 þ kd Þ
t∗C
i3 ∗A ¼ i3 ∗B þ
1 þ kd
i3 ∗ 1 ð1 þ WACCÞn i3 ∗ 1 ð1 þ k0 Þn t∗ð1 ð1 þ k d Þn Þ

¼ þ
WACC k0 1 þ kd
The dependences of company’s weighted average cost of capital (WACC) on the

coverage ratio on debt and interest on the credit i3 at company age n ¼ 3 and n ¼ 5
are shown at Figs. 22.5 and 22.6.

0.08
0.079
ratio on debt and interest on
the credit i3 at company age
0.078
n¼3
0.077
0.076
0.075
0 5 10 15

ratio on debt and interest on 0.079
the credit i2 at company age
n¼5 0.0785
0.078
0.0775
0.077
0.0765
0 5 10 15
22.4.4 All Three Coverage Ratios Together
Consolidated data of dependence of WACC on i1, i2, i3 at company age n ¼ 3 and

n ¼ 5 are shown at Figs. 22.7 and 22.8.
The analysis of the Tables 22.1, 22.2, 22.3, 22.4, 22.5, 22.6, and 22.7 and
Figs. 22.1, 22.2, 22.3, 22.4, 22.5, 22.6, 22.7, and 22.8 as well as conclusions will
be made at the end of next paragraph.
WACC(i1), WACC(i2), WACC(i3)

0.1
0.08
0.06
0.04
0.02
0
0 2 4 6 8 10 12
WACC1 WACC2 WACC3
Fig. 22.7 Consolidated data of dependence of WACC on i1, i2, i3 at company age n ¼ 3
WACC( i1),(i2),(i3)
0.1
0.08
0.06
0.04
0.02
0
0 2 4 6 8 10 12
-0.02
-0.04
WACC1 WACC2 WACC3
Table 22.2 The dependence t k0 kd i1 WACC

of the weighted average cost
0.2 0.08 0.04 1 0.075356711
of capital (WACC) on debt
coverage ratio i1 for company 0.2 0.08 0.04 2 0.077705469
age n ¼ 3 0.2 0.08 0.04 3 0.078412717
0.2 0.08 0.04 4 0.078808879
0.2 0.08 0.04 5 0.079046807
0.2 0.08 0.04 6 0.079205521
0.2 0.08 0.04 7 0.079318935
0.2 0.08 0.04 8 0.079404022
0.2 0.08 0.04 9 0.079470216
0.2 0.08 0.04 10 0.07952318

0.2 0.08 0.04 1 0.07663868
age n ¼ 5 0.2 0.08 0.04 3 0.0788732
0.2 0.08 0.04 4 0.079154
0.2 0.08 0.04 5 0.07932264
0.2 0.08 0.04 6 0.07943518
0.2 0.08 0.04 7 0.0795156
0.2 0.08 0.04 8 0.07957594
0.2 0.08 0.04 9 0.07962287
0.2 0.08 0.04 10 0.07966043

0.2 0.08 0.04 1 0.021238089
of capital (WACC) on interest
on the credit coverage ratio i2 0.2 0.08 0.04 2 0.02529016
for company age n ¼ 3 0.2 0.08 0.04 3 0.042483465
0.2 0.08 0.04 4 0.051456351
0.2 0.08 0.04 5 0.056965593
0.2 0.08 0.04 6 0.060692181
0.2 0.08 0.04 7 0.063380861
0.2 0.08 0.04 8 0.065412245
0.2 0.08 0.04 9 0.067001115
0.2 0.08 0.04 10 0.068277865

0.2 0.08 0.04 1 0.00793717
of capital (WACC) on interest
on the credit coverage ratio i2 0.2 0.08 0.04 2 0.04111354
for company age n ¼ 5 0.2 0.08 0.04 3 0.0533843
0.2 0.08 0.04 4 0.05974575
0.2 0.08 0.04 5 0.06365738
0.2 0.08 0.04 6 0.06630611
0.2 0.08 0.04 7 0.06821315
0.2 0.08 0.04 8 0.06966377
0.2 0.08 0.04 9 0.07078076
0.2 0.08 0.04 10 0.07168658

0.2 0.08 0.04 1 0.075536724
and interest on the credit 0.2 0.08 0.04 2 0.077796177
age n ¼ 3 0.2 0.08 0.04 4 0.078854621
0.2 0.08 0.04 5 0.079083426
0.2 0.08 0.04 6 0.079236052
0.2 0.08 0.04 7 0.079345114
0.2 0.08 0.04 8 0.079426934
0.2 0.08 0.04 9 0.079490586
0.2 0.08 0.04 10 0.079541516

0.2 0.08 0.04 1 0.07676703
and interest on the credit 0.2 0.08 0.04 2 0.07837722
age n ¼ 5 0.2 0.08 0.04 4 0.07918642
0.2 0.08 0.04 5 0.07934861
0.2 0.08 0.04 6 0.07945683
0.2 0.08 0.04 7 0.07953417
0.2 0.08 0.04 8 0.07959218
0.2 0.08 0.04 9 0.07963732
0.2 0.08 0.04 10 0.07967343
22.5 Coverage Ratios (Different Capital Cost Values)
Let us analyze the dependence of company’s weighted average cost of capital

(WACC) of coverage ratios (i1, i2, i3) for different capital cost values k0 ¼ 14%
and kd ¼ 8%.
Here as before t ¼ 20%, n ¼ 3 and 5, and the value of coverage ratios i is in the
range from 1 to 10.
22.5.1 Coverage Ratios of Debt
As we have derived above, the dependence of the weighted average cost of capital
(WACC) on debt coverage ratio (i1) in the BFO theory is described by the following
formula:
ð1 ð1 þ WACCÞn Þ ð1 ð1 þ k 0 Þn Þ
i1 ∗ i1 ∗ t∗½1 ð1 þ kd Þn ¼ 0,
WACC k0
Here
CF
i1 ¼ :
D
By using it, we get the following results, representing in Table 22.8 and Fig. 22.9
for company age n ¼ 3 and in Table 22.9 and Fig. 22.10 for company age n ¼ 5.
Table 22.8 The dependence i1 t k0 kd WACC n BFO

1 0.2 0.14 0.08 0.1298 3 0.00
coverage ratio i1 for company 2 0.2 0.14 0.08 0.1347 3 0.00
age n ¼ 3 3 0.2 0.14 0.08 0.1365 3 0.00
4 0.2 0.14 0.08 0.1374 3 0.00
5 0.2 0.14 0.08 0.1379 3 0.00
6 0.2 0.14 0.08 0.1382 3 0.00
7 0.2 0.14 0.08 0.1385 3 0.00
8 0.2 0.14 0.08 0.1387 3 0.00
9 0.2 0.14 0.08 0.1388 3 0.00
10 0.2 0.14 0.08 0.1389 3 0.00
22.5 Coverage Ratios (Different Capital Cost Values) 491
WACC (i1)
0.1400
0.1350
WACC
0.1300
0.1250
1 2 3 4 5 6 7 8 9 10
i1
Fig. 22.9 The dependence of the weighted average cost of capital WACC on debt coverage ratio i1
at company age n ¼ 3

1 0.2 0.14 0.08 0.1324 5 0.00
age n ¼ 5 3 0.2 0.14 0.08 0.1374 5 0.00
4 0.2 0.14 0.08 0.1381 5 0.00
5 0.2 0.14 0.08 0.1385 5 0.00
6 0.2 0.14 0.08 0.1387 5 0.00
7 0.2 0.14 0.08 0.1389 5 0.00
8 0.2 0.14 0.08 0.1390 5 0.00
9 0.2 0.14 0.08 0.1391 5 0.00
10 0.2 0.14 0.08 0.1392 5 0.00
WACC (i1)
0.1400
0.1380
0.1360
WACC
0.1340
0.1320
0.1300
0.1280
1 2 3 4 5 6 7 8 9 10
i1
Fig. 22.10 The dependence of the weighted average cost of capital WACC on debt coverage ratio
22.5.2 The Coverage Ratio on Interest on the Credit
(WACC) on interests on credit coverage ratio (i2) in the BFO theory is described by
the following formula:
ð1 ð1 þ WACCÞn Þ ð1 ð1 þ k0 Þn Þ ðt∗½1 ð1 þ kd Þn Þ

i2 ∗ i2 ∗ ¼0
WACC k0 kd
Here
CF
i2 ¼ :
kd ∗D
By using it, we get the following results, representing in Table 22.10 and
Fig. 22.11 for company age n ¼ 3 and in Table 22.11 and Fig. 22.12 for company
age n ¼ 5.

1 0.2 0.14 0.08 0.0285 3 0.00
of capital (WACC) on
interests on credit coverage 2 0.2 0.14 0.08 0.0795 3 0.00
ratio i2 for company age n ¼ 3 3 0.2 0.14 0.08 0.0985 3 0.00
4 0.2 0.14 0.08 0.1084 3 0.00
5 0.2 0.14 0.08 0.1145 3 0.00
6 0.2 0.14 0.08 0.1186 3 0.00
7 0.2 0.14 0.08 0.1216 3 0.00
8 0.2 0.14 0.08 0.1238 3 0.00
9 0.2 0.14 0.08 0.1256 3 0.00
10 0.2 0.14 0.08 0.1270 3 0.00
WACC(i2) at n=3
0.1400
0.1200
0.1000
0.0800
WACC
0.0600
0.0400
0.0200
0.0000
1 2 3 4 5 6 7 8 9 10
i2
Fig. 22.11 The dependence of the weighted average cost of capital (WACC) on interests on credit
coverage ratio (i2) at company age n ¼ 3

1 0.2 0.14 0.08 0.0583 5 0.00
interests on credit coverage 2 0.2 0.14 0.08 0.0957 5 0.00
ratio i2 for company age n ¼ 5 3 0.2 0.14 0.08 0.1096 5 0.00
4 0.2 0.14 0.08 0.1169 5 0.00
5 0.2 0.14 0.08 0.1213 5 0.00
6 0.2 0.14 0.08 0.1244 5 0.00
7 0.2 0.14 0.08 0.1265 5 0.00
8 0.2 0.14 0.08 0.1282 5 0.00
9 0.2 0.14 0.08 0.1295 5 0.00
10 0.2 0.14 0.08 0.1305 5 0.00
WACC(i2) at n=5
0.1500
0.1000
WACC
0.0500
0.0000
1 2 3 4 5 6 7 8 9 10
i2
Fig. 22.12 The dependence of the weighted average cost of capital (WACC) on interests on credit
leverage ratio (i2) at company age n ¼ 5

(New Ratios)
(WACC) on debt and interests on credit coverage ratio (i3) in the BFO theory is
described by the following formula:
ð1 ð1 þ WACCÞn Þ ð1 ð1 þ k 0 Þn Þ t∗½1 ð1 þ kd Þn

i3 ∗ i3 ∗ ¼ 0,
WACC k0 ð k d þ 1Þ
Here
CF
i3 ¼ :
ðkd þ 1Þ∗D
By using it, we get the following results, representing in Table 22.12 and
Fig. 22.13 for company age n ¼ 3 and in Table 22.13 and Fig. 22.14 for company
age n ¼ 5.

1 0.2 0.14 0.08 0.1303 3 0.00
and interests on credit 2 0.2 0.14 0.08 0.1351 3 0.00
age n ¼ 3 4 0.2 0.14 0.08 0.1376 3 0.00
5 0.2 0.14 0.08 0.1380 3 0.00
6 0.2 0.14 0.08 0.1384 3 0.00
7 0.2 0.14 0.08 0.1386 3 0.00
8 0.2 0.14 0.08 0.1388 3 0.00
9 0.2 0.14 0.08 0.1389 3 0.00
10 0.2 0.14 0.08 0.1390 3 0.00
WACC(i3) at n=3
0.1400
0.1380
0.1360
0.1340
WACC
0.1320
0.1300
0.1280
0.1260
0.1240
1 2 3 4 5 6 7 8 9 10
i3
Fig. 22.13 The dependence of the weighted average cost of capital (WACC) on debt and interests
on credit leverage ratio (i3) at company age n ¼ 3

1 0.2 0.14 0.08 0.1329 5 0.00
age n ¼ 5 4 0.2 0.14 0.08 0.1382 5 0.00
5 0.2 0.14 0.08 0.1386 5 0.00
6 0.2 0.14 0.08 0.1388 5 0.00
7 0.2 0.14 0.08 0.1390 5 0.00
8 0.2 0.14 0.08 0.1391 5 0.00
9 0.2 0.14 0.08 0.1392 5 0.00
10 0.2 0.14 0.08 0.1393 5 0.00
WACC(i3) at n=5
0.1400
0.1380
0.1360
WACC
0.1340
0.1320
0.1300
0.1280
1 2 3 4 5 6 7 8 9 10
i3
Fig. 22.14 The dependence of the weighted average cost of capital (WACC) on debt and interests
on credit leverage ratio (i3) at company age n ¼ 5
22.5.4 Analysis and Conclusions
It is seen from Tables 22.1, 22.2, 22.3, 22.4, 22.5, 22.6, 22.7, 22.8, 22.9, 22.10,
22.11, 22.12, and 22.13 and Figs. 22.1, 22.2, 22.3, 22.4, 22.5, 22.6, 22.7, 22.8, 22.9,
22.10, 22.11, 22.12, 22.13, 22.14, 22.15, and 22.16 that WACC(ij) is increasing
function on ij with saturation WACC ¼ k0 at high values of ij. Note that this
saturation for companies of finite age is a little bit more gradual than in case of
perpetuity companies: in latter case, the saturation takes place around ij value of
order 1 for ratios i1 and i3 and of order 4 or 5 for ratios i2. In perpetuity case as well as
in case of companies of finite age at saturation, WACC reaches the value k0 (equity
value at zero leverage level). This means that for high values of ij, one can choose k0
as a discount rate with a very good accuracy in perpetuity case and with a little bit
less accuracy in general case (companies of arbitrary ages). Thus the role of
parameter k0 increases drastically. The method of determination of parameter k0
WACC (i1), WACC (i2), WACC (i3) at n=3

0.1600
0.1400
0.1200
WACC
0.1000
0.0800
0.0600
0.0400
0.0200
0.0000
1 2 3 4 5 6 7 8 9 10
WACC (i1) 0.1298 0.1347 0.1365 0.1374 0.1379 0.1382 0.1385 0.1387 0.1388 0.1389
WACC (i2) 0.0285 0.0795 0.0985 0.1084 0.1145 0.1186 0.1216 0.1238 0.1256 0.1270
WACC (i3) 0.1303 0.1351 0.1367 0.1376 0.1380 0.1384 0.1386 0.1388 0.1389 0.1390
i
WACC (i1), WACC (i2), WACC (i3) at n=5

0.1600
0.1400
0.1200
WACC
0.1000
0.0800
0.0600
0.0400
0.0200
0.0000
1 2 3 4 5 6 7 8 9 10
WACC (i1) 0.1324 0.1362 0.1374 0.1381 0.1385 0.1387 0.1389 0.1390 0.1391 0.1392
WACC (i2) 0.0583 0.0957 0.1096 0.1169 0.1213 0.1244 0.1265 0.1282 0.1295 0.1305
WACC (i3) 0.1329 0.1364 0.1376 0.1382 0.1386 0.1388 0.1390 0.1391 0.1392 0.1393
i
has been developed by Anastasiya Brusova (Brusova 2011). So, parameter k0 is the
discount rate for case of high values of ij. In case of ratio i2 in general case as well as
in perpetuity case, the saturation of WACC(i2) takes place at higher values of i2.
In opposite to perpetuity case within BFO theory, one could make calculations for
companies of arbitrary age because a factor of time presents in this theory. Our
calculations show that curve WACC(ij) for company of higher age lies above this
curve for younger company. And with increase of ij value, the WACC values for
different company ages n become closer to each other.
Note that curves WACC(i1) and WACC(i3) are very close to each other at small
enough credit rates, but difference between them will become bigger at higher values
of credit rates.
Curve WACC(i2) turns out to be enough different from curves WACC(i1) and
WACC(i3).
22.6 Leverage Ratios
22.6.1 Leverage Ratios for Debt
We will analyze the dependence of company’s weighted average cost of capital

(WACC) on leverage ratios (l1, l2, l3). We will make calculation for capital costs
k0 ¼ 10%, kd ¼ 6%, t ¼ 20%, and n ¼ 3; 5; l values range from 0 to 10.
Dividing both parts of the formula (22.6) by the income value for one-period CF,
we enter the leverage ratios l1 for debt into the general BFO theory:
ð1 ð1 þ WACCÞn Þ ð1 ð1 þ k0 Þn Þ
t∗½1 ð1 þ k d Þn ∗l1 ¼ 0,
WACC k0
Here
22.6 Leverage Ratios 497
D
l1 ¼ :
CF
Be reminded that here WACC is the weighted average cost of capital of the
company, l1 is the leverage ratios l1 for debt, t is the tax on profit rate for organiza-
tions (t ¼ 20%), k0 is the equity cost of financially dependent company, kd is the debt
capital cost, n is the company age, CF is the income value for one period, and D is
the debt capital value.
The ratio (l2) can be used to assess the following parameters used in rating:
Interests/EBITDA and some others.
By using the above equation, we get the following results, representing in
Table 22.14 and Fig. 22.17 for company age n ¼ 3 and in Table 22.15 and
Fig. 22.18 for company age n ¼ 5.
Table 22.14 The dependence l1 t k0 kd WACC(l1) n BFO

