Robert Hamada combined the capital asset pricing model and the Modigliani and Miller capital structure theories to create the Hamada equation. There are two types of risk for a firm: financial and business. The business risk relates to the unlevered beta for the firm; the financial risk refers to the levered beta. An unlevered beta assumes zero debt. The Hamada equation illustrates that when a firm increases its debt, the financial leverage also increases the firm's risk and, in turn, its beta. Levered beta can be calculated based on the unlevered beta, tax rate, and debt-to-equity ratio.

Gather the following information about the company: unlevered beta; tax rate; and the debt-to-equity ratio (see Resources). The tax rate varies, based on the location and size of the firm. You must estimate the tax rate.

Multiply the debt-to-equity ratio by 1 minus the tax rate, and add 1 to this amount. For example, with a tax rate of 26.2 percent, a debt-to-equity ratio of 1.54 and a beta of 0.74, the resulting value is 2.13652 (1.54 times (1-.40))+1).

Multiply the amount in Step 3 by the unlevered beta to get the levered beta. In the example above, the levered beta would be 1.58 (2.13652 times 0.74).

References

About the Author

Shreya Mehta graduated from the University of Massachusetts with a Bachelors degree in business administration with a double concentration in finance and MIS. She attended Bentley College to obtain a MBA in finance and Masters in IT. She has been working for a financial software company for the past three years as an associate content manager.

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