Hamada Equation is one of the many methods used in fundamental analysis. It ascertains the cost of capital of the firm, particularly where the firm has external debt. And it is an extension of the basic capital structure model/analysis. This concept is applicable in the case of a levered firm. A levered firm, where a company has both, equity as well as debt, in its capital structure. To optimize the cost of capital and the capital structure, the firm may increase the external debt component in the overall capital. Hamada equation calculator calculates the increase in the cost of capital due to an increase in debt. Thus it can help management to evaluate the effect of each level of debt increase.
This concept of the Hamada equation was developed by Robert Hamada, University of Chicago. It makes a distinction between the financial and business risks of the levered company. And this exclusively deals with the increase in the risk due to additional external debt.
To calculate levered beta through Hamada equation, the formula is:
βL = βU [1 + (1 – T) (D/E)]
Where, βL = Beta of a levered company
βU = Beta of unlevered company
T = Tax rate
D/E = Debt-Equity Ratio
We can also write this equation by interchanging the position of LHS and RHS values.
βU = βL / [1 + (1 – T) (D/E)]
Beta of Levered Company
The beta of a levered company or simply beta is a metric to measure the risk. It is used under the CAPM (Capital Asset Pricing Model).
Refer to the following link to know more about levered beta –
About the Calculator / Features
Hamada equation calculator is an easy-to-go calculator. The user simply has to provide the following data to it.
- Beta of unlevered company
- Tax rate
- Debt-Equity ratio
How to Calculate using Calculator
The person accessing the calculator is required to insert the following figures into the calculator for an instant calculation.
Beta of Unlevered Company
Unlevered company means a company that does not have any debt component in its capital structure. It is an ideal tool for making a comparison between companies having different levels of debt and no debt at all.
To know more about unlevered beta, you can check our article on Unlevered Beta
And, also – Unlevered Beta Calculator
It is the rate of tax levied on the earnings of the company.
It is the widely known standard ratio and a key ratio for any capital structure decision. Insert this ratio of debt to equity of the company into the calculator.
Assume that a company Max Ltd. has a debt to equity ratio is 0.65. The applicable tax rate is 35% and an unlevered beta is 0.80.
Levered Beta through Hamada Equation is:
βL = 0.80 [1 + (1 – 0.35) (0.65)] = 1.138
In the above example, an increase in debt or change in the financial leverage of the company increases the risk by 0.338 (that is, 1.138 – 0.80) or 34%. Hence, it suggests that changes in optimal capital structure or an increase in debt will lead to what extent of an increase in the risk of the company.
A major drawback of the Hamada equation is that it does not consider the default risk. Also, it lacks incorporation of credit spread.