0 0.2 0.1 0.06 0.1000 3 0.00
leverage ratio l1 for company 1 0.2 0.1 0.06 0.0928 3 0.00
age n ¼ 3 2 0.2 0.1 0.06 0.0857 3 0.00
3 0.2 0.1 0.06 0.0787 3 0.00
4 0.2 0.1 0.06 0.0720 3 0.00
5 0.2 0.1 0.06 0.0654 3 0.00
6 0.2 0.1 0.06 0.0587 3 0.00
7 0.2 0.1 0.06 0.0523 3 0.00
8 0.2 0.1 0.06 0.0461 3 0.00
9 0.2 0.1 0.06 0.0399 3 0.00
10 0.2 0.1 0.06 0.0339 3 0.00
WACC(l1) at n=3
0.1000
0.0800
0.0600
WACC
0.0400
0.0200
0.0000
1 2 3 4 5 6 7 8 9 10
l1
Fig. 22.17 The dependence of company’s weighted average cost of capital (WACC) on debt
leverage ratio l1 at n ¼ 3

0 0.2 0.1 0.06 0.1000 5 0.00
age n ¼ 5 2 0.2 0.1 0.06 0.0898 5 0.00
3 0.2 0.1 0.06 0.0848 5 0.00
4 0.2 0.1 0.06 0.0799 5 0.00
5 0.2 0.1 0.06 0.0752 5 0.00
6 0.2 0.1 0.06 0.0705 5 0.00
7 0.2 0.1 0.06 0.0660 5 0.00
8 0.2 0.1 0.06 0.0615 5 0.00
9 0.2 0.1 0.06 0.0571 5 0.00
10 0.2 0.1 0.06 0.0528 5 0.00
WACC(l1) at n=5
0.1000
0.0800
WACC
0.0600
0.0400
0.0200
0.0000
1 2 3 4 5 6 7 8 9 10
L1
Fig. 22.18 The dependence of company’s weighted average cost of capital WACC on debt
leverage ratio at n ¼ 5
22.6.2 Leverage Ratios for Interest on Credit
The dependence of company’s weighted average cost of capital (WACC) on lever-

age ratios on interests on credit l2 is described within BFO theory by the following
formula:
ð1 ð1 þ WACCÞn Þ ð1 ð1 þ k0 Þn Þ ðt∗l2 ∗½1 ð1 þ k d Þn Þ

¼ 0,
WACC k0 kd
Here
kd ∗D
l2 ¼ :
CF
By using it, we find the dependence WACC(l2) at company ages n ¼ 3 and n ¼ 5.

22.7 Leverage Ratios (Different Capital Costs) 499
This ratio l2 can be used to assess the following parameters used in rating:
Interests/EBITDA and some others.
The dependence of company’s weighted average cost of capital (WACC) on
leverage ratios on debt and interests on credit l3 is described within BFO theory by
the following formula:
ð1 ð1 þ WACCÞn Þ ð1 ð1 þ k 0 Þn Þ t∗l3 ∗½1 ð1 þ k d Þn

¼ 0,
WACC k0 ð k d þ 1Þ
Here
ðkd þ 1Þ∗D
l3 ¼ :
CF
The ratio l3 can be used to assess the following parameters used in rating;
Debt þ interest/FFO, Debt þ interest/EBIT, Debt þ interest/EBITDA(R), and
some others.
By using it, we find the dependence WACC(l3) at company ages n ¼ 3 and n ¼ 5.
Below we represent the consolidated data of dependence of WACC on l1, l2, l3 at
company age n ¼ 3 and n ¼ 5.
22.7 Leverage Ratios (Different Capital Costs)

22.7.1 Leverage Ratios for Debt
Below we analyze the dependence of company’s weighted average cost of capital

(WACC) on leverage ratios l1, l2, l3 at capital cost values k0 ¼ 12%, kd ¼ 6%.
As before t ¼ 20%, company age n ¼ 3; 5, leverage ratio values range from 0 to
10.
The dependence of company’s weighted average cost of capital (WACC) on
leverage ratios on debt l1 is described within BFO theory by the following formula:
ð1 ð1 þ WACCÞn Þ ð1 ð1 þ k0 Þn Þ
t ∗ c∗ l1 ¼ 0
WACC k0
Here
D
l1 ¼ :
CF
Using it, we find the dependence WACC(l1) at company ages n ¼ 3 and n ¼ 5.

22.7.2 Leverage Ratios for Interests on Credit

age ratios on interests on credit l2 is described within BFO theory by the following
formula:
ð1 ð1 þ WACCÞn Þ ð1 ð1 þ k0 Þn Þ t ∗ l2 ∗ ð1 ð1 þ kd Þn Þ

¼0
WACC k0 kd
Here
D∗ kd
l2 ¼
CF
22.7.3 Leverage Ratios for Debt and Interests on Credit

age ratios on debt and interests on credit l3 is described within BFO theory by the
following formula:
ð1 ð1 þ WACCÞn Þ ð1 ð1 þ k0 Þn Þ t ∗ l3 ∗ ð1 ð1 þ kd Þn Þ

¼0
WACC k0 1 þ kd
Here
D ð1 þ k d Þ
l3 ¼
CF
22.7.4 Analysis and Conclusions
It is seen from Tables 22.14, 22.15, 22.16, 22.17, 22.18, 22.19, 22.20, 22.21, 22.22,
22.23, 22.24 and 22.25 and Figs. 22.17, 22.18, 22.19, 22.20, 22.21, 22.22, 22.23,
22.24, 22.25, 22.26, 22.27, 22.28, 22.29, 22.30, 22.31, and 22.32 that WACC(lj) is
decreasing function on lj. WACC decreases from value of k0 (equity value at zero

0 0.2 0.1 0.06 0.0998 3 0.00
interests on credit leverage 1 0.2 0.1 0.06 0.0036 3 0.00
ratio l2 for company age n ¼ 3 2 0.2 0.1 0.06 0.0804 3 0.00
3 0.2 0.1 0.06 0.1403 3 0.00
4 0.2 0.1 0.06 0.1888 3 0.00
5 0.2 0.1 0.06 0.2289 3 0.00
6 0.2 0.1 0.06 0.2629 3 0.00
7 0.2 0.1 0.06 0.2922 3 0.00
8 0.2 0.1 0.06 0.3178 3 0.00
9 0.2 0.1 0.06 0.3404 3 0.00
10 0.2 0.1 0.06 0.3605 3 0.00

0 0.2 0.1 0.06 0.1000 5 0.00
interests on credit leverage 1 0.2 0.1 0.06 0.0259 5 0.00
ratio l2 for company age n ¼ 5 2 0.2 0.1 0.06 0.0296 5 0.00
3 0.2 0.1 0.06 0.0732 5 0.00
4 0.2 0.1 0.06 0.1089 5 0.00
5 0.2 0.1 0.06 0.1388 5 0.00
6 0.2 0.1 0.06 0.1643 5 0.00
7 0.2 0.1 0.06 0.1865 5 0.00
8 0.2 0.1 0.06 0.2061 5 0.00
9 0.2 0.1 0.06 0.2235 5 0.00
10 0.2 0.1 0.06 0.2391 5 0.00

0 0.2 0.1 0.06 0.1000 3 0.00
age n ¼ 3 3 0.2 0.1 0.06 0.0798 3 0.00
4 0.2 0.1 0.06 0.0734 3 0.00
5 0.2 0.1 0.06 0.0671 3 0.00
6 0.2 0.1 0.06 0.0608 3 0.00
7 0.2 0.1 0.06 0.0548 3 0.00
8 0.2 0.1 0.06 0.0489 3 0.00
9 0.2 0.1 0.06 0.0430 3 0.00
10 0.2 0.1 0.06 0.0371 3 0.00

0 0.2 0.1 0.06 0.1000 5 0.00
age n ¼ 5 3 0.2 0.1 0.06 0.0856 5 0.00
4 0.2 0.1 0.06 0.0810 5 0.00
5 0.2 0.1 0.06 0.0765 5 0.00
6 0.2 0.1 0.06 0.0721 5 0.00
7 0.2 0.1 0.06 0.0678 5 0.00
8 0.2 0.1 0.06 0.0635 5 0.00
9 0.2 0.1 0.06 0.0593 5 0.00
10 0.2 0.1 0.06 0.0552 5 0.00
Table 22.20 The dependence l1 k0 kd n t WACC БФО

0 0.12 0.06 3 0.2 0.119997 0.00
leverage ratio l1 for company 1 0.12 0.06 3 0.2 0.112294 0.00
age n ¼ 3 2 0.12 0.06 3 0.2 0.104774 0.00
3 0.12 0.06 3 0.2 0.097444 0.00
4 0.12 0.06 3 0.2 0.090128 0.00
5 0.12 0.06 3 0.2 0.083078 0.00
6 0.12 0.06 3 0.2 0.076332 0.00
7 0.12 0.06 3 0.2 0.06959 0.00
8 0.12 0.06 3 0.2 0.062962 0.00
9 0.12 0.06 3 0.2 0.056492 0.00
10 0.12 0.06 3 0.2 0.050163 0.00

0 0.12 0.06 5 0.2 0.119994 0.00
age n ¼ 5 2 0.12 0.06 5 0.2 0.108927 0.00
3 0.12 0.06 5 0.2 0.103556 0.00
4 0.12 0.06 5 0.2 0.098332 0.00
5 0.12 0.06 5 0.2 0.093123 0.00
6 0.12 0.06 5 0.2 0.088164 0.00
7 0.12 0.06 5 0.2 0.083265 0.00
8 0.12 0.06 5 0.2 0.078452 0.00
9 0.12 0.06 5 0.2 0.073744 0.00
10 0.12 0.06 5 0.2 0.069 0.00

0 0.12 0.06 3 0.2 0.119997 0.00
interests on credit leverage 1 0.12 0.06 3 0.2 0.010838 0.00
ratio l2 for company age n ¼ 3 2 0.12 0.06 3 0.2 0.06941 0.00
3 0.12 0.06 3 0.2 0.13171 0.00
4 0.12 0.06 3 0.2 0.18169 0.00
5 0.12 0.06 3 0.2 0.22298 0.00
6 0.12 0.06 3 0.2 0.25785 0.00
7 0.12 0.06 3 0.2 0.28784 0.00
8 0.12 0.06 3 0.2 0.31392 0.00
9 0.12 0.06 3 0.2 0.33692 0.00
10 0.12 0.06 3 0.2 0.35745 0.00
Table 22.23 The dependence L2 k0 kd n1 t WACC БФО

0 0.12 0.06 5 0.2 0.119994 0.00
interests on credit leverage 1 0.12 0.06 5 0.2 0.040367 0.00
ratio l2 for company age n ¼ 5 2 0.12 0.06 5 0.2 0.01846 0.00
3 0.12 0.06 5 0.2 0.06439 0.00
4 0.12 0.06 5 0.2 0.10159 0.00
5 0.12 0.06 5 0.2 0.13262 0.00
6 0.12 0.06 5 0.2 0.15899 0.00
7 0.12 0.06 5 0.2 0.18185 0.00
8 0.12 0.06 5 0.2 0.20194 0.00
9 0.12 0.06 5 0.2 0.21978 0.00
10 0.12 0.06 5 0.2 0.23578 0.00
Table 22.24 The dependence l3 k0 kd n t WACC BFO

0 0.12 0.06 3 0.2 0.119997 0.00
and interests on credit 1 0.12 0.06 3 0.2 0.112716 0.00
age n ¼ 3 3 0.12 0.06 3 0.2 0.098686 0.00
4 0.12 0.06 3 0.2 0.091785 0.00
5 0.12 0.06 3 0.2 0.085114 0.00
6 0.12 0.06 3 0.2 0.078654 0.00
7 0.12 0.06 3 0.2 0.072249 0.00
8 0.12 0.06 3 0.2 0.065828 0.00
9 0.12 0.06 3 0.2 0.059771 0.00
10 0.12 0.06 3 0.2 0.053729 0.00
Table 22.25 The dependence l3 k0 kd n t WACC BFO

0 0.12 0.06 5 0.2 0.119994 0.00
and interests on credit 1 0.12 0.06 5 0.2 0.114614 0.00
age n ¼ 5 3 0.12 0.06 5 0.2 0.104444 0.00
4 0.12 0.06 5 0.2 0.099512 0.00
5 0.12 0.06 5 0.2 0.094598 0.00
6 0.12 0.06 5 0.2 0.08988 0.00
7 0.12 0.06 5 0.2 0.0852 0.00
8 0.12 0.06 5 0.2 0.080618 0.00
9 0.12 0.06 5 0.2 0.076129 0.00
10 0.12 0.06 5 0.2 0.071733 0.00
WACC(l2) at n=3
0.0000
-0.0500 1 2 3 4 5 6 7 8 9 10
-0.1000
-0.1500
WACC
-0.2000
-0.2500
-0.3000
-0.3500
-0.4000
L2
Fig. 22.19 The dependence of company’s weighted average cost of capital (WACC) on leverage
ratio of interests on credit at company age n ¼ 3
WACC(l2)
0.0500
0.0000
-0.0500 1 2 3 4 5 6 7 8 9 10
-0.1000
WACC
-0.1500
-0.2000
-0.2500
-0.3000
L2
ratio of interests on credit at company age n ¼ 3
WACC(l3) at n=3
0.1000
0.0800
0.0600
WACC
0.0400
0.0200
0.0000
1 2 3 4 5 6 7 8 9 10
L3
ratio on debt and interests on credit at company age n ¼ 3
WACC(l3)
0.1000
0.0800
0.0600
WACC
0.0400
0.0200
0.0000
1 2 3 4 5 6 7 8 9 10
L3
ratio of debt and interests on credit at company age n ¼ 5
leverage level) practically linearly for WACC(l1) and WACC(l3) and with higher
speed for WACC(l2). In opposite to perpetuity case within BFO theory, one could
make calculations for companies of arbitrary age because a factor of time presents in
this theory. Our calculations show that curve WACC(li) for company of higher age
lies above this curve for younger company.
Note that curves WACC(l1) and WACC(l3) are very close to each other at small
enough credit rates, but difference between them will become bigger at higher values
of credit rates.
Curve WACC(l2) turns out to be enough different from curves WACC(l1) and
WACC(l3).
WACC(l1), WACC(l2), WACC(l3)

0.2000
WACC(l1) WACC(l2) WACC(l3)
0.1000
0.0000
0 2 4 6 8 10 12
WACC
-0.1000
-0.2000
-0.3000
-0.4000
L
Fig. 22.23 Consolidated data of dependence of WACC on l1, l2, l3 at company age n ¼ 3
WACC(l1), WACC(l2), WACC(l3)
WACC(l1) WACC(l2) WACC(l3)

0.1500
0.1000
0.0500
0.0000
0 2 4 6 8 10 12
WACC
-0.0500
-0.1000
-0.1500
-0.2000
-0.2500
-0.3000
l
Fig. 22.24 Consolidated data of dependence of WACC on l1, l2, l3 at company age n ¼ 5
Fig. 22.25 The dependence WACC (l1) at n=3

(WACC) on leverage ratio 0.1
WACC
of debt l1 at company age
n¼3 0.05 WACC
0
0 1 2 3 4 5 6 7 8 9 10
L1

0.15
WACC
of debt at company age

n¼3 0.05
WACC
0
0 1 2 3 4 5 6 7 8 9 10
L1

of interests on credit at 0
company age n ¼ 3
WACC
-0.1 0 1 2 3 4 5 6 7 8 9 10
WACC
-0.2
-0.3
-0.4
L2

of interests on credit at
WACC
0
company age n ¼ 5 0 1 2 3 4 5 6 7 8 9 10
-0.1 WACC
-0.2
-0.3
L2

0.15
WACC
of debt and interests on
credit at company age n ¼ 3 0.05
WACC
0
0 1 2 3 4 5 6 7 8 9 10
L3
Fig. 22.30 The dependence WACC (L3) at n=5

0.15
WACC
of debt and interests on

credit at company age n ¼ 5 0.05 WACC
0
0 1 2 3 4 5 6 7 8 9 10
L3
Fig. 22.31 Consolidated WACC(l1, l2, l3) at n=3

data of dependence of
0.2
WACC on l1, l2, l3 at
company age n ¼ 3 0.1
0
WACC
0 1 2 3 4 5 6 7 8 9 10 WACC (L1)
-0.1
WACC (L2)
-0.2 WACC (L3)
-0.3
-0.4
L
Fig. 22.32 Consolidated WACC (l1, l2, l3) at n=5

data of dependence of 0.15
WACC on l1, l2, l3 at 0.1
company age n ¼ 5 0.05
0
-0.05 0 1 2 3 4 5 6 7 8 9 10 WACC (L1)
WACC
-0.1 WACC (L2)

