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A critical evaluation of the well known Hamada equation in Finance that states how debt affects market risk as measured by the beta coefficient

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ABSTRACT

A careful algebraic derivation of the well-known Hamada equation for levered beta

(Hamada 1972) reveals a refinement that implies that the Hamada equation under-

estimates the effect of leverage on beta. When there is no projected growth of cash

flows, the modified Hamada equation predicts that the cost of capital and the value of

the firm are independent of capital structure. The additional tax savings due to debt

are exactly offset by the increased riskiness of the equity holdings. This result is in

agreement with the Irrelevance Theorem postulated by Miller (Miller 1977).

When the projected growth rate is positive, the modified equation shows a steady

decrease in firm value when debt is added to the capital structure. This result is

contrary to that predicted by the Hamada equation and supports the agency cost

explanation of capital structure described by Jensen and Meckling (1976). Debt only

reduces the accounting value of the firm and not necessarily the value of the firm net of

agency costs. The results are consistent with the idea that with agency costs taken into

consideration the net firm value may first rise to a maximum as savings in agency

costs outweigh the loss of accounting value.

In deriving his equation, Hamada set the corporate cost of debt to the risk-free rate to

simplify the algebra. This restriction was overcome in a later revision of the equation

by Conine and Tamarkin (1985). However, since later works use Hamada's equation

as the starting point, they suffer from the same under-estimation problem. In this

paper, a generalized form of the equation is presented that makes no assumption

about the cost of debt. The equation is simple and easy to implement into

spreadsheet models for analyzing capital structure effects. A complete spreadsheet

model that allows for risky debt and preferred shares is included in the paper.

We Start with the equation for accounting returns to common shareholders of the

levered firm (kL) as

kL = (NIAT - j*P)/E

where NIAT is net after-tax income, j*P represents dividends payable to preferred

shareholders at a rate of j on a total outstanding value preferred shares of P. The

variable E is the value of common equity. We further define I as the interest payable to

debtholders as the product of i*D where i is the interest rate in debt and D is the debt

outstanding. Imposing these accounting definitions we obtain,

kL = [t*(NOI-I)j*P]/E

= [t*(ROI*TA - I)-j*P]/E

= [t*(ROI*D + ROI*E + ROI*P - i*D)-j*P]/E

= t*(ROI*D/E + ROI*E/E + ROI*P/E - i*D/E) - j*P/E

= t*[ROI*(1+P/E) + (D/E)*(ROI-i)] - j*P/E

kL = t*ROI + t*D/E)*(ROI-i) + [t*ROI-j]*P/E

Where t is 1 minus the corporate tax rate (or the `keep' rate), ROI is the return on

assets, P is preferred equity outstanding, and j is the rate of return on preferred equity.

The result is, in somewhat more general form, what is known as the DuPont Model. In

the absence of debt the middle term disappears and we have

kU = t*[ROI]+[t*ROI-j]*P/E

ROI*(1+ t*P/E) = kU - j*P/E

ROI = (kU - j*P/E)/(1+ t*P/E)

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Substituting this expression for ROI in the equation for kL to get kL = t*(kU - j*P/E)/(1+

t*P/E) + t*D/E)*((kU - +j*P/E)/(1+ t*P/E)-i) + [t*ROI-j]*P/E

kL = (1-t)* {kU /(1-t) + (D/E)*( [kU /(1-t)] - i]}

kL = kU + (D/E)*kU - i*(D/E)*(1-t)

kL = Rf + bL * (Rm - Rf)

kU = Rf + bU * (Rm - Rf)

to obtain

Rf + bL * (Rm - Rf) = Rf + bU * (Rm - Rf) +(D/E)*[Rf + bU * (Rm - Rf)] - i*(D/E)*(1-t)

or

bL*(Rm - Rf) = bU * (Rm - Rf) +(D/E)*Rf + (D/E)*bU*(Rm - Rf) - i*(D/E)*(1-t)

bL = bU + (D/E)*bU +(D/E)*Rf/(Rm - Rf) - i*(D/E)*(1-t)/(Rm - Rf)

Hamada did. We thus obtain the correct Hamada equation as

bL = bU + dbU + drt

bL = bU(1+ d) + drt

We will refer to the corrected Hamada equation as the Jamada equation. It differs

from the Hamada equation normally stated as

bL = bU(1+ d(1-t))

A more interesting point to note is that the assumption of i=Rf is not really necessary

since the equation is still quite manageable if we retain i as risky debt and use the

second form of the Jamada equation.

