Hamada Equation

AAA

DEFINITION of 'Hamada Equation'

A fundamental analysis method of analyzing a firm's costs of capital as it uses additional financial leverage, and how that relates to the overall riskiness of the firm. The measure is used to summarize the effects this type of leverage has on a firm's cost of capital (over and above the cost of capital as if the firm had no debt). The equation is:

Hamada Equation




INVESTOPEDIA EXPLAINS 'Hamada Equation'

The equation is used to determine the effects of financial leverage on a firm, as measured by the Hamada coefficient. The higher the coefficient, the higher the risk associated with the firm. For example, say a firm has a debt to equity ratio of 0.60, a tax rate of 33%, and a debt free beta of 0.95. The Hamada coefficient would be about 1.33 {0.95[1+(1-0.33)(0.60)]}. This means that financial leverage, for this firm, increases the overall risk by a factor of 0.38, or by 40%.

This equation quantifies the effects financial leverage has on a firm, and can serve as a quick and dirty analysis of a firm's overall business risk as it relates to the returns from the market overall.

RELATED TERMS
  1. Leverage Ratio

    Any ratio used to calculate the financial leverage of a company ...
  2. Cost Of Capital

    The required return necessary to make a capital budgeting project, ...
  3. Operating Leverage

    A measurement of the degree to which a firm or project incurs ...
  4. Leverage

    1. The use of various financial instruments or borrowed capital, ...
  5. High Beta Index

    An index composed of companies with high betas trading on the ...
  6. Beta

    A measure of the volatility, or systematic risk, of a security ...
RELATED FAQS
  1. As an investor in stock, how should I evaluate a company's capital employed?

    Before you evaluate a company's capital employed, you first need to nail down a consistent, working definition of capital ... Read Full Answer >>
  2. What is the difference between the cost of capital and the discount rate?

    The cost of capital refers to the actual cost of financing business activity through either debt or equity capital. The discount ... Read Full Answer >>
  3. Does increasing health consciousness among consumers make investing in fast food ...

    An increase in health consciousness does not necessarily make investments in fast food companies unwise, as convenience is ... Read Full Answer >>
  4. What risks does a business owner face under a business structure with unlimited liability?

    The risks that a business owner faces under a business structure with unlimited liability are literally unlimited, but they ... Read Full Answer >>
  5. What is the average price-to-earnings ratio in the chemicals sector?

    The price-to-earnings ratio (P/E) is an important valuation metric used in fundamental analysis. It tells investors how much ... Read Full Answer >>
  6. For what types of investments is the payout ratio the most relevant?

    The payout ratio is most relevant for investments that pay out dividends to shareholders. The payout ratio indicates the ... Read Full Answer >>
Related Articles
  1. Investing Basics

    Reading The Balance Sheet

    Learn about the components of the statement of financial position and how they relate to each other.
  2. Active Trading

    How Companies Use Derivatives To Hedge Risk

    Derivatives can reduce the risks associated with changes in foreign exchange rates, interest rates and commodity prices.
  3. Options & Futures

    Putting Management Under The Microscope

    We tell you where to find the telltale signs of corporate misdeeds.
  4. Fundamental Analysis

    Tesla Home Batteries Could Transform Your Electric Bill

    With limited daylight hours, solar power cannot power our homes at night, but Tesla Motors might help solve that problem.
  5. Fundamental Analysis

    Understanding Lululemon's Business Model

    Lululemon has succeeded in marketing more than just fitness apparel. The company has strategies for continued growth, but it faces tough competition.
  6. Home & Auto

    Buying a Home? The Best Places Share This Feature

    The most lucrative areas to invest in a home are cities where job growth is robust.
  7. Technical Indicators

    6 Stocks for Millennials (or Anyone)

    Savvy Millennial investors looking for long-term winners should take a look at these stocks.
  8. Personal Finance

    Top Healthcare, Medical Equipment Stocks of 2015

    A short list of the top healthcare and medical equipment stocks of 2015.
  9. Fundamental Analysis

    Calculating Future Value

    Future value is the value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today.
  10. Economics

    What is Deadweight Loss?

    Mainly used in economics, deadweight loss can be applied to any deficiency caused by an inefficient allocation of resources.

You May Also Like

Hot Definitions
  1. Stop-Loss Order

    An order placed with a broker to sell a security when it reaches a certain price. A stop-loss order is designed to limit ...
  2. Covered Call

    An options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset ...
  3. Butterfly Spread

    A neutral option strategy combining bull and bear spreads. Butterfly spreads use four option contracts with the same expiration ...
  4. Unlevered Beta

    A type of metric that compares the risk of an unlevered company to the risk of the market. The unlevered beta is the beta ...
  5. Moving Average - MA

    A widely used indicator in technical analysis that helps smooth out price action by filtering out the “noise” from random ...
  6. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
Trading Center