-0.15
WACC (L3)
-0.2
-0.25
-0.3
L
References 509
22.8 Conclusions
In current chapter, further development of a new approach to rating methodology 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 BFO theory in order to use it in rating procedure
has been required. It allows 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
to use the powerful tools of BFO theory in the rating. All these create a new base for
rating methodologies.
References
(11):815–824
Brusov P, Filatova T, Orekhova N, Brusov P, Brusova A (2012a) Modern approach to dividend
policy of company. Finance and credit 18(37):2012
Brusov P, Filatova T, Eskindarov M, Orehova N (2012b) Influence of debt financing on the
Brusov P, Filatova T, Eskindarov M, Orehova N (2012c) Hidden global causes of the global
org/10.1080/23322039.2014.946150
7:37–62
Brusova A (2011) А Comparison of the three methods of estimation of weighted average cost of
capital and equity cost of company. Financ Anal Prob Solut 34(76):36–42
Econ Rev 53:147–175
1954–1957. Am Econ Rev 56:333–391
Chapter 23
Ratings of Long-Term Projects: A New
Approach
Rating agencies play a very important role in economics. Via the analysis of issuer’s
state they generate credit ratings of issuers which help investors make reasonable
investment decision, as well as help issuers with good enough ratings get credits on
lower rates, etc.
The paper continues to create a new approach to rating methodology: in addition
to two papers, which have considered the creditworthiness of the non-finance issuers
(Brusov et al. 2018c, d), we develop here a new approach to project rating. We work
within investment models created by the authors. One of them describes the effec-
tiveness of investment project from the perspective of equity capital owners, while
the other model describes the effectiveness of investment project from the perspec-
tive 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 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 kd, as well as at different values of
leverage level L, we come to a very important conclusion that NPV (in units of NOI)
(NPV NPV
NOI ) [as well as NPV (in units of D) ( D )] depends only on equity cost k0, on credit
rates kd, on leverage level L, as well as on one of the leverage ratios lj (on one of the
coverage ratios ij) and does not depend on equity value S, debt value D, and NOI.
This means that results on the dependence of NPV (in units of NOI) (NPV NOI) on leverage
ratios lj [as well as on the dependence of NPV (in units of D) (NPV D ) on coverage ratios
ij] at different equity costs k0, at different credit rates kd, and at different leverage
levels L carry the universal character: these dependencies remain valid for invest-
ment projects with any equity value S, debt value D, and NOI.

https://doi.org/10.1007/978-3-319-99686-8_23
512 23 Ratings of Long-Term Projects: A New Approach
We work within investment models, created by the 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.
In the former case, investments at the initial time moment T ¼ 0 are equal to –S
and the flow of capital for the period (in addition to the tax shields kdDt, it includes a
CF ¼ ðNOI kd DÞð1 t Þ: ð23:1Þ
shares kdD during all periods. Note that principal repayment is made at the end of the
last period.
We will consider the case of discounting, when operating and financial flows are
not separated and both are discounted, using the general rate [as which, obviously,
the weighted average cost of capital (WACC) can be selected]. In this case for long-
term (perpetuity) projects, the Modigliani–Miller formula (Мodigliani and Мiller
1958, 1963, 1966) for WACC will be used, and for projects of finite (arbitrary)
duration, Brusov–Filatova–Orekhova formula will be used (Brusov and Filatova
Note that debt capital is the least risky, because interest on credit is paid after
cost, whether of ordinary or of preference shares ke > kd; kp > kd. Here ke, kp is the
equity cost of ordinary or of preference shares consequently.

the Perspective of the Equity Holders Only (Without
Flows Separation)
In this case operating and financial flows are not separated and are discounted using
The credit reimbursable at the end of the project [at the end of the period (n)] can
X
n
NPV ¼ S þ
i¼1 ð1 þ WACCÞ i ð1 þ WACCÞn

¼ S þ 1 :
ð23:2Þ

Accounting that in the case S ¼ const NOI is proportional to the invested capital, I,
NOI ¼ βI ¼ βS(1 + L ), and substituting D ¼ LS, we get

NPV ¼ S þ 1
WACC ð1 þ WACCÞn
D
, ð23:3Þ
ð1 þ WACCÞn

Lk d ð1 t Þ 1 L
NPV ¼ S 1 þ 1 þ
ð23:4Þ
þ 1 :
WACC ð1 þ WACCÞn
23.1.2 Modigliani–Miller Limit [Long-Term (Perpetuity)

Projects]

NPV ¼ S þ : ð23:5Þ
WACC
WACC

NPV ¼ S 1 þ þ
WACC WACC
ð23:7Þ
¼ S 1 þ þ :
In the last equation, we substituted the perpetuity (Modigliani–Miller) formula for

WACC:

Lt
WACC ¼ k0 1 : ð23:8Þ
1þL
So, below we consider the long-term (perpetuity) projects and will use the
following formula for calculations:
2 3
Lkd ð1 t Þ 5 βSð1 þ LÞð1 t Þ
NPV ¼ S41 þ þ ð23:9Þ
k0 1 1þL
Lt
k0 1 1þL
Lt
23.2 Incorporation of Financial Coefficients, Used

in Project Rating, into Modern Investment Models
Below we incorporate the financial coefficients, used in project rating, into modern
investment models, created by the authors. We will consider two kinds of financial
coefficients: coverage ratios and leverage coefficients. In each group of financial
coefficients, we incorporate three particular quantities.
For coverage ratios, we incorporate (1) coverage ratios of debt, i1 ¼ NPV D ;
(2) coverage ratios of interest on the credit i2 ¼ NPV kd D ; and (3) coverage ratios of
debt and interest on the credit i3 ¼ ð1þkNPV
d ÞD
.
For leverage ratios, we incorporate (1) leverage ratios of debt, l1 ¼ NPV D
; (2) lever-
age ratios of interest on the credit l2 ¼ NPV; and (3) leverage ratios of debt and interest
kd D
on the credit l3 ¼ ð1þk d ÞD

NPV .
23.2.1 Coverage Ratios
23.2.1.1 Coverage Ratios of Debt
Let us first incorporate the coverage ratios, used in project rating, into modern
investment models, created by the authors. Dividing both parts of Eq. (23.9) by D,
one gets
NPV 1 ðk d i 1 Þð1 t Þ
¼ ð23:10Þ
D L k0 1 Lt 1þL
Here
23.2 Incorporation of Financial Coefficients, Used in Project Rating, into. . . 515
NPV
i1 ¼ ð23:11Þ
D
23.2.1.2 Coverage Ratios of Interest on the Credit
Dividing both parts of Eq. (23.9) by kdD one gets
NPV 1 ð1 i 2 Þð1 t Þ
¼ ð23:12Þ
kd D Lkd k 0 1 Lt 1þL
Here
NPV
i2 ¼ ð23:13Þ
kd D
23.2.1.3 Coverage Ratios of Debt and Interest on the Credit
Dividing both parts of Eq. (23.9) by (1 + kd)D, one gets
NPV 1 ½kd i3 ð1 þ k d Þð1 t Þ

¼ ð23:14Þ
ð1 þ kd ÞD Lð 1 þ k d Þ k 0 1 Lt 1þL
Here
NPV
i3 ¼ ð23:15Þ
ð1 þ kd ÞD
Analyzing the formulas (23.10, (23.12, and 23.14), we come to a very important
conclusion that NPV (in units of D) (NPV D ) depends only on equity cost k0, on credit
rates kd, on leverage level L, as well as on one of the coverage ratios ij and does not
depend on equity value S, debt value D, and NOI. This means that results on the
dependence of NPV (in units of D) (NPV D ) on coverage ratios ij at different equity costs
k0, at different credit rates kd, 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.
23.2.2 Leverage Ratios
23.2.2.1 Leverage Ratios for Debt
Now let us incorporate the leverage ratios, used in project rating, into modern
investment models, created by the authors.
Dividing both parts of Eq. (23.9) by NOI, one gets
NPV l1 ð1 kd l1 Þð1 t Þ

¼ þ ð23:16Þ
NOI L k 0 1 Lt 1þL
Here
D
l1 ¼ ð23:17Þ
NPV
23.2.2.2 Leverage Ratios for Interest on Credit
NPV l2 ð1 l2 Þð1 t Þ

¼ þ ð23:18Þ
NOI kd L k 0 1 Lt 1þL
Here
kd D
l2 ¼ ð23:19Þ
NPV
23.2.2.3 Leverage Ratios for Debt and Interest on Credit
NPV l3 ð1 þ k d l 3 k d Þð1 t Þ

¼ þ ð23:20Þ
NOI ð1 þ kd ÞL ð1 þ kd Þk 0 1 Lt
1þL
Here
ð1 þ kd ÞD
l3 ¼ ð23:21Þ
NPV
23.3 Dependence of NPV on Coverage Ratios 517
Analyzing the formulas (23.16, 23.18, and 23.20), we come to a very important
conclusion that NPV (in units of NOI) (NPV
NOI) depends only on equity cost k0, on credit
rates kd, on leverage level L, as well as on one of the leverage ratios lj and does not
depend on equity value S, debt value D, and NOI. This means that results on the
dependence of NPV (in units of NOI) (NPV NOI ) on leverage ratios lj at different equity
costs k0, at different credit rates kd, 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.
We investigate below the effectiveness of long-term investment projects studying
the dependence of NPV on coverage ratios and on leverage ratios. We make
calculations for coefficients i1 and l1. Calculations for the rest of coefficients (i2, i3
and l2, l3) could be made in a similar way.
We start from the calculations of the dependence of NPV on coverage ratios. We
consider different values of equity costs k0, of debt costs kd, and of leverage level
L ¼ D/S. Here t is tax on profit rate, which in our calculations is equal to 20%.
23.3 Dependence of NPV on Coverage Ratios
23.3.1 Coverage Ratio on Debt
Below we calculate the dependence of NPV (in units of D) (NPV

D ) on coverage ratio on
debt i1 at different equity costs k0 (k0 is equity cost at L ¼ 0). We will make
calculations for two leverage levels L (L ¼ 1 and L ¼ 3) and for different credit
rates kd.
For calculation within MM approximation, we use the formula (23.10)
NPV 1 ðkd i1 Þð1 t Þ

¼ :
D L k0 ∗ 1 Lt
1þL
23.3.1.1 The Dependence of NPV on Coverage Ratio on Debt I1 at

Equity Cost k0 ¼ 24%
Below we investigate the dependence of NPV on coverage ratio on debt i1 at

different values of equity costs k0, at different values of debt costs kd, at fixed
value of equity cost, as well as at different values of leverage levels L.
Let us start our calculations from the case of equity cost k0 ¼ 24%.
The results of calculations of the dependence of NPV on coverage ratio on debt i1
at equity cost k0 ¼ 24%, at different values of debt costs kd, and at L ¼ 1 are shown in
Table 23.1.
Table 23.1 The dependence of NPV on coverage ratio on debt i1 at equity cost k0 ¼ 24%; kd ¼ 6,
10, 14, and 20%; and L ¼ 1
NPV/D NPV/D NPV/D NPV/D
i1 L k0 t (kd ¼ 0.2) (kd ¼ 0.14) (kd ¼ 0.1) (kd ¼ 0.06)
0 1 0.24 0.2 1.741 1.519 1.37 1.222
1 1 0.24 0.2 1.963 2.185 2.333 2.481
2 1 0.24 0.2 5.667 5.889 6.037 6.185
3 1 0.24 0.2 9.37 9.593 9.741 9.889
4 1 0.24 0.2 13.07 13.3 13.44 13.59
5 1 0.24 0.2 16.78 17 17.15 17.3
6 1 0.24 0.2 20.48 20.7 20.85 21
7 1 0.24 0.2 24.19 24.41 24.56 24.7
8 1 0.24 0.2 27.89 28.11 28.26 28.41
9 1 0.24 0.2 31.59 31.81 31.96 32.11
10 1 0.24 0.2 35.3 35.52 35.67 35.81
NPV/D (i1) AT L=1

kd=0,20 kd=0,14 kd=0,10 kd=0,06
40
35
30
25
20
NPV/D
15
10
0
0 1 2 3 4 5 6 7 8 9 10
-5
I1
Fig. 23.1 The dependence of NPV (in units of D) on coverage ratio on debt i1 at k0 ¼ 24%; kd ¼ 6,
10, 14, and 20%; and L ¼ 1
The dependence of NPV (in units of D) on coverage ratio on debt i1 at k0 ¼ 24%;

kd ¼ 6, 10, 14, and 20%; and L ¼ 1 is illustrated in Fig. 23.1.
Let us calculate the value of i1 above which the investment project remains
effective (NPV > 0).
kd 0.20 0.14 0.1 0.06

i1 0.48 0.42 0.38 0.32
NPV/D (i1) at L=3

kd=0,20 kd=0,14 kd=0,10 kd=0,06
45
40
35
30
25
NPV/D
20
15
10
5
0
-5 0 1 2 3 4 5 6 7 8 9 10
I1
10, 14, and 20%; and L ¼ 3
One can see from this table that the value of i1 above which the investment project
remains effective (NPV > 0) increases with credit rate kd; that means that effective-
ness of the investment project as well as its creditworthiness decreases with credit
rate kd.
Let us calculate the dependence of NPV (in units of D) on coverage ratio on debt
i1 at k0 ¼ 24%; kd ¼ 6, 10, 14, and 20%; and L ¼ 3.
The dependence of NPV (in units of D) on coverage ratio on debt i1 at k0 ¼ 24%;
kd ¼ 6, 10, 14, and 20%; and L ¼ 3 is illustrated in Fig. 23.2.
Let us calculate the value of l1 above which the investment project remains
kd 0.20 0.14 0.1 0.06

i1 0.3 0.23 0.18 0.12
One can see from this table that like the case of L ¼ 1, the value of i1 above which
the investment project remains effective (NPV > 0) increases with credit rate kd; that
means that effectiveness of the investment project as well as its creditworthiness
decreases with credit rate kd. Comparing the case of L ¼ 1, one can see that at bigger
leverage level (L ¼ 3), the investment project becomes effective (NPV > 0) starting
from smaller coverage ratio i1, so bigger leverage level favors to the effectiveness of
the investment project as well as its creditworthiness.
We see from the Tables 23.1 and 23.2 and Figs. 23.1 and 23.2 that NPV D increases
with i1 and that NPV
D values turn out to be very close to each other at all i 1 values. It is
Table 23.2 The dependence of NPV on coverage ratio on debt i1 at equity cost k0 ¼ 24%; kd ¼ 6,
10, 14, and 20%; and L ¼ 3
NPV/D NPV/D NPV/D NPV/D
i1 L k0 t (kd ¼ 0.2) (kd ¼ 0.14) (kd ¼ 0.1) (kd ¼ 0.06)
0 3 0.24 0.2 1.118 0.882 0.725 0.569
1 3 0.24 0.2 2.804 3.039 3.196 3.353
2 3 0.24 0.2 6.725 6.961 7.118 7.275
3 3 0.24 0.2 10.65 10.88 11.04 11.2
4 3 0.24 0.2 14.57 14.8 14.96 15.12
5 3 0.24 0.2 18.49 18.73 18.88 19.04
6 3 0.24 0.2 22.41 22.65 22.8 22.96
7 3 0.24 0.2 26.33 26.57 26.73 26.88
8 3 0.24 0.2 30.25 30.49 30.65 30.8
9 3 0.24 0.2 34.18 34.41 34.57 34.73
10 3 0.24 0.2 38.1 38.33 38.49 38.65
seen as well that NPV increases with decreasing kd. This means that effectiveness of
the investment project as well as its creditworthiness decreases with credit rate kd.
Below we investigate the dependence of NPV D on i1 at different values of kd in more
details and will show the ordering of NPV
D ð i 1 Þ curves at different values of kd, as well
as at different leverage levels L.
23.3.1.2 The Dependence of NPV on Coverage Ratio on Debt i1 at

