Harris Technical note prepared by Michael J Schill RWJ BMM RPand other academic

Harris technical note prepared by michael j schill

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Harris, Technical note prepared by Michael J. Schill, RWJ, BMM, RP,and other academic papers 9
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Where Does it Leave Us?The optimal capital structure depends on market imperfections, such as taxes, financial distress costs, agency costs, and asymmetric information.Even though in principle firms should trade off the tax advantages of debt against financial distress costs and the incentive effects of debt, in practice, managers may not behave in this fashion. Some stylized facts are pronounced industry patterns, profitable firms have less debt, taxes have small influence and firms forced away from their preferred capital structure tend to return to it in time.The management entrenchment theory suggests that managers choose a capital structure to avoid the discipline of debt and maintain their own job security.Managers seek to minimize leverage to prevent the job loss that would accompany financial distress, but are constrained from using too little debt (to keep shareholders happy).Shareholders should be active in voting against policies that protect managers unduly from the negative effects of their actions. Oversight by the board, through effective corporate governance practices can discipline managers.References: Note prepared by Susan Chaplinsky and Robert S. Harris, Technical note prepared by Michael J. Schill, RWJ, BMM, RP,and other academic papers 10
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Cost of Capital: Principles and PracticeReferences: Note prepared by Susan Chaplinsky and Robert S. Harris, Technical note prepared by Michael J. Schill, RWJ, BMM, RP,and other academic papers 11
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Weighted Average Cost of CapitalWACC is a broadly accepted standard for use as the discount rate tocalculate the present value of a company’s projected FCF and terminalvalue.WACC can also be thought of as an opportunity cost of capital or whatan investor would expect to earn in an alternative investment with asimilar risk profile.Represents the weighted average of the required return on theinvested capital (customarily debt and equity) in a given company.References: Note prepared by Susan Chaplinsky and Robert S. Harris, Technical note prepared by Michael J. Schill, RWJ, BMM, RP,and other academic papers 12
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Steps forCalculating WACCDetermine Target Capital StructureEstimate Cost of Debt (𝑟𝑟𝑑𝑑)Estimate Cost of Equity (𝑟𝑟𝑒𝑒)Calculate WACCReferences: Note prepared by Susan Chaplinsky and Robert S. Harris, Technical note prepared by Michael J. Schill, RWJ, BMM, RP,and other academic papers 13
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Determine Target Capital StructureChoose a target capital structure for the company that is consistent with long-term strategy.debt-to-total capitalization (D/(D+E)) and equity-to-total capitalization (E/(D+E)) ratiosHistorical data and comparison with peersApproach used to determine a company’s target capital structure may differ from one firm to the next.
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