Hamada Equation

a model which is based on CAPM, and adjusts for financial risk L = U[1 + (1 - T)(D/E)] U is the unleveraged (zero-debt) beta, L is the leveraged (levered) beta observe existing T, D/E and , and then rewrite the above to find U

U = L/[1 + (1 - T)(D/E)] can now estimate the L (the leveraged beta) for various D/E,
i.e. how rS (and PS) change when D/E (and D/A) changes rS = rRF + L(rM - rRF) rS = rRF + {U[1 + (1 - T)(D/E)]}(rM - rRF) rS = rRF + U(rM - rRF) business risk premium L L firms stock risk = = = + [ U(1 - T)(D/E)](rM - rRF) financial risk premium U[1 + (1 - T)(D/E)] U + U[(1 - T)(D/E)] firms financial risk recall:

risk-free rate back to the beta formula:

firms business risk +

Cost of Equity rS

D/E (or D/A)

D/E (or D/A)