Equity Cost k0 ¼ 12%
We study here the dependence of NPV D on i1 at fixed equity cost k0 ¼ 12% and at
different values of kd in more details and will show the ordering of NPV D ði1 Þ curves at
different values of kd, as well as at different leverage levels L.
Table 23.3.
Table 23.4.
We see from Tables 23.3 and 23.4 that NPV (in units of D) (NPV D ) increases with i1
NPV
and that D values turn out to be very close to each other at all i1 values.
To show the difference in NPVD values in more detail, we show at the Fig. 23.3 the
dependence of NPV D on parameter i1 for range i1 from 1 to 2.
One can see that all NPV (i1) curves corresponding to L ¼ 3 lie above the curves
corresponding to L ¼ 1. This means that NPV increases with L (with increasing of
the debt financing). At fixed value L, NPV increases with decreasing the credit rate
kd. This means that effectiveness of the investment project as well as its creditwor-
thiness decreases with credit rate kd.
Table 23.3 The dependence of NPV (in units of D) on coverage ratio on debt i1 at k0 ¼ 12%;
kd ¼ 2, 4, 6, 8, and 10%; and L ¼ 1
NPV/D NPV/D NPV/D NPV/D NPV/D
i1 t k0 (kd ¼ 0.1) (kd ¼ 0.08) (kd ¼ 0.06) (kd ¼ 0.04) (kd ¼ 0.02)
0 0.2 0.12 1.741 1.593 1.444 1.296 1.148
1 0.2 0.12 5.667 5.815 5.963 6.111 6.259
2 0.2 0.12 13.074 13.222 13.370 13.519 13.667
3 0.2 0.12 20.481 20.630 20.778 20.926 21.074
4 0.2 0.12 27.889 28.037 28.185 28.333 28.481
5 0.2 0.12 35.296 35.444 35.593 35.741 35.889
6 0.2 0.12 42.704 42.852 43.000 43.148 43.296
7 0.2 0.12 50.111 50.259 50.407 50.556 50.704
8 0.2 0.12 57.519 57.667 57.815 57.963 58.111
9 0.2 0.12 64.926 65.074 65.222 65.370 65.519
10 0.2 0.12 72.333 72.481 72.630 72.778 72.926
Table 23.4 The dependence of NPV (in units of D) on coverage ratio on debt i1 at k0 ¼ 12%;
kd ¼ 2, 4, 6, 8, and 10%; and L ¼ 3
NPV/D NPV/D NPV/D NPV/D NPV/D
i1 t k0 (kd ¼ 0.1) (kd ¼ 0.08) (kd ¼ 0.06) (kd ¼ 0.04) (kd ¼ 0.02)
0 0.2 0.12 1.118 0.961 0.804 0.647 0.490
1 0.2 0.12 6.725 6.882 7.039 7.196 7.353
2 0.2 0.12 14.569 14.725 14.882 15.039 15.196
3 0.2 0.12 22.412 22.569 22.725 22.882 23.039
4 0.2 0.12 30.255 30.412 30.569 30.725 30.882
5 0.2 0.12 38.098 38.255 38.412 38.569 38.725
6 0.2 0.12 45.941 46.098 46.255 46.412 46.569
7 0.2 0.12 53.784 53.941 54.098 54.255 54.412
8 0.2 0.12 61.627 61.784 61.941 62.098 62.255
9 0.2 0.12 69.471 69.627 69.784 69.941 70.098
10 0.2 0.12 77.314 77.471 77.627 77.784 77.941
Analyzing the obtained results, one should remember that NPV (in units of D)
(NPV
D ) depends only on equity cost k0, on credit rates kd, on leverage level L, as well as
on one of the coverage ratios ij 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 D)
(NPV
D ) on coverage ratios ij at different equity costs k0, at different credit rates kd, 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.
NPV/D (i1) (for i1 from 1 to 2) at L=1 and L=3
15.500
(1)
(2)
(3)
(4)
(5)
(6)
13.500 (7)
(8)
(9)
(10)
NPV/D, L=1, Kd=0,1 (10)
NPV/D, L=1, Kd=0,08 (9)
11.500 NPV/D, L=1, Kd=0,06 (8)

NPV/D
NPV/D, L=1, Kd=0,04 (7)

NPV/D, L=1, Kd=0,02 (6)
NPV/D, L=3, Kd=0,1 (5)
9.500 NPV/D, L=3, Kd=0,08 (4)
NPV/D, L=3, Kd=0,06 (3)
NPV/D, L=3, Kd=0,04 (2)
NPV/D, L=3, Kd=0,02 (1)
7.500
5.500
1 2
4, 6, 8, and 10%; and L ¼ 1 and L ¼ 3
23.4 Dependence of NPV on Leverage Ratios

23.4.1 Leverage Ratio of Debt
Below we calculate the dependence of NPV (in units of NOI) (NPV

NOI ) on leverage ratio
on debt l1 at different equity costs k0 (k0 is equity cost at L ¼ 0). We make
calculations for two leverage levels L (L ¼ 1 and L ¼ 3) and for different credit
rates kd.
For calculation within MM approximation, we use the formula (23.19)
NPV l1 ð1 k d ∗ l1 Þð1 t Þ

¼ þ :
NOI L k0 ∗ 1 Lt 1þL
23.4 Dependence of NPV on Leverage Ratios 523
23.4.1.1 The Dependence of NPV (in Units of NOI) (NPV

NOI ) on Leverage
Ratio on Debt l1 at Equity Cost k0 ¼ 0.12
Results are shown in Tables 23.5 and 23.6 and in Figs. 23.4 and 23.5.
Based on the above calculations, we plot the dependences of NPV/NOI on
leverage ratio on debt l1 at different leverage levels L.
From Tables 23.5 and 23.6 and Figs. 23.4 and 23.5, one can come to a conclusion
that the NPV (in units of NOI) (NPV/NOI) decreases with increasing of the leverage
ratio on debt l1. With the increasing of the cost of debt capital kd, curves of the
dependence of NPV/NOI (l1), outgoing from a single point at a zero value of l1, lie
below (i.e., the rate of decrease (or negative slope of curves) grows). Note that while
the dependences of NPV (in units of D) on coverage ratio on debt i1 lie very close to
each other (see above), the dependences of NPV (in units of NOI) on leverage ratio
on debt l1 are separated significantly more.
Also, Figs. 23.6, 23.7, 23.8, and 23.9 of the NPV/NOI dependence on l1 can be
plotted for fixed values of the debt cost kd and two values of the leverage level L ¼ 1
and L ¼ 3.
One can see that the rate of decrease of the ratio NPV/NOI decreases with an
increase of the leverage level L.

NOI ) on Leverage
L¼1
L¼3
Based on the obtained data, we plot the dependences of NPV/NOI on l1 at
k0 ¼ 14%, at different values of debt cost kd, and at two different leverage levels
L ¼ 1 and L ¼ 3 in Figs. 23.10 and 23.11.
From Tables 23.7 and 23.8 and Figs. 23.10 and 23.11, one can come to a
conclusion that the NPV (in units of NOI) (NPV/NOI) decreases with increasing
of the leverage ratio on debt l1. With the increasing of the cost of debt capital kd,
curves of the dependence of NPV/NOI (l1), outgoing from a single point at a zero
value of l1, fall below (i.e., the rate of decrease grows).

NOI ) on Leverage
The formula of Modigliani and Miller in Excel will look like
¼ ðA3=C3Þ þ ððð1 ðE3∗ A3ÞÞ∗ð1 B3ÞÞ=ðD3∗ ð1 ððC3∗ B3Þ=ð1 þ C3ÞÞÞÞÞ

524
Table 23.5 The dependence of NPV (in units of NOI) (NPV

NOI ) on leverage ratio on debt l1 at equity cost k0 ¼ 0.12; kd ¼ 4, 6, 8, and 10%; and L ¼ 1
23
l1 0 1 2 3 4 5 6 7 8 9 10
kd ¼ 0.10 7.407 5.667 3.926 2.185 0.444 1.296 3.037 4.778 6.519 8.259 10
kd ¼ 0.08 7.407 5.815 4.222 2.63 1.037 0.556 2.148 3.741 5.333 6.926 8.519
kd ¼ 0.06 7.407 5.963 4.519 3.074 1.63 0.185 1.259 2.704 4.148 5.593 7.037
kd ¼ 0.04 7.407 6.111 4.815 3.519 2.222 0.926 0.37 1.667 2.963 4.259 5.556
Ratings of Long-Term Projects: A New Approach
23.4

NOI ) on leverage ratio on debt l1 at equity cost k0 ¼ 0.12, kd ¼ 4, 6, 8, and 10%; and L ¼ 3
l1 0 1 2 3 4 5 6 7 8 9 10
Dependence of NPV on Leverage Ratios
kd ¼ 0.10 7.843 6.725 5.608 4.49 3.373 2.255 1.137 0.02 1.098 2.216 3.333
kd ¼ 0.08 7.843 6.882 5.922 4.961 4 3.039 2.078 1.118 0.157 0.804 1.765
kd ¼ 0.06 7.843 7.039 6.235 5.431 4.627 3.824 3.02 2.216 1.412 0.608 0.196
kd ¼ 0.04 7.843 7.196 6.549 5.902 5.255 4.608 3.961 3.314 2.667 2.02 1.373
525
NPV/NOI (l1) at L=1

10
8
6
4
2 Kd=10
NPV/NOI
0
Kd=8
-2 0 1 2 3 4 5 6 7 8 9 10
-4 Kd=6
-6 Kd=4
-8
-10
-12
l1
Fig. 23.4 The dependence of NPV (in units of D) on leverage ratio on debt l1 at k0 ¼ 12%; kd ¼ 4,
6, 8, and 10%; and L ¼ 1
NPV/NOI (l1) at L=3

10
6
Kd=10
NPV/NOI
4
Kd=8
2
Kd=6
0 Kd=4
0 1 2 3 4 5 6 7 8 9 10
-2
-4
l1
Fig. 23.5 The dependence of NPV (in units of D) on leverage ratio on debt l1 at k0 ¼ 12%; kd ¼ 4,
6, 8, and 10%; and L ¼ 3
Using this formula, we calculate the dependence of NPV (in units of NOI) (NPV NOI )
on leverage ratio on debt l1 at equity cost k0 ¼ 0.26; at different values of kd ¼ 22,
16, 10, and 6%; and at two values of leverage levels L ¼ 1 and L ¼ 3.
Let us start from the case at L ¼ 1 (Tables 23.9 and 23.10 and Fig. 23.12).
Let us calculate the value of l1 below which the investment project remains
kd 0.22 0.16 0.1 0.06

l1 1.9 2.2 2.5 2.7
One can see from this table that the value of l1 below which the investment project
remains effective (NPV > 0) decreases with credit rate kd; that means that
NPV/NOI (l1) at L=1 and L=3 for Kd=0.10

10
5
NPV/NOI
0
0 1 2 3 4 5 6 7 8 9 10 L=1
-5 L=3
-10
-15
l1
Fig. 23.6 The dependence of NPV (in units of NOI) on leverage ratio on debt l1 at k0 ¼ 12%;
kd ¼ 10%; and L ¼ 1 and L ¼ 3

10
8
6
4
NPV/NOI
2
0 L=1
-2 0 1 2 3 4 5 6 7 8 9 10 L=3
-4
-6
-8
-10
l1
kd ¼ 8%; and L ¼ 1 and L ¼ 3

10
5
NPV/NOI
0 L=1
0 1 2 3 4 5 6 7 8 9 10 L=3
-5
-10
l1
kd ¼ 6%; and L ¼ 1 and L ¼ 3

10
8
6
4
NPV/NOI
2
L=1
0
0 1 2 3 4 5 6 7 8 9 10 L=3
-2
-4
-6
-8
l1
Fig. 23.9 The dependence of NPV (in units of NOI) on leverage ratio on debt l1 at k0 ¼ 12%,
kd ¼ 4% and L ¼ 1 and L ¼ 3
NPV/NOI (l1) at L=1

6
0
1 2 3 4 5 6 7 8 9 10 11
NPV/NOI
-2
-4
-6
1
-8
2
-10 3
4
-12
kd ¼ 6% (1), 8% (2), 10% (3), and 12% (4); and L ¼ 1
effectiveness of the investment project as well as its creditworthiness decreases with

credit rate kd (Fig. 23.13).
Let us calculate the value of l1 below which the investment project remains
kd 0.22 0.16 0.1 0.06

l1 3.85 4 5.6 6.6
NPV/NOI (l1) at L=3

7
3
NPV/NOI
1 2 3 4 5 6 7 8 9 10 11
-1 1
2
-3
3
4
-5
kd ¼ 6% (1), 8% (2), 10% (3), and 12% (4); and L ¼ 3

NOI ) on leverage ratio on debt l1 at equity
cost k0 ¼ 0.14; kd ¼ 6, 8, 10, and 12%; and L ¼ 1
NPV/NOI NPV/NOI NPV/NOI NPV/NOI
l1 L k0 t (kd ¼ 0.12) (kd ¼ 0.1) (kd ¼ 0.08) (kd ¼ 0.06)
0 1 0.14 0.2 6.349206349 6.349206349 6.349206349 6.349206349
1 1 0.14 0.2 4.587301587 4.714285714 4.841269841 4.968253968
2 1 0.14 0.2 2.825396825 3.079365079 3.333333333 3.587301587
3 1 0.14 0.2 1.063492063 1.444444444 1.825396825 2.206349206
4 1 0.14 0.2 0.698412698 0.19047619 0.317460317 0.825396825
5 1 0.14 0.2 2.46031746 1.825396825 1.19047619 0.555555556
6 1 0.14 0.2 4.222222222 3.46031746 2.698412698 1.936507937
7 1 0.14 0.2 5.984126984 5.095238095 4.206349206 3.317460317
8 1 0.14 0.2 7.746031746 6.73015873 5.714285714 4.698412698
9 1 0.14 0.2 9.507936508 8.365079365 7.222222222 6.079365079
10 1 0.14 0.2 11.26984127 10 8.73015873 7.46031746
One can see from this table that like the case of L ¼ 1, the value of l1 below which
the investment project remains effective (NPV > 0) decreases with credit rate kd; that
decreases with credit rate kd. Comparing the case at L ¼ 1, one can see that at bigger
leverage level (L ¼ 3), the investment project remains effective (NPV > 0) until

cost k0 ¼ 0.14; kd ¼ 6, 8, 10, and 12; and L ¼ 3
NPV/NOI NPV/NOI NPV/NOI NPV/NOI
l1 L k0 t (kd ¼ 0.12) (kd ¼ 0.1) (kd ¼ 0.08) (kd ¼ 0.06)
0 3 0.14 0.2 6.722689 6.722689 6.722689 6.722689
1 3 0.14 0.2 5.582633 5.717087 5.851541 5.985994
2 3 0.14 0.2 4.442577 4.711485 4.980392 5.2493
3 3 0.14 0.2 3.302521 3.705882 4.109244 4.512605
4 3 0.14 0.2 2.162465 2.70028 3.238095 3.77591
5 3 0.14 0.2 1.022409 1.694678 2.366947 3.039216
6 3 0.14 0.2 0.11765 0.689076 1.495798 2.302521
7 3 0.14 0.2 1.2577 0.31653 0.62465 1.565826
8 3 0.14 0.2 2.39776 1.32213 0.2465 0.829132
9 3 0.14 0.2 3.53782 2.32773 1.11765 0.092437
10 3 0.14 0.2 4.67787 3.33333 1.9888 0.64426

cost k0 ¼ 0.26; kd ¼ 22, 16, 10, and 6%; and L ¼ 1
NPV/NOI(l1) NPV/NOI(l1) NPV/NOI(l1) NPV/NOI(l1)
l1 kd ¼ 0.22 kd ¼ 0.16 kd ¼ 0.1 kd ¼ 0.06
0 3.418803419 3.4188034 3.41880342 3.4188034
1 1.666666667 1.8717949 2.07692308 2.2136752
2 0.08547009 0.3247863 0.73504274 1.008547
3 1.83760684 1.2222222 0.60683761 0.196581
4 3.58974359 2.7692308 1.94871795 1.401709
5 5.34188034 4.3162393 3.29059829 2.606838
6 7.09401709 5.8632479 4.63247863 3.811966
7 8.84615385 7.4102564 5.97435897 5.017094
8 10.5982906 8.957265 7.31623932 6.222222
9 12.3504274 10.504274 8.65811966 7.42735
10 14.1025641 12.051282 10 8.632479
bigger leverage ratio l1, so bigger leverage level favors to the effectiveness of the
investment project as well as its creditworthiness.
Let us analyze also the dependence of NPV (in units of NOI) (NPV NOI ) on leverage
ratio on debt l1 at equity cost k0 ¼ 0.26 and each value of kd at two leverage levels
L ¼ 1 and L ¼ 3 (Figs. 23.14, 23.15, 23.16, and 23.17).
Studying the dependence of NPV (in units of NOI) (NPV NOI ) on leverage ratio on debt
l1 at equity cost k0 ¼ 0.26 and each value of kd at two leverage levels L ¼ 1 and L ¼ 3
shows that the curve NPV NOI (l1) corresponding to bigger leverage level (L ¼ 3) lies
above the curve NPV NOI (l1 ) corresponding to smaller leverage level (L ¼ 1). The curve
NPV
NOI (l 1 ) corresponding to bigger leverage level (L ¼ 3) has smaller (negative) slope.
This means that debt financing of long-term projects favors effectiveness of the
investment project as well as its creditworthiness.

cost k0 ¼ 0.26; kd ¼ 22, 16, 10, and 6%; and L ¼ 3
NPV/NOI(l1) NPV/NOI(l1) NPV/NOI(l1) NPV/NOI(l1)
l1 kd ¼ 0.22 kd ¼ 0.16 kd ¼ 0.1 kd ¼ 0.06
0 3.619909502 3.6199095 3.6199095 3.6199095
1 2.490196078 2.7073906 2.92458522 3.0693816
2 1.360482655 1.7948718 2.22926094 2.5188537
3 0.230769231 0.8823529 1.53393665 1.9683258
4 0.89894419 0.0301659 0.83861237 1.4177979
5 2.02865762 0.9426848 0.14328808 0.86727
6 3.15837104 1.8552036 0.5520362 0.3167421
7 4.28808446 2.7677225 1.24736048 0.233786
8 5.41779789 3.6802413 1.94268477 0.784314
9 6.54751131 4.5927602 2.63800905 1.334842
10 7.67722474 5.505279 3.33333333 1.88537
2.00
0.00
0 1 2 3 4 5 6 7 8
-2.00
-4.00
-6.00
-8.00
-10.00
-12.00
-14.00
-16.00
Kd = 0,22 Kd = 0,16 Kd = 0,1 Kd = 0,06
Fig. 23.12 The dependence of NPV (in units of NOI) (NPV

cost k0 ¼ 0.26; kd ¼ 22, 16, 10, and 6%; and L ¼ 1
Analyzing the obtained results, one should remember that NPV (in units of NOI)
(NPV
NOI) depends only on equity cost k0, on credit rates kd, on leverage level L, as well as
on one of the leverage ratios lj 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 lj at different equity costs k0, at different credit rates kd,
and at different leverage levels L carry the universal character: these dependencies
4.00
2.00
0.00
0 1 2 3 4 5 6 7 8 9
-2.00
-4.00
-6.00
-8.00
-10.00
Kd = 0,22 Kd = 0,16 Kd = 0,1 Kd = 0,06

cost k0 ¼ 0.26; kd ¼ 22, 16, 10, and 6%; and L ¼ 3
6.00
4.00
2.00
0.00
-2.00 1 2 3 4 5 6 7 8 9 10 11
-4.00
-6.00
-8.00
-10.00
-12.00
-14.00
L=1 L=3
-16.00

cost k0 ¼ 0.26, kd ¼ 22, and L ¼ 1 and L ¼ 3
6.00
4.00
2.00
0.00
-2.00 1 2 3 4 5 6 7 8 9 10 11
-4.00
-6.00
-8.00
-10.00
-12.00
L=1 L=3
-14.00

cost k0 ¼ 0.26, kd ¼ 16%, and L ¼ 1 and L ¼ 3
6.00
4.00
2.00
0.00
1 2 3 4 5 6 7 8 9 10 11
-2.00
-4.00
-6.00
-8.00
-10.00
L=1 L=3
-12.00

