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Incorporating default risk into Hamada's Equation for application to capital structure

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  • Cohen, Ruben D

Abstract

Implemented widely in the area of corporate finance, Hamada’s Equation enables one to separate the financial risk of a levered firm from its business risk. The relationship, which results from combining the Modigliani-Miller capital structuring theorems with the Capital Asset Pricing Model, is used extensively in practice, as well as in academia, to help determine the levered beta and, through it, the optimal capital structure of corporate firms. Despite its regular use in the industry, it is acknowledged that the equation does not incorporate the impact of default risk and, thus, credit spread - an inherent component within every levered institution. Several attempts have been made so far to correct this, but, for one reason or another, they all seem to have their faults. This, of course, presents a major setback, as there is a strong need, especially by practitioners, to have in place a solid methodology to enable them to assess a firm’s capital structure in a consistent manner. This work addresses the issue and provides a robust modification to Hamada’s Equation, which achieves this consistency.

Suggested Citation

  • Cohen, Ruben D, 2007. "Incorporating default risk into Hamada's Equation for application to capital structure," MPRA Paper 3190, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:3190
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    File URL: https://mpra.ub.uni-muenchen.de/3190/1/MPRA_paper_3190.pdf
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    References listed on IDEAS

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    1. Hamada, Robert S, 1972. "The Effect of the Firm's Capital Structure on the Systematic Risk of Common Stocks," Journal of Finance, American Finance Association, vol. 27(2), pages 435-452, May.
    2. Gonzalez, Nestor & Litzenberger, Robert & Rolfo, Jacques, 1977. "On Mean Variance Models of Capital Structure and the Absurdity of Their Predictions," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(2), pages 165-179, June.
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    1. repec:ath:journl:tome:31:v:3:y:2013:i:31:p:75-84 is not listed on IDEAS
    2. Sarmiento-Sabogal, Julio & Sadeghi, Mehdi, 2014. "Unlevered betas and the cost of equity capital: An empirical approach," The North American Journal of Economics and Finance, Elsevier, vol. 30(C), pages 90-105.
    3. Hayette Gatfaoui, 2010. "Capital Asset Pricing Model," Post-Print hal-00589904, HAL.
    4. Piyapas Tharavanij, 2021. "Optimal Book-Value Debt Ratio," SAGE Open, , vol. 11(1), pages 21582440209, February.
    5. Peter Reichling & Anastasiia Zbandut, 2017. "Costs of capital under credit risk," FEMM Working Papers 170003, Otto-von-Guericke University Magdeburg, Faculty of Economics and Management.

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    More about this item

    Keywords

    corporate finance; capital structure; optimal leverage; debt; equity; Modigliani-Miller; Hamada's Equation; beta;
    All these keywords.

    JEL classification:

    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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