CAPITAL STRUCTURE AND LEVERAGE Applying the Hamada equation We previously introduced the concept of the Capital Asset Pricing Model (CAPM). The CAPM contends that all stocks have an element of market risk. This market risk is materialized in the form of beta, which is determined by the covariance of an asset's returns with the market returns divided by the variance of the market returns. We arrive at an asset beta by running a linear regression of an asset's returns against market returns. However, we have never really addressed the matter of what drives beta. In 1969, Robert Hamada published his paper, "Portfolio Analysis, Market Equilibrium, and Corporation Finance," wherein he combined the traditional CAPM and the Modigliani and Miller capital structure theory to create what is now called the "Hamada equation." The Hamada equation seeks to illustrate how financial leverage (by increasing debt)
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This note was uploaded on 04/20/2008 for the course BUS 4243 taught by Professor Marko.tengesdal during the Spring '08 term at Texas Woman's University.