6.00
4.00
2.00
0.00
1 2 3 4 5 6 7 8 9 10 11
-2.00
-4.00
-6.00
-8.00
L=1 L=3
-10.00

23.5 Conclusions
This chapter continues to create a new approach to rating methodology: in addition

to the two previous chapters (21 and 22), which have considered the creditworthi-
ness of the non-finance issuers (Brusov et al. 2018c, d), we develop here a new
approach to project rating. We work within investment models, created by the
authors. One of them describes the effectiveness of investment project from the
perspective of equity capital owners, while the other model describes the effective-
ness 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 financial flows virtually not used in existing
rating methodologies
2. The incorporation of rating parameters (financial “ratios”), used in project rating,

into considered modern investment models
leverage level L, we come to a very important conclusion that NPV in units of NOI
(NPV NPV
NOI ) [as well as NPV in units of D ( D )] depends only on equity cost k0, on credit
rates kd, on leverage level L, as well as on one of the leverage ratios lj (on one of the
coverage ratios ij) 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 )
NPV
on leverage ratios lj (as well as on the dependence of NPV (in units of D) ( D ) on
coverage ratios ij) at different equity costs k0, at different credit rates kd, 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.
Calculations on dependence of NPV in units of D (NPV/D) on the coverage ratio
on debt i1 show that NPV NPV
D increases with i1 and that D values turn out to be very close
to each other at all i1 values. It is seen as well that NPV increases with decreasing kd.
This means that effectiveness of the investment project as well as its creditworthi-
ness decreases with credit rate kd. One can see that all NPV (i1) curves corresponding
to L ¼ 3 lie above the curves corresponding to L ¼ 1. This means that NPV increases
with leverage level L (with increasing of the debt financing). Thus, debt financing
favors to effectiveness of the long-term project. At fixed value L, NPV increases with
decreasing the credit rate kd.
It is shown that the value of the coverage ratio on debt i1 above which the
investment project remains effective (NPV > 0) increases with credit rate kd; that
decreases with credit rate kd. Comparing the cases of L ¼ 1 and L ¼ 3, one can see
that at bigger leverage level (L ¼ 3), the investment project becomes effective
(NPV > 0) starting from smaller coverage ratio i1, so bigger leverage level favors
to the effectiveness of the investment project as well as its creditworthiness.
Calculations on dependence of NPV in units of NOI (NPV/NOI) on the leverage
ratio on debt l1 show that NPV in units of NOI decreases with increasing of the
leverage ratio on debt l1. With the increasing of the cost of debt capital kd, curves of
the dependence of NPV/NOI (l1), outgoing from a single point at a zero value of l1,
lie below (i.e., the rate of decrease (or negative slope of curves) grows). Note that
while the dependences of NPV (in units of D) on coverage ratio on debt i1 lie very
close to each other, the dependences of NPV (in units of NOI) on leverage ratio on
debt l1 are separated significantly more.
One can see that the value of l1 below which the investment project remains
effective (NPV > 0) decreases with credit rate kd; that means that effectiveness of the
investment project as well as its creditworthiness decreases with credit rate kd.
l1 at fixed equity cost k0 and fixed credit rate kd at two leverage levels L ¼ 1 and
L ¼ 3, it was shown that the curve NPV NOI (l1) corresponding to bigger leverage level
References 535
(L ¼ 3) lies above the curve NPV

NOI (l1) corresponding to smaller leverage level (L ¼ 1).
The curve NPVNOI (l1 ) corresponding to bigger leverage level (L ¼ 3) has smaller
(negative) slope. This means that debt financing of long-term projects favors effec-
tiveness of the investment project as well as its creditworthiness.
Investigations, conducted in the current paper, create a new approach to rating
methodology with respect to the long-term project rating. And this paper in combi-
nation with our two previous papers on this topic (Brusov et al. 2018c, d) creates a
new base for rating methodology as a whole.
In our future papers, we will consider rating methodology for investment projects
of arbitrary duration.
References
(11):815–824
Brusov P, Filatova T, Orekhova N, Brusov P, Brusova A (2012c) Modern approach to dividend
policy of company. Finance Credit 18(37):2012
org/10.1080/23322039.2014.946150
Brusov P, Filatova T, Orehova N, Eskindarov M (2015) Modern corporate finance, investments and
taxation, monograph, 1st edn. Springer International Publishing, Berlin, 368pp
7:37–62
1954–1957. Am Econ Rev 56:333–391
Мodigliani F, Мiller M (1958) The cost of capital, corporate finance and the theory of investment.
Econ Rev 53:147–175
Chapter 24
New Meaningful Effects in Modern Capital
Structure Theory
24.1 Introduction
One of the main and the most important problems in corporate finance is the problem
of cost of capital, the impact of capital structure on its cost and capitalization of the
companies, and the problem of an optimal capital structure of the companies
(at which the company capitalization is maximal and weighted average cost of
capital WACC is minimal). The importance of these problems is connected to the
fact, that it is possible doing nothing, just by change the ratio between debt and
equity capital (by change the capital structure) to increase the capitalization of the
company, i.e. to solve the main task of the management of any company.
However, to date, even the question of the existence of an optimal capital
structure of the companies still remains open. Numerous theories and models,
including the first and the only one until recently quantitative theory by Nobel
laureates Modigliani and Miller (MM), not only does not solve the problem, but
also because of the large number of restrictions (such as, for example, theory of MM)
have a weak relationship to the real economy. Herewith the qualitative theories and
models, based on the empirical approaches, do not allow to carry out the necessary
assessment.
This special issue is devoted to recent development of capital structure theory and
its applications. Discussions will be made within both main theories: modern theory
by Brusov, Filatova, and Orekhova (BFO theory) (Brusov and Filatova 2011;
Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b, 2015, 2018a, b, c, d) and
its perpetuity limit, classical Modigliani–Miller (MM) theory, which will be com-
pared in details. From 2008 the BFO theory has replaced the famous theory of capital
cost and capital structure by Nobel laureates Modigliani and Miller. The authors of
BFO have moved from the assumption of Modigliani–Miller concerning the perpe-
tuity (infinite time of life) of companies and further elaborated quantitative theory of
valuation of core parameters of financial activities of companies of arbitrary age as
well as of arbitrary time of life.

https://doi.org/10.1007/978-3-319-99686-8_24
538 24 New Meaningful Effects in Modern Capital Structure Theory
Within modern theory of capital cost and capital structure (BFO theory), a lot of
qualitatively new results, described in this paper, have been obtained, among them:
– Bankruptcy of the famous trade-off theory has been proven. BFO theory has
destroyed some main existing principles of financial management: among them is
the trade-off theory, which was considered as keystone of formation of optimal
capital structure of the company during many decades.
It would be a great pity if the optimal capital structure of the company does not
exist in general; thus, BFO authors have suggested the mechanism of formation
of the company optimal capital structure, different from what is suggested by
trade-off theory.
– The qualitatively new effect in corporate finance has been discovered by BFO
authors: abnormal dependence of equity cost on leverage, which significantly
alters the principles of the company’s dividend policy.
– Existence of “A golden age” of the companies has been discovered. It was
shown for the first time that valuation of WACC in the Modigliani–Miller theory
is not minimal and valuation of the company capitalization is not maximal, as all
financiers supposed up to now: at some age of the company, its WACC value
turns out to be lower than in the Modigliani–Miller theory (in perpetuity limit),
and company capitalization V at some company age turns out to be greater than
company capitalization V in Modigliani–Miller theory.
– The inflation in both Modigliani–Miller and in Brusov–Filatova–Orekhova
theories has been taken into account in explicit form, with the detected
non-trivial impact on the dependence of equity cost on leverage.
– The study of the role of taxes and leverage has been done, and obtained results
allow the regulator to set the tax on profit rate and businesses to choose the
optimal level of debt financing.
– Investigation of the influence of tax on profit rate on effectiveness of invest-
ment projects at different debt levels showed that increase of tax on profit rate
from one side leads to decrease of project NPV, but from the other side, it leads to
decrease of sensitivity of NPV with respect to leverage level. At high leverage
level L, the influence of tax on profit rate on effectiveness of investment projects
becomes significantly less.
– The influence of growth of tax on profit rate on the efficiency of the investment
as well has led to two qualitatively new effects in investments:
1. The growth of tax on profit rate changes the nature of the NPV dependence on
leverage L at some value t*: there is a transition from diminishing function
NPV(L ) at t < t* to growing function NPV(L ) at t > t*.
2. At high leverage levels, the growth of tax on profit rate leads to the growth of
the efficiency of the investments.
24.2 Comparison of Modigliani–Miller (MM) and Brusov–Filatova–Orekhova. . . 539

optimizing the management of investments.
Established BFO theory allows to conduct a valid assessment of the core param-
eters of financial activities of companies, such as weighted average cost of capital
and equity capital cost of the company, its capitalization. It allows the management
of company to make adequate decisions that improve the effectiveness of the
company management. More generally, the introduction of the new system of
evaluation of the parameters of financial activities of companies into the sys-
tems of financial reporting (IFRS, GAAP, etc.) would lead to lower risk of
flows. The proposed Brusov–Filatova–Orekhova theory allows to correctly identify
discount rates—basic parameters for discounting financial flows to arbitrary time
moment—and compare financial flows with a view to adoption of literate managerial
decisions. The discount rate is a key link of the existing financial system, by pulling
on which modern finance can be adequately built on and BFO theory can assist in
this.
In this paper we discuss numerous new meaningful effects in the modern capital
structure theory.
24.2 Comparison of Modigliani–Miller (MM)

and Brusov–Filatova–Orekhova (BFO) Results
24.2.1 The Traditional Approach
The traditional (empirical) approach told to businessmen that weighted average cost
of capital, WACC, and the associated company capitalization, V ¼ CF/WACC,
depend on the capital structure, the level of leverage. Debt cost always turns out to be
lower than equity cost, because the first one has lower risk, because in the event of
bankruptcy, creditor claims are met prior to shareholders’ claims.
As a result an increase in the proportion of lower-cost debt capital in the overall
capital structure up to the limit which does not cause violation of financial sustain-
ability and growth in risk of bankruptcy leads to lower weighted average cost of
capital, WACC.
The required profitability by investors (the equity cost) is growing; however, its
growth has not led to compensation benefits from use of more low-cost debt capital.
Therefore, the traditional approach welcomes the increased leverage L ¼ D/S and the
associated increase of company capitalization. The traditional (empirical) approach
has existed up to the appearance of the first quantitative theory by Modigliani and
Мiller (1958) (Fig. 24.1).
Fig. 24.1 Dependence of company capitalization, UL; equity cost, ke; debt cost, kd; and weighted
average cost of capital, WACC, in traditional (empirical) approach
24.2.2 Modigliani–Miller Theory
Modigliani–Miller theory with taxes is based on the following three formulae for
capitalization V, WACC, and equity cost ke (Fig. 24.2):
V ¼ V 0 þ Dt,
WACC ¼ k0 ð1 wd T Þ,
ke ¼ k 0 þ Lð1 T Þðk 0 kd Þ:
One of the most important assumptions of the Modigliani–Miller theory is that all
financial flows are perpetuity.
This limitation was lifted out by Brusov–Filatova–Orekhova in 2008, who have
created the BFO theory—modern theory of capital cost and capital structure for
companies of arbitrary age (BFO-I) and for companies of arbitrary lifetime (BFO-II)
(Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b, 2015, 2018a, b, c, d)
(Fig. 24.3).
Note that before 2008, only two results for capital structure of company were
available:
Modigliani–Miller for perpetuity company and Myers for 1-year company (see
Fig. 24.4).
24.2 Comparison of Modigliani–Miller (MM) and Brusov–Filatova–Orekhova. . . 541
Fig. 24.2 Dependence of equity capital cost, debt cost, and WACC on leverage in Modigliani–
Miller theory without taxes (t ¼ 0) and with taxes (t 6¼ 0)
Fig. 24.3 Historical development of capital structure theory (here TA traditional (empirical)
approach, MM Modigliani–Miller approach, BFO Brusov–Filatova–Orekhova theory)
Fig. 24.4 MM theory describes perpetuity limit, and Myers paper describes 1-year company, while
BFO theory fills the whole numeric axis (from n ¼ 1 up to perpetuity limit n ¼ 1)
BFO theory has filled out the whole interval between t ¼ 1 and t ¼ 1. One got
the possibility to calculate capitalization V, WACC, and equity cost ke for companies
of arbitrary age (BFO-1) and for companies of arbitrary lifetime (BFO-2). BFO
theory has led to a lot of new meaningful effects in modern capital structure theory,
discussed in this paper.
BFO theory is based on famous formula
¼ : ð24:1Þ
Here, S is the value of own (equity) capital of the company, wd ¼ DþS D

is the share
of debt capital, k e , we ¼ DþS is the cost and the share of the equity of the company,
S
respectively, and L ¼ D/S is financial leverage.

of Arbitrary Age)
We could compare the Modigliani–Miller results (perpetuity company) with Myers

results (1-year company) and Brusov–Filatova–Orekhova ones (company with arbi-
trary age) under valuation of WACC and equity cost.
We calculate below the dependence of WACC and ke on leverage level for n ¼ 1
and n ¼ 1 (Table 24.1) and for n ¼ 3 and n ¼ 1 (Table 24.2).
We show results on dependence of WACC on leverage level L for all three
company ages (n ¼ 1, n ¼ 3, and n ¼ 1) at Fig. 24.5.
From Tables 24.1 and 24.2 and Fig. 24.5, it is obvious that WACC has a
maximum for 1-year company and decreases with the age (lifetime) of the company,
reaching the minimum in the Modigliani–Miller perpetuity case. [Note, however,
that this not always be so via the effect of “golden age” of the company (see below).]
Results of modern BFO theory turn out to be quite different from ones of
Modigliani–Miller theory. They show that later, via its perpetuity, it underestimates
the assessment of weighted average cost of capital and the equity cost of the
Table 24.1 Dependence of WACC and ke on leverage level for n ¼ 1 and n ¼ 1

WACC
L k0 kd t n wd WACC (%) BFO ke (MM) (%) ke (MM)
0 0.2 0.1 0.2 1 0.00 20.00 0.000 0.2000 20.00 0.2000
1 0.2 0.1 0.2 1 0.50 18.91 0.000 0.2982 18.00 0.2800
2 0.2 0.1 0.2 1 0.67 18.55 0.000 0.3964 17.33 0.3600
3 0.2 0.1 0.2 1 0.75 18.36 0.000 0.4945 17.00 0.4400
4 0.2 0.1 0.2 1 0.80 18.25 0.000 0.5927 16.80 0.5200
5 0.2 0.1 0.2 1 0.83 18.18 0.000 0.6909 16.67 0.6000
6 0.2 0.1 0.2 1 0.86 18.13 0.000 0.7891 16.57 0.6800
7 0.2 0.1 0.2 1 0.88 18.09 0.000 0.8873 16.50 0.7600
8 0.2 0.1 0.2 1 0.89 18.06 0.000 0.9855 16.44 0.8400
9 0.2 0.1 0.2 1 0.90 18.04 0.000 1.0836 16.40 0.9200
10 0.2 0.1 0.2 1 0.91 18.02 0.000 1.1818 16.36 1.0000

WACC
0 0.2 0.1 0.2 3 0.00 20.00 0.000 0.2000 20.00 0.2000
1 0.2 0.1 0.2 3 0.50 18.41 0.000 0.2881 18.00 0.2800
2 0.2 0.1 0.2 3 0.67 17.87 0.000 0.3762 17.33 0.3600
3 0.2 0.1 0.2 3 0.75 17.61 0.000 0.4642 17.00 0.4400
4 0.2 0.1 0.2 3 0.80 17.44 0.000 0.5522 16.80 0.5200
5 0.2 0.1 0.2 3 0.83 17.34 0.000 0.6402 16.67 0.6000
6 0.2 0.1 0.2 3 0.86 17.26 0.000 0.7283 16.57 0.6800
7 0.2 0.1 0.2 3 0.88 17.20 0.000 0.8163 16.50 0.7600
8 0.2 0.1 0.2 3 0.89 17.16 0.000 0.9043 16.44 0.8400
9 0.2 0.1 0.2 3 0.90 17.12 0.000 0.9923 16.40 0.9200
10 0.2 0.1 0.2 3 0.91 17.09 0.000 1.0803 16.36 1.0000
20.00%
19.50%
19.00%
18.50%
18.00%
WACC
n=1 ko=0,2 kd=0,1

