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. Cost Of Capital

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

    1. The use of various financial instruments or borrowed capital, ...
  3. Operating Leverage

    A measurement of the degree to which a firm or project incurs ...
  4. High Beta Index

    An index composed of companies with high betas trading on the ...
  5. Quantitative Analysis

    A business or financial analysis technique that seeks to understand ...
  6. Beta

    A measure of the volatility, or systematic risk, of a security ...
RELATED FAQS
  1. No results found.
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

    Efficiency Ratio

    There are many types of efficiency ratios, but all measure how well a company utilizes its resources to make a profit. Business managers use these ratios to determine how well they are operating ...
  5. Investing Basics

    What is Profit?

    Profit is a general term used to denote when earnings exceed the expenses incurred to generate those earnings.
  6. Investing

    Deferred Tax Liability

    Deferred tax liability is a tax that has been assessed or is due for the current period, but has not yet been paid. The deferral arises because of timing differences between the accrual of the ...
  7. Charts & Patterns

    Why These Are 2015's Most-Promising Bank Stocks

    Which bank stocks should offer the best bang for your buck in 2015? Possibly these, so read on.
  8. Fundamental Analysis

    Interested In Pharmaceutical Stocks? Try Novartis (ADR)

    Novartis AG, is the world's leading pharmaceutical company by sales. Here is a closer look at Novartis, and how its financials stack up.
  9. Fundamental Analysis

    Is Apple's Stock Over Valued Or Undervalued?

    Despite several drawbacks, the CAPM gives an overview of the level of return that investors should expect for bearing only systematic risk. Applying Apple, we get annual expected return of about ...
  10. Savings

    Top 10 Fastest Growing Industries in the United States

    Six of the ten fastest growing industries are directly related to new residential construction.

You May Also Like

Hot Definitions
  1. Technical Skills

    1. The knowledge and abilities needed to accomplish mathematical, engineering, scientific or computer-related duties, as ...
  2. Prepaid Expense

    A type of asset that arises on a balance sheet as a result of business making payments for goods and services to be received ...
  3. Gordon Growth Model

    A model for determining the intrinsic value of a stock, based on a future series of dividends that grow at a constant rate. ...
  4. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
  5. Law Of Supply

    A microeconomic law stating that, all other factors being equal, as the price of a good or service increases, the quantity ...
  6. Investment Grade

    A rating that indicates that a municipal or corporate bond has a relatively low risk of default. Bond rating firms, such ...
Trading Center