26-11-2016
A firms cost of capital is a function of its business riskthe
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
average of the beta of the firms debt (D), and the beta
of the firms equity (E).
If the beta of the firms debt is positive (meaning the
debt is sensitive to market moves), the beta for the
firms equity will exceed the firms asset beta because
of the financial risk associated with the debt.
The weighted averages of the firms debt beta and
equity beta will equal the firms asset beta (i.e., the
beta of a non leveraged or low leveraged firm).
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.
Thus, the firms asset beta can be expressed
algebraically as:
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.
Assume that a non-leveraged firm has an asset beta of
0.8.
Now assume that the firm takes on such substantial
debt that debt represents 40% of the value of the firm
and the debt has a beta of 0.2.
The firms equity beta can then be computed
algebraically using the earlier formula.
1

Using the earlier formula, the firms equity beta is 1.2.
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
expressed as the unlevered equity beta, u.
If, however, the firm has debt, the firms equity beta
will reflect this leverage and can be expressed as a
leveraged equity beta, l.
In a 1969 article, Robert Hamada set out a
mathematical formula for moving between levered
and unlevered betas, and the formula is commonly
used today.
26-11-2016
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.
T is the combined federal and state corporate income tax
rate, and D/E is the firms debt to equity ratio.
Thus, if the firm has no debt, the financial risk term
becomes zero and the firms cost of equity, rle, is
determined by the standard form CAPM, with beta being
the unlevered beta, u.
Hamadas formula divides the required cost of equity
capital for the levered firm (rle) into three elements:
(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).