17.50%
n=3 ko=0,2 kd=0,1
17.00%
MM ko=0,2 kd=0,1
16.50%
16.00%
15.50%
15.00%
0 1 2 3 4 5 6 7 8 9 10
Fig. 24.5 Dependence of WACC on leverage level for n ¼ 1, n ¼ 3, and n ¼ 1
company and substantially overestimates the assessment of the capitalization of the

company.
serious difficulties in adequate managerial decision-making that was one of the
implicit reasons of global financial crisis of the year 2008.
BFO theory allows to make a correct assessment of key parameters of financial
activities of companies of arbitrary age (arbitrary lifetime) that leads accordingly to
adequate managerial decision-making.
24.4 Bankruptcy of the Famous Trade-Off Theory
Within modern theory of capital structure and capital cost by Brusov–Filatova–

2014a, b, 2018d; Filatova et al. 2008), the analyses of a widely known trade-off
theory have been made. It is shown that suggestion of risky debt financing (and
growing credit rate near the bankruptcy) in opposite to waiting result does not lead to
growing of weighted average cost of capital, WACC, which still decreases with
leverage. This means the absence of minimum in the dependence of WACC on
leverage as well as the absence of maximum in the dependence of company
capitalization on leverage. Thus, it means that the optimal capital structure is absent
in the famous trade-off theory. The explanation to this fact has been done.
In modified Modigliani–Miller theory, we have proved the following theorem:
In modified Modigliani–Miller theory (allowing riskiness debt capital) under arbitrary
change of debt cost with leverage (growing, as well as decrease) weighted average cost
of capital, WACC always fall down with leverage. This means the absence of the
company optimal capital structure and proves insolvency well-known classical trade
off in its original formulation.
We consider linear and quadratic growth of debt cost kd with leverage, starting
from some value (with different coefficients), at different values of k0 , and different
ages of the companies. Let us find WACC values (Table 24.3 and Fig. 24.6):
1. n ¼ 3; t ¼ 20 % ; L ¼ 0, 1, 2, ...10

0:07; at L 2
k 0 ¼ 24%; kd ¼ ð24:2Þ
0:07 þ 0:01ðL 2Þ2 ; at L > 2
Let us see how the growth of debt cost kd with leverage affects the equity cost ke
dependence on leverage. We will consider the same cases as above for the calcula-
tions of dependences WACC (L ) (Table 24.4 and Fig. 24.7).
The analysis of the well-known trade-off theory, conducted with the help of
modern theory of capital structure and capital cost by Brusov–Filatova–Orekhova,
has shown that suggestion of risky debt financing (and growing credit rate near the
bankruptcy) in opposite to waiting result does not lead to growing of WACC, which
still decreases with leverage. This means the absence of minimum in the dependence
of WACC on leverage as well as the absence of maximum in the dependence of
capitalization V on leverage. Thus, it seems that the optimal capital structure is
absent in the famous trade-off theory. The explanation to this fact has been done
within the same Brusov–Filatova–Orekhova theory by studying the dependence of
the equity cost ke with leverage. It turned out that the growth of debt cost kd with
leverage leads to decrease of equity cost ke with leverage, starting from some
24.4

n L 0 1 2 3 4 5 6 7 8 9 10
3 kd 0.07 0.07 0.07 0.08 0.11 0.16 0.23 0.32 0.43 0.56 0.71
Bankruptcy of the Famous Trade-Off Theory
k0 A 1.9813 2.0184 2.0311 2.0445 2.0703 2.1075 2.1520 2.1988 2.2438 2.2842 2.3186
0.24 WACC 0.2401 0.2279 0.2238 0.2195 0.2111 0.1997 0.1864 0.1730 0.1605 0.1496 0.1406
545
WACC(L)
0.3000
0.2500
0.2000
0.1500
0.1000
0.0500
0.0000
0 1 2 3 4 5 6 7 8 9 10 11
leverage level, which is higher than starting point of debt cost growth. This paradox
conclusion gives the explanation of the absence of the optimal capital structure in the
famous trade-off theory. This means, that competition of benefits from using of debt
financing and of financial distress cost (or a bankruptcy cost) are NOT balanced and
hopes, that trade off theory gives us the optimal capital structure, unfortunately, do
not realized.
The absence of the optimal capital structure in the trade-off theory questioned the
existence of an optimal capital structure of the company [but as authors have shown,
the optimal capital structure for the investment still exists (Brusov et al. 2011b, c)].
In the search for the “golden fleece,” one needs to switch to study of other mecha-
nisms for formation of the capital structure of the company, different from the ones
considered in the trade-off theory.
24.5 The Qualitatively New Effect in Corporate Finance
The qualitatively new effect in corporate finance is discovered: decreasing of cost of

equity ke with leverage L. This effect, which is absent in perpetuity Modigliani–
Miller limit, takes place under account of finite lifetime of the company at tax on
profit rate, which exceeds some value T*.
At some ratios between cost of debt and cost of equity, the discovered effect takes
24.5

n L 0 1 2 3 4 5 6 7 8 9 10
3 kd 0.07 0.07 0.07 0.08 0.11 0.16 0.23 0.32 0.43 0.56 0.71
k0 A 1.9813 2.0184 2.0311 2.0445 2.0703 2.1075 2.1520 2.1988 2.2438 2.2842 2.3186
0.24 ke 0.2401 0.3997 0.5594 0.6861 0.7036 0.5581 0.2011 0.4081 1.3075 2.5356 4.133
The Qualitatively New Effect in Corporate Finance
547
Ke(L)
0.8000
0.7000
0.6000
0.5000
0.4000
0.3000
0.2000
0.1000
0.0000
0 1 2 3 4 5 6 7
Fig. 24.8 Dependence of Ke Ke (L), at fix T

cost of equity on leverage 0.3000
L at different tax on profit
rates T for the case
0.2500 1
k0 ¼ 10 % ; kd ¼ 8% (1— 2
T ¼ 0; 2—T ¼ 0.1; 3— 3
T ¼ 0.2; 4—T ¼ 0.3; 5— 0.2000 4
5
T ¼ 0.4; 6—T ¼ 0.5; 7— 6
T ¼ 0.6; 8—T ¼ 0.7; 9— 0.1500 7
8
10—T ¼ 0.9; 11—T ¼ 1) 9
0.1000 10
11
0.0500
0.0000
0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0
L
practical meaning of discussed effect. Its accounting is important at modification of

tax law and can change the dividend policy of the company.
24.5.1 Perpetuity Modigliani–Miller Limit
One sees from Fig. 24.8 that position limit of dependence of cost of equity on
leverage L is in horizontal line 11 at T ¼ 1. Below we’ll see that in BFO theory, the
abnormal effect takes place (see Fig. 24.9) and dependence of cost of equity on
leverage L line could have a negative slope.
24.5 The Qualitatively New Effect in Corporate Finance 549
Fig. 24.9 Dependence of Ke Ke(T), at fix Wd

cost of equity ke on tax on 0.2000
profit rate T at different fix
leverage level L (n ¼ 10,
k0 ¼ 10 % , kd ¼ 8%) (1— 0.1500
wd ¼ 0; 2—wd ¼ 0.2; 3—
wd ¼ 0.4; 4—wd ¼ 0.6; 5— 0.1000 1
wd ¼ 0.8) 2
3
0.0500
4
0.0000
0 0.2 0.4 0.6 0.8 1 1.2
-0.0500
5
-0.1000
T
24.5.2 BFO Theory
From Fig. 24.10 it is seen that dependence of cost of equity ke on leverage level
L with a good accuracy is linear. The tilt angle decreases with tax on profit rate like
the perpetuity case.
However, for the finite lifetime of companies along with the behavior ke(L ),
similar to the perpetuity behavior of the Modigliani–Miller case (Fig. 24.8), for some
sets of parameters n, k0, kd, there is an otherwise behavior ke(L ).
From the Fig. 24.10, it is seen that starting from some values of tax on profit rate T
∗
(in this case from T∗ ¼ 40%, although at other sets of parameters n, k0, kd critical
values of tax on profit rate T∗ could be lower), there is not the rise in the cost of
equity of the company with leverage but descending. Once again, the presence or the
absence of such an effect depends on a set of parameters k0, kd, n.
This effect has been observed above in the dependence of cost of equity ke on tax
on profit rate T at fix leverage level, but it is more clearly visible, depending on value
of cost of equity of the company on the leverage for various values of tax on profit
rate T.
Note that this is a new effect, which may take place only for the finite lifetime
company and which is not observed in perpetuity Modigliani–Miller limit.
It is easy to receive from the Modigliani–Miller formula for WACC
WACC ¼ ke we þ k d wd ð1 T Þ
formula for ke
ke ¼ k0 þ Lð1 T Þðk 0 kd Þ,
Ke Ke(L), at fix T
0.4000
0.3000 1
0.2000 2
0.1000 3
0.0000 4
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6 6.5 7 7.5 8 8.5 9 9.5 1010.5
-0.1000
5
-0.2000
6
-0.3000
L
Fig. 24.10 Dependence of cost of equity ke on leverage level L at different tax on profit rate
T (n ¼ 5, k0 ¼ 10 % , kd ¼ 8%) (1—T ¼ 0; 2—T ¼ 0.2; 3—T ¼ 0.4; 4—T ¼ 0.6; 5—T ¼ 0.8; 6—
T ¼ 1)
from which one can see that at maximum value of tax on profit T ¼ 1(100%), cost of
equity ke does not change with leverage, ke ¼ k0, while at lower T values ke increases
with leverage. This means that there is no decreasing of ke with leverage at any tax on
profit rate T.
24.6 Conclusions
A qualitatively new effect in corporate finance is discovered: decreasing of cost of

equity ke with leverage L. This effect, which is absent in perpetuity Modigliani–
Miller limit, takes place under account of finite lifetime 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, 2015, 2018a, b, c, d; Filatova et al. 2008).
At some ratios between debt cost and equity cost, the discovered effect takes
practical meaning of the discussed effect. Its accounting is important at modification
of tax law and can change the dividend policy of the company.
The complete and detailed investigation of the discussed effect, discovered within
Brusov–Filatova–Orekhova (BFO) theory, has been done (Brusov and Filatova
24.7 Mechanism of Formation of the Company Optimal Capital Structure 551
2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b, 2014a, b, 2018d; Filatova et al.
2008). It has been shown that the absence of the effect at some particular set of
parameters is connected to the fact that in these cases, T* exceeds 100% (tax on profit
rate is situated in a “nonfinancial” region).
In the future, the papers and monographs will be devoted to discussion of
discovered abnormal effect, but it is already now clear that we will have to abandon
some established views in corporate finance.
24.7 Mechanism of Formation of the Company Optimal

Capital Structure
Under condition of proved by us insolvency of well–known classical trade off theory

question of finding of new mechanisms of formation of the company optimal capital
structure, different from one, suggested by trade off theory, becomes very important.
One of the real such mechanisms has been developed by authors in Chap. 5. It is
based on the decrease of debt cost with leverage, which is determined by growth of
debt volume. This mechanism is absent in perpetuity Modigliani–Miller theory, even
in modified version, developed by us, and exists within more general modern theory
of capital cost and capital structure by Brusov–Filatova–Orekhova (BFO theory).
Suggested mechanism of the formation of the company optimal capital structure
is based on the decrease of debt cost, which (in some range of leverage levels) is
determined by growing of the debt volume.
We will study below the dependence of equity cost ke and weighted average cost
of capital, WACC, on leverage level L in case of debt cost kd exponential decrease.
The Case α ¼ 0.01 Let us consider first the case α ¼ 0.01 (Table 24.5 and
Fig. 24.11, 24.12, 24.13, 24.14, 24.15, 24.16, 24.17, 24.18, and 24.19).
Table 24.5 kd, ke, and weighted average cost of capital, WACC, for companies with lifetimes
n ¼ 1, n ¼ 3, n ¼ 5, and n ¼ 10
L 0 0.5 1 1.1 1.3 1.6 2 3 4
kd 0.12 0.12 0.12 0.1188 0.1161 0.1107 0.1 0.04 0.14
WACC (n ¼ 1) 0.220 0.211 0.207 0.206 0.205 0.206 0.206 0.214 0.252
ke (n ¼ 1) 0.220 0.257 0.294 0.302 0.320 0.358 0.417 0.736 1.819
WACC (n ¼ 3) 0.219 0.208 0.201 0.201 0.199 0.199 0.198 0.209 0.279
ke (n ¼ 3) 0.219 0.252 0.281 0.291 0.307 0.340 0.395 0.716 1.955
WACC (n ¼ 5) 0.220 0.206 0.200 0.199 0.197 0.197 0.196 0.207 0.301
ke (n ¼ 5) 0.220 0.250 0.279 0.287 0.303 0.335 0.388 0.710 2.067
WACC 0.220 0.206 0.199 0.198 0.196 0.196 0.194 0.205 0.383
(n ¼ 10)
ke ( n ¼ 10) 0.220 0.249 0.277 0.285 0.301 0.332 0.383 0.699 2.474

level L in case of its 0,8
exponential decrease at 0,6
α ¼ 0.01 0,4
0,2
0
–0,2
0 1 2 3 4 5
–0,4
–0,6
–0,8
L

weighted average cost of 0,250
capital, WACC, on leverage n=5
0,230
level L in case of
exponential decrease of debt n=1
0,210 n=3
cost at α ¼ 0.01
0,190 n=10
0,170
0,150
0 1 2 3 4
L
Fig. 24.13 Dependence of Ke(L)

equity cost ke on leverage 0,6
level L in case of its n=1 n=5
exponential decrease at n=3
0,4
α ¼ 0.01
n=10
0,2
0,0
0 1 2 3
L

level L in case of its 0,8
exponential decrease at 0,6
α ¼ 0.01 0,4
0,2
0
–0,2 0 1 2 3 4 5
–0,4
–0,6
–0,8
L
24.7 Mechanism of Formation of the Company Optimal Capital Structure 553

weighted average cost of 0,250
capital, WACC, on leverage n=5
level L in case of 0,230
exponential decrease of debt n=1
0,210 n=3
cost at α ¼ 0.01
0,190 n=10
0,170
0,150
0 1 2 3 4
L
Fig. 24.16 Dependence of Ke(L)

equity cost ke on leverage 0,6
level L in case of its n=1 n=5
exponential decrease at n=3
0,4
α ¼ 0.01
n=10
0,2
0,0
0 1 2 3
L
Fig. 24.17 Monotonic

dependence of weighted
average cost of capital,
WACC, on the age of the
company n
The Case α ¼ 0.01 Let us consider first the case α ¼ 0.01.

