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

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

Expert Solution

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.

jeff jeffy answered 2 years ago

What is the impact and risk of financial leverage?

5. Business and financial risk The impact of financial leverage on return on equity and earnings...

5. Business and financial risk The impact of financial leverage on return on equity and earnings per share Consider the following case of Happy Turtle Transportation Company: Suppose Happy Turtle Transportation Company is considering a project that will require $350,000 in assets. • The project is expected to produce earnings before interest and taxes (EBIT) of $45,000. • Common equity outstanding will be 15,000 shares. • The company incurs a tax rate of 30%. 1. If the project is financed...

How does a firm's financial leverage affect its profitability? Its level of risk?

what is a financial statement derivative. Identify an example and how company’s use to leverage the...

what is a financial statement derivative. Identify an example and how company’s use to leverage the business activities.

What is the concept of Financial Risk. How is it tied to financial leverage? and As an...

What is the concept of Financial Risk. How is it tied to financial leverage? and As an investor, why should this be important to you?

How does the industry impact a company’s risk? Would the risk associated with the industry/company you...

How does the industry impact a company’s risk? Would the risk associated with the industry/company you selected influence your decision to invest? Explain.

A firm's risk level will fluctuate as its changes. a) financial leverage, b) debt-to-equity, c) degree...

A firm's risk level will fluctuate as its changes. a) financial leverage, b) debt-to-equity, c) degree of financial leverage, d) all of the above?

What is the difference between 'business risk' and 'financial risk'? What is meant by financial leverage?

In problems where no equity risk premium or tax rate are provided, please use an equity...

In problems where no equity risk premium or tax rate are provided, please use an equity risk premium of 5.5% and a tax rate of 40%. 1. You have been given the following information on a project: • It has a five-year lifetime • The initial investment in the project will be $25 million, Year % of Depreciable Asset 1 40 2 20 3 14.4 4 13.3 5 13.3 • The revenues are expected to be $20 million next year and to grow 10% a year...

Which of the following does not impact your risk premium? A. Tenant Credit Risk B. Treasury...

Which of the following does not impact your risk premium? A. Tenant Credit Risk B. Treasury Rates C. Liquidity D. All the above impact your risk premiums

Question