Where z is the ratio of the interest rate on corporate debt to the risk free rate (i/Rf).

Under the assumptions of the Hamada equation, the Jamada equation predicts a

larger effect of debt on beta and the additional effect exactly offsets the apparent

advantage of debt financing predicted by the Hamada equation. This means that

under the same set of assumptions Hamada predicts a decreasing cost of capital with

debt while Jamada predicts that the cost of capital and therefore the value of the firm

is invariant with capital structure. These relationships are developed below.

The weighted average cost of capital (WACC) of the firm with w fraction of its assets

supported by debt and (1-w) supported by equity may be written as

(Rm-Rf)bu + w(1-t)(Rm-Rf) = (1-w)Rf + (1-w)Rmbu - (1-w)Rfbu + wRm(1-t) = Rf + Rmbu

- Rfbu + w[Rm(1-t)-Rf-Rmbu+Rfbu]

The first derivative of WACC with respect to w is d/dw[WACC] = (1-t)Rm - [Rf + (Rm-

Rf)bu] Created with www.PDFonFly.com

= (1-t)Rm - ku

and the second derivative is zero. The Hamada relation thus predicts a linear

relationship between the debt ratio and cost of capital

The returns from the unlevered firm ku may be expressed as ROI(1-t) where ROI is the

operating income per dollar of total assets. The equation shows that as long as ku is

greater than Rm(1-t) or ROI is greater than Rm debt reduces the cost of capital and

the `optimal' capital structure (for maximum firm value) would be all debt. If ku=Rm(1-t),

or Rm = ROI then firm value is invariant with capital structure. And if ku is less than Rm

(1-t) or ROI is less than Rm, firm value falls with debt, i.e., the optimal capital structure

is all equity.

REFERENCES

Baxter Leverage, Risk of Ruin, and the Cost of Capital, Journal of Finance, Vol.22 No.

3, September 1967

Black, F. and Myron Scholes, The Pricing of Options and Corporate liability, Journal of

Political Economy, May/June 1973.

Boquist, John A., and William T. Moore, The Inter-Industry Leverage Differences and

the DeAngelo-Masulis Tax Shield Hypothesis, Financial Management, Spring, 1984

Bowen, Robert with Lane Daley and Charles Huber, Evidence on the Existence and

Determinants of Inter-Industry Differences in Leverage, Financial Management,

Winter, 1982

Assessing Leverage, Journal of Accounting Research, Vol 18 No 1, Spring 1980

Bradley, Michael with Gregg Jarrell and Han Kim, On the Existence of an Optimal

Capital Structure: Theory and Evidence, Journal of Finance, July 1984

Brennan, Michael with Eduardo Schwartz, Corporate Income Taxes, Valuation, and

the Problem of Optimal Capital Structure, Journal of Business, January 1978

Brennan, Michael, Optimal Financial Policy and Firm Valuation, Journal of Finance,

July 1984

Adjusting for Leverage, Financial Management, Spring 1985, p54

Personal Taxes, Journal of Financial Economics, March 1980

Fischer, Edwin with Robert Heinkel and Josef Zechner, Dynamic Capital Structure

Choice: Theory and Tests, Journal of Finance, Vol 44 No 1, March 1989

Hamada, Robert S., The Effect of the Firm's Capital Structure on the Systematic Risk

of Common Stocks, The Journal of Finance, May 1972, p435

Costs, and Ownership Structure, Journal of Financial Economics, October 1976

Kane, Alex with Alan Marcus and Robert McDonald, How Big is the Tax Advantage to

Debt, The Journal of Finance, Vol 39 No 3, July 1984

Kim, Wi Saeng and Eric Sorenson, Evidence on the Impact of the Agency Cost of

Debt on Corporate Finance, Journal of Financial and Quantitative Analysis, Vol 21 NO

2, June 1986

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Mandelker, Gershon, and S. Ghon Rhee, The Impact of the Degrees of Operating and

Financial Leverage on Systematic Risk of Common Stock, Journal of Financial and

Quantitative Analysis, Vol 19 No 1, March 1984.

Miller, Merton, Debt and Taxes, Journal of Finance, Vol 32 No 2, May 1977

Modigliani, Franco, and Merton Miller, The Cost of Capital, Corporation Finance, and

the Theory of Investment, American Economic Review, Vol. 48 No. 3, June 1958

November 1977

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