We will study below the dependence of debt cost kd, equity cost ke, and weighted
average cost of capital, WACC, on leverage level L in case of kd exponential
decrease.
Fig. 24.18 Dependence of weighted average cost of capital, WACC, on the age of the company n,
showing descending with n and with the passage through a minimum and then a limited growth
Fig. 24.19 Two kinds of dependences of weighted average cost of capital, WACC, and company
capitalization, V, on the age of the company: n: 1–10 , monotonic dependence of weighted average
cost of capital, WACC, and company capitalization, V, on lifetime of the company; n: 2–20 ,
showing descending of WACC with n and with the passage through a minimum and then a limited
growth and increase of V with the passage through a maximum (at n0) and then a limited descending
24.8 “A Golden Age” of the Company
Authors of BFO theory have investigated the dependence of attracting capital cost on
the age of company n at various leverage levels, at various values of capital costs,
with the aim of defining the minimum cost of attracting capital. All calculations have
24.8 “A Golden Age” of the Company 555
been done within modern theory of capital cost and capital structure by Brusov–
Filatova–Orekhova (Brusov and Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b,
2013a, b, 2014a, b, 2015, 2018d; Filatova et al. 2008).
It was shown for the first time that valuation of WACC in the Modigliani–Miller
theory (Modigliani and Мiller 1958, 1963, 1966) is not minimal and valuation of the
company capitalization is not maximal, as all financiers supposed up to now: at some
age of the company, its WACC value turns out to be lower than in Modigliani–Miller
theory, and company capitalization V turns out to be greater than V in Modigliani–
Miller theory. We call this effect “the golden age” of company.
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 time of life
of company n, monotonic descending with n and descending with passage through
minimum, followed by a limited growth. The conditions of existing second type of
behavior (existing of “the golden age” of company) have been investigated in
Chap. 19. It is interesting to note that since the “golden age” of company depends
on the company’s capital costs, by controlling them (e.g., by modifying the value of
dividend payments that 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 concluded that existed before our new calculations (within BFO theory) the
results of the theory of Modigliani–Miller (Modigliani and Мiller 1958, 1963, 1966)
in these aspects are incorrect. The conclusion made in Chaps. 18 and 19 for the first
time that the assessment of weighted average cost of capital of the company, WACC,
in the theory of Modigliani and Miller (MM) (Modigliani and Мiller 1958, 1963,
1966) is not minimal and capitalization is not maximal seems to be very significant
and important.
Below we show the dependence of weighted average cost of capital, WACC, on
the age of the company n at fixed value of equity cost, k0¼20%, and at four values of
debt cost.
From Fig. 24.20, it is seen that with increase of debt cost, kd, the character of
dependence of weighted average cost of capital, WACC, on the age of the company
n is changed from monotonic descending of WACC with n to descending of WACC
with n with passage through minimum, followed by a limited growth.
It is important to note that “golden age” of company effect changes the depen-
dence of WACC on L: the curve WACC (L ) for perpetuity company turns out to be
not lowest for company with this effect—as it is seen from Tables 24.6, 24.7 and
24.8 and Fig. 24.21, the curve WACC(L ) for 3-year company lies below the
perpetuity curve.
In Chap. 19 authors have shown that existence of the “golden age” of company
does not depend on the value of capital costs of the company but depends on the
difference between equity k0 and debt kd costs. The “golden age” of company exists
at small enough difference between k0 and kd costs, while at high value of this
difference, the “golden age” of company is absent: curve WACC(n) monotonic
descends with n. For the companies with the “golden age,” curve WACC(L) for
WACCC(n), k0=0.2
19.2000%
19.0000%
18.8000%
18.6000%
18.4000%
WACC
Kd=0,18
18.2000%
Kd=0,15
18.0000%
Kd=0,10
17.8000%
Kd=0,08
17.6000%
17.4000%
17.2000%
0 5 10 15 20 25 30 35 40 45
n
Fig. 24.20 Dependence of weighted average cost of capital, WACC, on the age of the company
n at fixed value of equity cost,k0¼ 20%, and at four values of debt cost, kd¼8%, 10%, 15%, and
18%, at leverage level L ¼ 1
Table 24.6 kd, ke, and weighted average cost of capital, WACC, for companies at ages n ¼ 1,
n ¼ 3, n ¼ 5, and n ¼ 10
L 0 0.5 1 1.1 1.3 1.6 2 3 4
kd 0.12 0.12 0.12 0.1188 0.1161 0.1107 0.1 0.04 0.14
WACC (n ¼ 1) 0.220 0.211 0.207 0.206 0.205 0.206 0.206 0.214 0.252
ke (n ¼ 1) 0.220 0.257 0.294 0.302 0.320 0.358 0.417 0.736 1.819
WACC (n ¼ 3) 0.219 0.208 0.201 0.201 0.199 0.199 0.198 0.209 0.279
ke (n ¼ 3) 0.219 0.252 0.281 0.291 0.307 0.340 0.395 0.716 1.955
WACC (n ¼ 5) 0.220 0.206 0.200 0.199 0.197 0.197 0.196 0.207 0.301
ke (n ¼ 5) 0.220 0.250 0.279 0.287 0.303 0.335 0.388 0.710 2.067
WACC 0.220 0.206 0.199 0.198 0.196 0.196 0.194 0.205 0.383
(n ¼ 10)
ke (n ¼ 10) 0.220 0.249 0.277 0.285 0.301 0.332 0.383 0.699 2.474
perpetuity companies lies between curve WACC(L) for company ages n ¼ 1 and
n ¼ 3, while for the companies without the “golden age,” curve WACC(L ) for
perpetuity companies is the lowest one.
Brusov et al. (2015) have found also a third type of WACC(n) dependence:
descending with passage through minimum, which lies below the perpetuity limit
value, and then going through maximum followed by a limited descending. They
called this effect “Kulik effect.” In Chap. 19 authors have found a variety of “Kulik
effect”: descending with passage through minimum of WACC, which lies above the
perpetuity limit value, and then going through maximum followed by a limited
descending. We call this company age, where WACC has a minimum, which lies
above the perpetuity limit value, “a silver age” of the company.
24.9 Inflation in Modigliani–Miller and BFO Theories 557

WACC
0 0.2 0.15 0.2 1 0.00 20.00 0.000 0.2000 20.00 0.2000
1 0.2 0.15 0.2 1 0.50 18.43 0.000 0.2487 18.00 0.2400
2 0.2 0.15 0.2 1 0.67 17.91 0.000 0.2974 17.33 0.2800
3 0.2 0.15 0.2 1 0.75 17.65 0.000 0.3461 17.00 0.3200
4 0.2 0.15 0.2 1 0.80 17.50 0.000 0.3948 16.80 0.3600
5 0.2 0.15 0.2 1 0.83 17.39 0.000 0.4435 16.67 0.4000
6 0.2 0.15 0.2 1 0.86 17.32 0.000 0.4922 16.57 0.4400
7 0.2 0.15 0.2 1 0.88 17.26 0.000 0.5409 16.50 0.4800
8 0.2 0.15 0.2 1 0.89 17.22 0.000 0.5896 16.44 0.5200
9 0.2 0.15 0.2 1 0.90 17.18 0.000 0.6383 16.40 0.5600
10 0.2 0.15 0.2 1 0.91 17.15 0.000 0.6870 16.36 0.6000

WACC
0 0.2 0.15 0.2 3 0.00 20.00 0.000 0.2000 20.00 0.2000
1 0.2 0.15 0.2 3 0.50 17.80 0.000 0.2360 18.00 0.2400
2 0.2 0.15 0.2 3 0.67 17.06 0.000 0.2719 17.33 0.2800
3 0.2 0.15 0.2 3 0.75 16.69 0.000 0.3078 17.00 0.3200
4 0.2 0.15 0.2 3 0.80 16.47 0.000 0.3436 16.80 0.3600
5 0.2 0.15 0.2 3 0.83 16.32 0.000 0.3795 16.67 0.4000
6 0.2 0.15 0.2 3 0.86 16.22 0.000 0.4153 16.57 0.4400
7 0.2 0.15 0.2 3 0.88 16.14 0.000 0.4511 16.50 0.4800
8 0.2 0.15 0.2 3 0.89 16.08 0.000 0.4869 16.44 0.5200
9 0.2 0.15 0.2 3 0.90 16.03 0.000 0.5228 16.40 0.5600
10 0.2 0.15 0.2 3 0.91 15.99 0.000 0.5586 16.36 0.6000
24.9 Inflation in Modigliani–Miller and BFO Theories
Here we describe the influence of inflation on capital cost and capitalization of the
company within modern theory of capital cost and capital structure (Brusov–
Filatova–Orekhova theory) (BFO theory) (Brusov and Filatova 2011; Brusov et al.
2011a, b, c, 2012a, b, 2013a, b, 2014a, b, 2018d; Filatova et al. 2008) and within its
perpetuity limit—Modigliani–Miller theory (Modigliani and Мiller 1958, 1963,
1966). By direct incorporation of inflation into both theories, Brusov, Filatova,
and Orekhova have shown for the first time that inflation not only increases the
equity cost and the weighted average cost of capital, but also it changes their
dependence on leverage. In particular, it increases the growing rate of equity cost
with leverage. Capitalization of the company is decreased under accounting of
inflation.
21.00%
20.00%
19.00%
n=1 ko=0,2 kd=0,15

WACC
18.00% n=3 ko=0,2 kd=0,15

MM ko=0,2 kd=0,15
17.00%
16.00%
15.00%
0 1 2 3 4 5 6 7 8 9 10
Fig. 24.21 The demonstration of the existence of the “golden age”: the curve WACC(L ) for
perpetuity company turns out to be not lowest for company with the effect of “golden age”—the
curve WACC(L ) for 3-year company lies below the perpetuity curve
Under accounting of inflation, all original MM (Modigliani–Miller) statements

have been modified as done below:
Second Original MM Statement
Equity cost of leverage company ke could be found as equity cost of financially
independent company k0 of the same group of risk, plus premium for risk, with
value equal to production of difference (k0 kd)on leverage level L.
Second Modified MM–BFO Statement
Under accounting of inflation with rate α equity cost of leverage company ke
could be found as equity cost of financially independent company k0 of the same
group of risk, multiplied by (1 + α), plus inflation rate α and plus premium for
risk, which value is equal to production of difference (k0 kd) on leverage level
L and on multiplier (1 + α).
Fourth Original MM Statement
Equity cost of leverage company ke paying tax on profit could be found as equity
cost of financially independent company k0 of the same group of risk, plus
premium for risk, with value equal to production of difference (k0 kd)on
leverage level L and on tax shield (1 T) and on multiplier (1 + α).
Fourth Modified MM–BFO Statement
Equity cost of leverage company ke paying tax on profit under existence of
inflation with rate α could be found as equity cost of financially independent
company k0 of the same group of risk, multiplied by (1 + α), plus inflation rate α
24.9 Inflation in Modigliani–Miller and BFO Theories 559

the equity cost and the
capital on leverage in the
Modigliani–Miller theory
with taxing under
accounting of inflation. It is
seen that growing rate of
equity cost increases with
leverage. y-Axis refers to
capital costs—CC
and plus premium for risk, with value equal to production of difference (k0 kd)
on leverage level L, on tax shield (1–T), and on multiplier (1 + α) (Fig. 24.22).
We generalized a very important Brusov–Filatova–Orekhova theorem under
accounting of inflation.
Generalized Brusov–Filatova–Orekhova Theorem
Under accounting of inflation without corporate taxing, the equity cost k ∗
0 and
the weighted average cost of capital WACC∗ do not depend on company
lifetime and are equal to

k∗ ∗ ∗ ∗
e ¼ k 0 þ L k 0 k d ¼ k 0 ð1 þ αÞ þ α þ Lðk 0 k d Þð1 þ αÞ
and
WACC∗ ¼ k∗
0 ¼ k 0 ð1 þ αÞ þ α: ð24:3Þ
consequently.
It is shown that inflation not only increases the equity cost and the weighted
average cost of capital, but also it changes their dependence on leverage. In partic-
ular, it increases the growing rate of equity cost with leverage. Capitalization of the
company is decreased under accounting of inflation.
Within the modern theory of capital cost and capital structure—Brusov–Filatova–

Orekhova theory (BFO theory)—the modified equation for the weighted average
cost of capital, WACC, applicable to companies with arbitrary lifetime under
accounting of inflation has been derived. Modified BFO equation allows to inves-
tigate the dependence of the weighted average cost of capital, WACC, and equity
cost, ke, on leverage level L, on tax on profit rate t, on lifetime of the company n, on
equity cost of financially independent company k0 and on debt cost kd, as well as on
inflation rate α.
Using the modified BFO equation, the analysis of the dependence of the weighted
average cost of capital, WACC, on debt ratio, wd, at different tax on profit rate t, as
well as inflation rate α has been done.
It has been shown that WACC decreases with debt ratio, wd, faster at bigger tax
on profit rate t. The space between lines, corresponding to different values of tax on
profit rate at the same step (10%), increases with inflation rate α. The variation region
(with change of tax on profit rate t) of the weighted average cost of capital, WACC,
increases with inflation rate α, as well as with lifetime of the company n.
24.10 Effects, Connected with Tax Shields, Taxes,

and Leverage
The role of tax shields, taxes, and leverage is investigated within the theory of
Modigliani–Miller as well as within the modern theory of corporate finance by
2012a, b, 2013a, b, 2014a, b, 2018d; Filatova et al. 2008). It is shown that equity cost
of the company and weighted average cost of capital decrease with the growth of tax
on profit rates. A detailed study of the dependence of weighted average cost of
capital WACC and equity cost of the company ke on tax on profit rates at fixed
leverage level (fixed debt capital fraction wd) as well as on leverage level (debt
capital fraction wd) at fixed tax on profit rate has been done. The dependences of
weighted average cost of capital WACC and equity cost of the company ke on
company lifetime have been investigated as well.
The concept “tax operating lever” has been introduced. For companies with finite
lifetime, a number of important qualitative effects that do not have analogues for
perpetuity companies have been detected.
One such effect—decreasing of equity cost with leverage level at values of tax on
profit rate T, which exceeds some critical value T*—is described in detail in Chap. 10
(at certain ratios between the debt cost and equity capital, discovered effect takes
place at tax on profit rate, existing in the Western countries and in Russia that
provides practical value effect). Its accounting is important in improving tax legis-
lation and may change dividend policy of the company.
24.12 Influence of Growth of Tax on Profit Rate 561
24.11 Effects, Connected with the Influence of Tax on Profit

Rate on Effectiveness of Investment Projects
BFO authors have conducted the analysis of effectiveness of investment projects

within the perpetuity (Modigliani–Miller) approximation (Modigliani and Мiller
1958, 1963, 1966) as well as within BFO theory. They analyzed the effectiveness
of investment projects for three cases:
1. At a constant difference between equity cost (at L ¼ 0) and debt cost Δk ¼ k0 kd
2. At a constant equity cost (at L ¼ 0) and varying debt cost kd
3. At a constant debt cost kd and varying equity cost (at L ¼ 0) k0
The dependence of NPV on investment value and/or equity value will be also
analyzed. The results have been represented in the form of tables and graphs.
It should be noted that the obtained tables have played an important practical role
in determining the optimal or acceptable debt level, at which the project remains
effective. The optimal debt level there is for the situation, when in the dependence of
NPV on leverage level L there is an optimum (leverage level value, at which NPV
reaches a maximum value). There is an acceptable debt level for the situation when
NPV decreases with leverage. And, finally, it is possible that NPV is growing with
leverage. In this case, an increase in borrowing leads to increased effectiveness of
investment projects, and their limit is determined by financial sustainability of
investing company.
24.12 Influence of Growth of Tax on Profit Rate
Within modern theory of capital cost and capital structure by Brusov–Filatova–

Orekhova (BFO theory) (Brusov and Filatova 2011; Brusov et al. 2011a, b, c, 2012a,
b, 2013a, b, 2014a, b, 2018d; Filatova et al. 2008) and created within this theory
modern investment models influence of growth of tax on profit rate on the efficiency
of the investment is investigated. It has been shown that for long-term investment
projects, as well as for arbitrary duration projects, the growth of tax on profit rate
changes the nature of the NPV dependence on leverage at some value t*: there is a
transition from diminishing function NPV(L ) when t < t* to growing function NPV
(L ). The t* value depends on the duration of the project, cost of capital (equity and
debt) values, and other parameters of the project.
At high leverage levels, this leads to qualitatively new effect in investments:
growth of the efficiency of the investments with growth of tax on profit rate.
capital (Tables 24.9, 24.10, and 24.11).
Table 24.9 Dependence of NPV and ΔNPV on leverage level L at fixed levels of tax on profit rates
t for 5-year project at t ¼ 0.3
0 0.18 0.14 0 0.3 5 800 0.18 751.22 4.922709
1 0.18 0.14 0.5 0.3 5 800 0.197488 756.14 36.8599
2 0.18 0.14 0.66667 0.3 5 800 0.214367 719.28 44.7663
3 0.18 0.14 0.75 0.3 5 800 0.231082 674.51 46.126
4 0.18 0.14 0.8 0.3 5 800 0.24773 628.39 45.4549
5 0.18 0.14 0.83333 0.3 5 800 0.264343 582.93 44.027
6 0.18 0.14 0.85714 0.3 5 800 0.280937 538.90 42.3084
7 0.18 0.14 0.875 0.3 5 800 0.297518 496.60 40.4978
8 0.18 0.14 0.88889 0.3 5 800 0.314091 456.10 38.6879
9 0.18 0.14 0.9 0.3 5 800 0.330658 417.41 36.9239
10 0.18 0.14 0.90909 0.3 5 800 0.34722 380.49
Table 24.10 Dependence of NPV and ΔNPV on leverage level L at fixed levels of tax on profit
rates t for 5-year project at t ¼ 0.4
0 0.18 0.14 0 0.4 5 800 0.18 501.04 64.13345
1 0.18 0.14 0.5 0.4 5 800 0.189578 565.18 4.73089
2 0.18 0.14 0.66667 0.4 5 800 0.19803 569.91 9.5017
3 0.18 0.14 0.75 0.4 5 800 0.206172 560.40 14.7815
4 0.18 0.14 0.8 0.4 5 800 0.214184 545.62 17.1025
5 0.18 0.14 0.83333 0.4 5 800 0.22213 528.52 18.1709
6 0.18 0.14 0.85714 0.4 5 800 0.230037 510.35 18.6246
7 0.18 0.14 0.875 0.4 5 800 0.23792 491.73 18.7461
8 0.18 0.14 0.88889 0.4 5 800 0.245786 472.98 18.6762
9 0.18 0.14 0.9 0.4 5 800 0.253642 454.30 18.4911
10 0.18 0.14 0.90909 0.4 5 800 0.261488 435.81
Table 24.11 Dependence of NPV and ΔNPV on leverage level L at fixed levels of tax on profit
rates t for 5-year project at t ¼ 0.5
0 0.18 0.14 0 0.5 5 800 0.18 250.87 116.0669
1 0.18 0.14 0.5 0.5 5 800 0.181448 366.94 41.1323
2 0.18 0.14 0.66667 0.5 5 800 0.181065 408.07 22.57738
3 0.18 0.14 0.75 0.5 5 800 0.180162 430.65 15.19888
4 0.18 0.14 0.8 0.5 5 800 0.179041 445.84 11.52994
5 0.18 0.14 0.83333 0.5 5 800 0.177806 457.37 9.446706
6 0.18 0.14 0.85714 0.5 5 800 0.176505 466.82 8.154973
7 0.18 0.14 0.875 0.5 5 800 0.175162 474.98 7.302458
8 0.18 0.14 0.88889 0.5 5 800 0.173792 482.28 6.713275
9 0.18 0.14 0.9 0.5 5 800 0.172401 488.99 6.291579
10 0.18 0.14 0.90909 0.5 5 800 0.170996 495.28
24.12 Influence of Growth of Tax on Profit Rate 563
Fig. 24.23 Dependence of NPV on leverage level L at fixed levels of tax on profit rates t for 5-year
project
Fig. 24.24 Dependence of NPV on tax on profit rate t at fixed leverage level L for 10-year project
One can see from Figs. 24.23 and 24.24 the nature of the NPV dependence on
leverage at t* ¼ 0.5: there is a transition from diminishing function NPV(L ) when
t < t* to growing function NPV(L ) at t > t*.
Within modern theory of capital cost and capital structure by Brusov–Filatova–
Orekhova (BFO theory) and created within this theory modern investment models
influence of growth of tax on profit rate on the efficiency of the investment is
investigated. It has been shown that for arbitrary duration projects as well as for
perpetuity projects, the growth of tax on profit rate changes the nature of the NPV
dependence on leverage at some value t*: there is a transition from diminishing
function NPV(L ) when t < t* to growing function NPV(L ). The t* value depends on
the duration of the project, cost of capital (equity and debt) values, and other
parameters of the project.
At high leverage levels, this leads to qualitatively new effect in investments:
growth of the efficiency of the investments with growth of tax on profit rate.
capital.
The observed at high leverage levels (starting from L ¼ 6) increase of NPV with
growth of the tax on profit rate t (Fig. 24.24) takes place at all values of t, that means
that this is an entirely new effect in investments which can be applied in a real
economic practice for optimizing of the management of investments.
So, two very important qualitatively new effects in investments have been
discovered:
1. Change of the character of NPV dependence on leverage
2. Growth of the efficiency of the investments with growth of tax on profit rate
Both effects could be used in practice to optimize the investments.
24.13 New Approach to Ratings
A new approach to rating methodology has been developed (see Chaps. 21, 22, and
23). Chapters 21 and 22 are devoted to rating of nonfinancial issuers, while Chap. 23
is devoted to long-term project rating. The key factors of a new approach are (1) the
adequate use of discounted 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 BFO (and its perpetuity limit). This on the
one hand allows use the powerful tool of this theory in the rating, and on the other
hand it ensures the correct discount rates when discounting financial flows. Two
models for accounting discounted financial flows—one-period and multi-period—
have been discussed. An algorithm of valuation of correct discount rate, accounting
ratios, is suggested. We discuss also the interplay between rating ratios and leverage
level which can be quite important in rating. All above creates a new base for rating
methodologies.
24.13.1 New Approach to Ratings: The Creditworthiness

