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26-11-2016

A firms cost of capital is a function of its business riskthe


risk associated with the firms investments or assets.
In a firm with no debt, the common shareholders face only
this business risk.
But if the firm carries debt (i.e., is leveraged), the common
shareholders also face financial risk: the risk that the firm
will not be able to service the debt and therefore will go
into bankruptcy.
Obviously, the more leverage, the greater the risk to the
common shareholders.
Financial risk, however, does not affect business risk;
leverage does not affect the firms assets.

If the beta of a firms debt is zero, the beta of its stock


will equal the firms asset beta.
The asset beta is equal to the sum of the weighted Thus, the firms asset beta can be expressed
average of the beta of the firms debt (D), and the beta algebraically as:
of the firms equity (E).

In this formula, D/V is the portion of the firms value


attributable to debt, and E/V is the portion of the
value attributable to equity.

If the beta of the firms debt is positive (meaning the Assume that a non-leveraged firm has an asset beta of
debt is sensitive to market moves), the beta for the 0.8.
firms equity will exceed the firms asset beta because Now assume that the firm takes on such substantial
of the financial risk associated with the debt. debt that debt represents 40% of the value of the firm
The weighted averages of the firms debt beta and and the debt has a beta of 0.2.
equity beta will equal the firms asset beta (i.e., the The firms equity beta can then be computed
beta of a non leveraged or low leveraged firm). algebraically using the earlier formula.

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26-11-2016

Using the earlier formula, the firms equity beta is 1.2. This result is intuitively appealing because it can be
expected that, as a firm becomes more and more
leveraged, the equity holders will demand a higher
return to compensate for the added financial risk.

If a firm has no debt (i.e., leverage) and only one type


of asset (e.g., cement plants) the firms equity beta will
also be its asset beta, and the equity beta could be T is the combined federal and state corporate income tax
expressed as the unlevered equity beta, u. rate, and D/E is the firms debt to equity ratio.
If, however, the firm has debt, the firms equity beta Thus, if the firm has no debt, the financial risk term
will reflect this leverage and can be expressed as a becomes zero and the firms cost of equity, rle, is
leveraged equity beta, l. determined by the standard form CAPM, with beta being
In a 1969 article, Robert Hamada set out a the unlevered beta, u.
mathematical formula for moving between levered Hamadas formula divides the required cost of equity
and unlevered betas, and the formula is commonly capital for the levered firm (rle) into three elements:
used today. (1) a risk-free rate, rf;
(2) a premium for business risk, u(rm - rf ); and
(3) a premium for financial risk, u(rm - rf )(1-T)(D/E).

Therefore, the firms market risk, which is measured


by [l], depends on both the firms business risk as
measured by u and its financial risk as measured by
u (1-T)(D/E).