Question

How does a company’s use of financial leverage impact its risk premium (cost of equity)? What does Hamada equation describe?

Answer 1

Use of financial leverage is generally leading to increase in the risk premium of a investor in normal scenario because when there will be additional use of leverage, it would be meaning that the company is facing additional solvency risk due to additional amount of debt capital in its overall capital structure so the company will be having the fixed redemption and fixed repayment structure and hence it would be leading to increase in the overall risk of the company and it is meaning that the risk premium of the company in relation to the market has also increased.

Hamada equation is combining the Modigliani Miller approach along with Capital Asset pricing model and it advocates that when there will be higher amount of Beta coefficient, it will mean that the overall risk related to the company is increasing and if we are using the leverage, it will mean that the beta of the company is going down as the the beta associated with debt capital is lower and hence it would be leading to a lower risk for the company as we are using additional leverage and hence the risk premium will also go lower so hamada equation of risk premium advocates that use of additional leverage will be leading to lowering of the the overall risk associated with the business.