Definition
Hamada’s equation, named after Robert Hamada, is used in corporate finance to distinguish between the financial risk of a leveraged corporation and the business risk of the firm. It integrates the Modigliani-Miller theorem with the capital asset pricing model to form a single equation. It is used to assist in determining the levered beta of a business and, as a result, the appropriate capital structure of the firm.
What is the ‘Hamada Equation’
This equation is used in fundamental analysis to determine how a business’s costs of capital change when it takes on increasing financial leverage, and how this relates to the overall riskiness of that firm. Essentially, the metric is intended to describe the implications that this form of leverage has on a company’s cost of capital (over and above the cost of capital as if the firm had no debt).
The equation is:
![{\displaystyle \beta _{L}=\beta _{U}[1+(1-T)\phi ]\qquad (1)}](https://wikimedia.org/api/rest_v1/media/math/render/svg/69f0329b708147b6391ed2ea27502fa96f8eea12)
‘Hamada Equation’ FAQ
Why do we use Hamada equation?
Hamada's Equation is a mixture of the Modigliani-Miller and the Capital Asset Pricing Model theorems, and it is used to value financial assets. It is used to aid in the understanding of how the cost of capital of a firm will be altered when leverage is used. Companies with higher beta coefficients are considered to be riskier.
Is beta of debt always zero?
Because it captures the various factors that influence the market, it is sometimes referred to as equity beta. When it comes to debt beta, it is believed to be 0 when calculating levered beta since debt is deemed to be risk-free, in contrast to equity, and so has no value.
Further Reading
- The Hamada Equation reconsidered – papers.ssrn.com [PDF]
- Portfolio analysis, market equilibrium and corporation finance – www.jstor.org [PDF]
- The theoretical relationship between systematic risk and financial (accounting) variables – www.jstor.org [PDF]
- Market equilibrium and corporation finance: Some issues – www.jstor.org [PDF]
- The effect of the firm’s capital structure on the systematic risk of common stocks – www.jstor.org [PDF]
- Contingent claim pricing using probability distortion operators: methods from insurance risk pricing and their relationship to financial theory – www.tandfonline.com [PDF]
- Hamada’s equation, the Sarbanes‐Oxley Act of 2002 and the UK Companies Act of 2006 – www.emerald.com [PDF]
- Capital Flight, North‐South Lending, and Stages of Economic Development – onlinelibrary.wiley.com [PDF]
- The brain drain, international integration of markets for professionals and unemployment: a theoretical analysis – www.sciencedirect.com [PDF]
