Leverage Policy

Zoom Session 5
 References:
Chapter 14 of Brigham, E.F. and Houston, J.F., 2015. 13th
Edition. Fundamentals of financial management. Cengage

Chapter 16 & 17 Ehrhardt, M. C., & Brigham, E. F. (2011).

Financial management: theory and practice. South-Western
Cengage Learning.
Business • The riskiness inherent in the firm’s
operations if it uses no debt

Risk

Financial • An increase in stockholders’ risk,

over and above the firm’s basic
business risk, resulting from the
Risk use of financial leverage.
 Financial Risk
• An increase in stockholders’ risk, over and above the firm’s
basic business risk, resulting from the use of financial
leverage.
• If a firm uses debt (financial leverage), this concentrates
the business risk on common stockholders.
The Hamada Equation
It is harder to quantify leverage’s effects on the cost of
equity, but a theoretical formula can help measure the effect:
Practice Question
14-4) Harley Motors has $10 million in assets, which were financed with
$2 million of debt and $8 million in equity. Harley’s beta is currently 1.2,
and its tax rate is 40%. Use the Hamada equation to find Harley’s
unlevered beta, bU.
𝑏𝑙
𝑏𝑢 =
(1+ ( 1− 𝑇 ) ( )
𝐷
𝐸
)

1.2
𝑏𝑢 =
(1 + ( 1 − 0.40 ) ( )
2
8
)

𝑏𝑢 =1.043
Practice Question
Use the Hamada equation to calculate the unlevered beta for Firm X with
the following data: bL = 1.25, T = 40%, Debt/Assets = 0.42, and
Equity/Assets 0.58. (bU = 0.8714)
Practice Question
What would be the cost of equity for Firm X at Equity/Assets ratios of 1.0
(no debt) and 0.58 if rRF = 5% and RPM = 4%?
𝐷
𝑏𝑙 =𝑏𝑢 (1+ ( 1− 𝑇 ) )
𝐸
𝑏𝑙 =0.8714

𝑅𝑖 =𝑟 𝑓 +(𝑟 𝑚 − 𝑟 𝑓 ) 𝛽 𝑖
𝑅𝑖 =0.05+ ( 0.04 ) 0.8714 𝑅𝑖 =0.05+ ( 0.04 ) 1.25
𝑅𝑖 =8.49 % 𝑅𝑖 =0.1 𝑜𝑟 10 %
Thank you!