of the Non-Finance Issuers
The most important feature of the suggested approach is the incorporation of rating
parameters, used in ratings, into modern theory of capital structure by Brusov–
Filatova–Orekhova and in its perpetuity limit.
24.13 New Approach to Ratings 565
In quantification of the creditworthiness of the issuers, the crucial role belongs to

the so-called financial ratios that constitute direct and inverse ratios of various
generated cash flows to debt values and interest ones. We could mention such ratios
as DCF/Debt, FFO/Debt, CFO/Debt, FOCF/Debt, FFO/cashinterest, EBITDA/inter-
est, Interests/EBITDA, Debt/EBITDA, and some others.
We incorporate these rating parameters (financial “ratios”) into the modern theory
of capital structure—BFO theory and its perpetuity limit. The importance of such
incorporation, which has been done by authors for the first time, is in using of this
theory as a powerful tools when discounting of financial flows using the correct
discounting rate in rating. Only this theory allows to valuate adequately the weighted
average cost of capital WACC and equity cost of capital ke used when discounting
financial flows.
Use of the tools from well-developed theories in rating opens completely new
horizons in the rating industry, which could go from the mainly use of qualitative
methods of the evaluation of the creditworthiness of issuers to a predominantly
quantitative evaluation methods that will certainly enhance the quality and correct-
ness of the rating.
Currently, rating agencies just directly use financial ratios, while the new meth-
odology will allow [knowing the values of these “relations” (and parameter k0)] to
determine the correct values of discount rates (WACC and ke) that should be used
when discounting the various financial flows, both in terms of their timing and
forecasting.
This has required the modification of the BFO theory (and its perpetuity limit—
Modigliani–Miller theory), as used in financial management the concept of “lever-
age” as the ratio of debt value to the equity value substantially differs from the
concept of “leverage” in the rating, where it is understood as the direct and inverse
ratio of the debt value to the generated cash flow values (income, profit, etc.). The
authors introduced some additional ratios, allowing to more fully characterize the
issuer’s ability to repay debts and to pay interest thereon.
Thus a bridge is built between the discount rates (WACC, ke) used when
discounting financial flows and “ratios” in the rating methodology. The algorithm
for finding the discount rates for given ratio values is developed.
In Chap. 22 further development of a new approach to rating methodology has
been done. Authors have generalized it for the general case of modern theory of
capital structure [Brusov–Filatova–Orekhova (BFO) theory]: for companies of arbi-
trary age. A serious modification of BFO theory in order to use it in rating procedure
has been required. It allows 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, use the correct discount rate, etc. This allows
use of the powerful tools of BFO theory in the rating. All these create a new base for
rating methodologies.
24.13.2 New Approach to Long-Term Project Ratings
Chapter 23 continues create a new approach to rating methodology: in addition to

two previous Chaps. (21 and 22), which have considered the creditworthiness of the
non–finance issuers (Brusov et al. 2018c, d), authors develop in this Chapter 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, (2) The incorporation of rating parameters (financial “ratios”),
used in project rating, into considered modern investment models.
on leverage level L, we come to a very important conclusion that NPV in units of
NOI (NPV NPV
NOI ) [as well as NPV in units of D ( D )] depends only on equity cost k0, on
credit rates kd, and on leverage level L but also on one of the leverage ratios lj (on one
of the coverage ratios ij) 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 lj [as well as on the dependence of NPV (in units of D)
(NPV
D ) on coverage ratios ij] at different equity costs k0, at different credit rates kd, and
at different leverage levels L carry the universal character: these dependencies
Calculations on dependence of NPV in units of D (NPV/D) on the coverage ratio
on debt i1 show that NPV NPV
D increases with i1 and that D values turn out to be very close
to each other at all i1 values. It is seen as well that NPV increases with decreasing kd.
This means that effectiveness of the investment project as well as its creditworthi-
ness decreases with credit rate kd. One can see that all NPV (i1) curves corresponding
to L ¼ 3 lie above the curves corresponding to L ¼ 1. This means that NPV increases
with leverage level L (with increasing of the debt financing). Thus, debt financing
favors to effectiveness of the long-term project. At fixed value L, NPV increases with
decreasing credit rate kd.
It is shown that the value of the coverage ratio on debt i1 above which the
investment project remains effective (NPV > 0) increases with credit rate kd,
which means that effectiveness of the investment project as well as its creditworthi-
ness decreases with credit rate kd. Comparing the cases of L ¼ 1 and L ¼ 3, one can
see that at bigger leverage level (L ¼ 3), the investment project becomes effective
(NPV > 0) starting from smaller coverage ratio i1, so bigger leverage level favors to
the effectiveness of the investment project as well as its creditworthiness.
Calculations on dependence of NPV in units of NOI (NPV/NOI) on the leverage
ratio on debt l1 show that NPV in units of NOI decreases with increase of the
leverage ratio on debt l1. With the increase of the cost of debt capital kd, curves of the
References 567
dependence of NPV/NOI (l1), outgoing from a single point at a zero value of l1, lie
below (i.e., the rate of decrease (or negative slope of curves) grows). Note that while
the dependences of NPV (in units of D) on coverage ratio on debt i1 lie very close to
each other, the dependences of NPV (in units of NOI) on leverage ratio on debt l1 are
separated significantly more.
One can see that the value of l1 below which the investment project remains
effective (NPV > 0) decreases with credit rate kd, which means that effectiveness of
the investment project as well as its creditworthiness decreases with credit rate kd.
l1 at fixed equity cost k0 and fixed credit rate kd at two leverage levels L ¼ 1 and
L ¼ 3, it was shown that the curve NPV NOI (l1) corresponding to bigger leverage level
(L ¼ 3) lies above the curve NPV (l
NOI 1 ) corresponding to smaller leverage level (L ¼ 1).
The curve NPV NOI (l1 ) corresponding to bigger leverage level (L ¼ 3) has smaller
(negative) slope. This means that debt financing of long-term projects favors effec-
tiveness of the investment project as well as its creditworthiness.
Investigations, conducted in the current paper, create a new approach to rating
methodology with respect to the long-term project rating. And this paper in combi-
nation with the two of our previous papers on this topic (Brusov et al. 2018c, d)
creates a new base for rating methodology as a whole.
In our future papers, we will consider rating methodology for investment projects
of arbitrary duration.
In conclusion, we remind again that the introduction of the new system of
evaluation of the parameters of financial activities of companies into the sys-
tems of financial reporting (IFRS, GAAP, etc.) would lead to lower risk of
References
(11):815–824
Brusov P, Filatova T, Orekhova N (2013a) Absence of an optimal capital structure in the famous
org/10.1080/23322039.2014.946150
7:37–62
1954–1957. Am Econ Rev 56:333–391
Modigliani F, Мiller M (1958) The cost of capital, corporate finance, and the theory of investment.
Modigliani F, Мiller M (1963) Corporate income taxes and the cost of capital: a correction. Am
Econ Rev 53:147–175
Chapter 25
Conclusion
This book changes our understanding of corporate finance, investments, taxation,

and rating procedures. It shows that the most used principles of financial manage-
ment should be changed in accordance to BFO theory. Many of discoveries made
within this theory still require interpretations and understanding as well as incorpo-
ration into real finance and economy. But it is clear now that without very serious
modification of the conceptions of financial management, it is impossible to ade-
quately manage manufacture, investments, taxation, and rating procedures, as well
as finance in general.
The book has destroyed some main existing principles of financial management:
among them is the trade-off theory, which was considered as a keystone of formation
of optimal capital structure of the company during many decades. It was proved by
the authors that the balance between advantages and shortcomings of debt financing
could not provide the optimal capital structure for the company at all [and an
explanation (nontrivial) to this fact has been done]. A new mechanism of formation
of the company’s optimal capital structure, different from the ones suggested by
trade-off theory, has been suggested in monograph.
Let us also mention the discovered qualitatively new effect in corporate finance:
decreasing of cost of equity ke with leverage L. This changes the conceptions of
dividend policy of company very significantly.
A very important discovery has been done recently by the authors within BFO
theory. It is shown for the first time that valuation of weighted average cost of capital
(WACC) in the Modigliani–Miller theory (perpetuity limit of BFO theory) (Modi-
gliani and Мiller 1958, 1963, 1966) is not minimal and valuation of the company
capitalization is not maximal, as all financiers supposed up to now: at some age of
the company (“golden age”), 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 Modigliani–Miller theory (see Chaps. 18 and 19).
Existing rating methodologies have a lot of shortcomings. One of the major flaws
of all of them is a failure or a very narrow use of discounting. But even in those rare
cases where it is used, it is not quite correct, since the discount rate when discounting

https://doi.org/10.1007/978-3-319-99686-8_25
570 25 Conclusion
financial flows is chosen incorrectly. In this book, a new approach to rating meth-
odology is suggested. Chapters 21 and 22 are devoted to rating of nonfinancial
issuers, while Chap. 23 is devoted to long-term project rating. The key factors of a
new approach are (1) the adequate use of discounting 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]. This on the one hand allows use of 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 discuss also 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
to issue more correct ratings of issuers and makes the rating methodologies more
understandable and transparent.
A distinctive feature of the book is the extensive and adequate use of mathematics
that allows the reader to count various financial and economic parameters, including
investment and taxation ones, up to the quantitative result.
Application of BFO theory in corporate finance, investments, taxation, business
valuation, and ratings as well as in other areas of economy and finance (Filatova et al.
2008; Brusov and Filatova 2011; Brusov et al. 2011a, b, c, 2012a, b, 2013a, b,
2014a, b, 2015, 2018a, b, c, d) allows to make correct assessment of main financial
parameters of the objects and the right managerial decisions. This will help to avoid
financial crises, like the global financial crisis of 2008, in the future.
And we can see similar influence of the obtained results in many areas of finance
and economy. Not all results, obtained by authors, found reflection in a book via its
limited volume. Readers should look for recent and coming papers by authors in
journals.
In conclusion, we mention the applications of BFO theory in corporate
finance, investments, business valuation, taxation, and ratings:
1. Companies and corporations
2. Rating agencies
3. Investment companies
4. Banks and credit organizations
5. Central banks
6. Ministry of finance
7. Business valuation
8. Insurance companies
9. Financial reports (ISFR, GAAP, etc.)
10. Fiscal organizations
References
capital structure of the company. Finance Credit 435:2–8
References 571
Brusov P, Filatova T, Orehova N, Brusova A (2011a) Weighted average cost of capital in the theory of
Modigliani–Miller, modified for a finite life-time company. Appl Financ Econ 21(11):815–824
Brusov P, Filatova T, Orekhova N (2013a) Absence of an optimal capital structure in the famous
structure, different from suggested by trade off theory. Cogent Econ Finance 2:1–13
7:37–62
Econ Rev 53:147–175
1954–1957. Am Econ Rev 56:333–391

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Peter Brusov · Tatiana Filatova

Natali Orekhova · Mukhadin Eskindarov

Modern Corporate Finance,

Natali Orekhova Mukhadin Eskindarov

ISBN 978-3-319-99685-1 ISBN 978-3-319-99686-8 (eBook)

Library of Congress Control Number: 2018955714

© Springer Nature Switzerland AG 2015, 2018

Dedicated to our dear granddaughter Anyuta,

rating of non-ﬁnancial issuers, while Chap. 23 is devoted to long-term project rating.

Kronburg, Moscow, Russia Peter Brusov

4. Mechanism of formation of the company optimal capital structure, different from

This book is intended for students, postgraduate students, teachers of economic

Moscow, Russia Peter Brusov

Part I Corporate Finance

8.3.2 Dependence of Equity Cost ke on Leverage Level

11.3 Without Flows Separation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

14 Investment Models with Uniform Debt Repayment and Their

Part III Taxation

16.2 Dependence of NPV on Tax on Proﬁt Rate at Fixed Leverage

19 A “Golden Age” of the Companies: Conditions of Its Existence . . . 395

Part IV Ratings and Rating Methodologies

22.3 Modiﬁcation of the BFO Theory for Companies

24 New Meaningful Effects in Modern Capital Structure Theory . . . . 537

Petr Nickitovich Brusov is professor at the Finan-

Tatiana Filatova is professor at the Financial Uni-

Natali Orekhova is professor of the Center of

Mukhadin Abdurakhmanovich Eskindarov is

© Springer Nature Switzerland AG 2018 3

Such an incorrect assessment of key performance indicators of ﬁnancial activities

The second part of this monograph is devoted to assess effectiveness of the

Brusov P, Filatova T, Orehova N et al (2011b) From Modigliani–Miller to general theory of capital

© Springer Nature Switzerland AG 2018 9

t ¼ 1. It gives the possibility to calculate the capitalization V; the weighted average

2.2 The Traditional Approach

2.3 Modigliani–Miller Theory

2.3.1 Modigliani–Miller Theory Without Taxes

Fig. 2.3 Dependence of U

Index L means ﬁnancially dependent company (using debt ﬁnancing), while

V 0 ¼ V L; CF=k0 ¼ CF=WACC, and thus WACC ¼ k 0 :

Note that ﬁrst Modigliani–Miller theorem is based on suggestion about indepen-

Finding from here ke, one gets

D Value of debt capital of the company

Thus, we come to second statement (theorem) of Modigliani–Miller theory about

2.3.2 Modigliani–Miller Theory with Taxes

Fig. 2.4 Dependence of CC

and the cost of leverage company is equal to

where V0 is the value of ﬁnancially independent company.

V ¼ CF=k 0 þ wd VT: ð2:7Þ

Because the value of leverage company is V ¼ CF/WACC, for weighted average

From here the dependence of WACC on leverage L ¼ D/S becomes the

WACC ¼ k0 ð1 LT=ð1 þ LÞÞ: ð2:9Þ

Equating Eqs. (2.9) and (2.11), one gets

Fig. 2.5 Dependence of CC Ke = K0+L(K0-Kd)

2.3.3 Main Assumptions of Modigliani–Miller Theory

The most important assumptions of the Modigliani–Miller theory are as follows:

while, as in attracting large loans, as well as during placement of shares at a

2.3.4 Modiﬁcations of Modigliani–Miller Theory

The equity cost for company with debt capital

The debt cost

The weighted average cost of capital (WACC)

WACC ¼ ke we þ kd wd ð1 T Þ, ðWACC ¼ k 0 ð1 Twd ÞÞ: ð2:19Þ

here t is a moment of payment a credit and N(d1), cumulative normal distribution

CFL ¼ CFe þ CFd ¼ ðEBIT I Þð1 T C Þð1 T S Þ þ I ð1 T D Þ, ð2:23Þ

k0 ¼ 8% 24%; kd ¼ 7%; T ¼ 50%; wd ¼ 0% 60%

2. WACC ¼ we ke + wd kd; and thus

α WACC2 þ ð2α 1Þ WACC þ ðα 2Þ ¼ 0: ð3:22Þ