Implications of Inconsistency in Adjusting the Cost of Capital for Leverage. A Note

Abstract

A common procedure for determining the cost of capital for capital investment decisions involves adjusting an unlevered beta for the risk of financial leverage. This note demonstrates that a widespread practice of levering the beta coefficients using the formula of Hamada implies a possibility of significant errors in the cost of capital estimates that may eventually yield implausible valuation results. To avoid potential distortions, the formula of Hamada should be replaced with a consistent expression relating the beta coefficients of unlevered equity, levered equity and debt.