The Hamada equation is a tool used to assess the cost of capital associated with increased financial leverage in a company. Leverage is a relationship between a company’s debt and equity, in which a ratio of the two is calculated. The higher the ratio, the more financial leverage a company has and the higher the debt burden is with its associated cost of capital. The Hamada equation was formulated in 1974 by Robert Hamada and was influenced by the Modigliani-Miller Capital Structure Theorem.

The Hamada equation states that the cost of capital of a firm (K) is a linear function of the cost of equity capital (Ke) and the beta coefficient of equity (βE). The equation is expressed as:

K = Ke + (1 + (D/E))βE

Where, K = cost of capital (debt and equity combined) Ke = cost of equity βE = the beta coefficient of equity D/E = the firms’ debt to equity ratio

The Modigliani-Miller theorem states that the total value of a company is not affected by changes in capital structure as long as there is an efficient markets and rational investors. However, the Hamada equation shows that the cost of capital can increase due to an increase in leverage if the debt to equity ratio is high.

The higher the beta coefficient, the higher the risk associated with the firm. The beta coefficient assesses the risk of holding a company’s stock, and depends both on the systematic risk and the unsystematic risk. Systemic risk is the inherent risk of the market, whole unsystematic risk relates to risks that only the firm is affected by. The debt taken on by a company adds risk to the stock, and a higher debt to equity ratio will lead to an increase in the cost of capital.

The Hamada equation is an important tool in analyzing a firm’s capital structure. Companies aim to have increased financial leverage to maximize their return, however the increased leverage may lead to an increase of risk, indicated by the Hamada equation. When implementing a new capital structure, companies should analyze their cost of capital carefully and compare the results with their expected return. As the Hamada equation shows, the cost of capital will increase with increasing leverage and firms must ensure that the return of their investments outweigh the costs.